Policy Formation in Railroad Finance: Refinancing the Burlington, 1936-1945 [Reprint 2014 ed.] 9780674423220, 9780674423206

Citation preview

Policy Formation in Railroad Finance

STUDIES IN E C O N O M I C H I S T O R Y Published in cooperation with the Committee on Research in Economic History

Policy Formation in Railroad Finance REFINANCING THE B U R L I N G T O N 1936-1945

John Tettemer O'Neil

Cambridge, Massachusetts HARVARD UNIVERSITY PRESS I

95

6

© 1956 by the President and Fellows of Harvard College

Distributed in Great Britain by Geo§rey Cumberlege Oxford University Press London

Library of Congress Catalog Card Number: 56-9024 Printed in the United States of America

TO

Mildred Katherine McCloskey O'Neil

ACKNOWLEDGMENTS Without invaluable aid and assistance from many sources, this case history of the Burlington System's refinancing in 1944-45 could never have been written. The most fundamental debt of gratitude that the author wishes to acknowledge is that to the officials of the Chicago, Burlington & Quincy Railroad. The patience and helpfulness, shown on innumerable occasions, of President Ralph Budd, Vice President J. C. James, and Assistant to General Counsel Richard T. Cubbage permitted the author to clarify many points left obscure in the written record. Moreover, it was they who made available the basic data from which the study was prepared. The full extent of the author's indebtedness to Professor Richard C. Overton of the Northwestern University School of Commerce can never be fully expressed. Professor Overton was primarily responsible for the laborious sifting and accumulation of the data from the Burlington's files. Both Professor Overton and Professor Kent Healy of Yale University conducted original interviews with the Burlington's officials and their bankers with the purpose of amplifying the written record, and transcripts of their interviews have proven immeasurably helpful to the author in his effort to explain motives prompting certain decisions. Professor Overton is also to be given credit for originally introducing the author to the possibility of conducting the present investigation. Moreover, the author wishes to express his appreciation for the critical assistance rendered by Mr. R. T. Cubbage of the Burlington Railroad and Mr. A. N. Jones of Morgan Stanley and Company, for reading the manuscript and offering many helpful suggestions. Of course the author accepts full responsibility for the completed work. Finally, the author wishes to acknowledge the aid granted him by the Committee on Research in Economic History at Harvard University under Mr. Arthur H. Cole's chairmanship. This assistance has made publication possible. J O H N TETTEMER

Chapel Hill, North Carolina

o'NEIL

CONTENTS List of Abbreviations

facing page

i

INTRODUCTION I

THE PROBLEM AND ITS BACKGROUND

7

A. Physical development of the Burlington System B. Financial evolution: Developments, 1874-1899; Creation of the Illinois Division bonds, 1899; Development of the general mortgage bonds, 1908; Weaknesses in the general mortgage financial arrangements; Creation of the first and refunding mortgage, 1921 II

THE APPROACHING BONDS

MATURITY

OF ILLINOIS

DIVISION 27

A. Developments up to 1936 B. Developments, 1937-1940: Retirement provisions of the Illinois Division mortgage; Financial condition of the Burlington's competitors; The Burlington's credit position III

F I R S T EFFORTS TO F O R M U L A T E A F I N A N C I A L P L A N

48

A. Internal consideration of the problem: Preliminary explorations; Appointment of a committee to create a financial plan; The 1941 financial plan developed by the special committee B. Resumption of efforts in 1942 C. A bond-purchasing program is adopted IV

I N I T I A L A P P L I C A T I O N OF T H E D E V E L O P E D POLICY

FINANCIAL 61

A. Difficulty is encountered in the magnitude of the bond-buying program; Aid is sought from bankers in furtherance of the program B. An agreement is reached to continue bond purchases V VI

M O D I F I C A T I O N OF P O L I C Y A N D C L A R I F I C A T I O N OBJECTIVES

OF

T H E D E V E L O P I N G F E A S I B I L I T Y OF C A L L I N G T H E NOIS DIVISION BONDS

77 ILLI-

A. Additional purchases of bonds is authorized: Shall purchases be made at prices over par? B. Emergence of the possibility of redeeming bonds before maturity C. The initial development of refunding plans

88

CONTENTS

X

VII

T H E C R E A T I O N OF F I N A L P L A N S FOR R E F U N D I N G ILLINOIS DIVISION M A T U R I T I E S

hi

A. A decision is reached to follow up Morgan Stanley's proposals B. A conference is arranged to discuss development of refunding plans C. Morgan Stanley submits alternative refunding plans D. Selection of an appropriate refunding plan E. Characteristics and antecedents of the refunding plan finally created VIII

E X E C U T I O N OF T H E A P P R O V E D F I N A N C I A L P L A N

139

A. Policy formulation contrasted with its application B. Preparation of the mortgage indenture and I C C application — First details C. When will the Illinois Division bonds be redeemed? D. Distribution of the $10,000,000 serial notes E. Final details in rounding out the proposed plan F. Finance docket 14535 — ICC approval granted and serial notes sold IX

PUBLIC A T T A C K S UPON T H E BURLINGTON'S R E F U N D I N G PLAN

157

A. The question of competitive bidding B. Attacks upon the Burlington's perfected refunding plan X

SUBSEQUENT R E F U N D I N G OPERATIONS A. B. C. D.

172

Background for action Principles of financial policy to be applied Subsequent refunding operations Reduction in funded debt and interest charges, 1945 compared with 1940

E. Conclusion APPENDIX

189

BIBLIOGRAPHY

211

NOTES

215

Map Chicago, Burlington and Quincy Railroad Mortgages as of 1936 Facing 31 Chart Market quotations of selected C. B. & Q. Railroad bonds, 1928-1942, average of monthly high-low prices

46

TABLES 1. Funded debt of the Burlington, 1936. 2. Growth of the Burlington System to 1940.

8 10

3. Northern lines' participation in the Burlington in 1901.

10

4. Chicago, Burlington & Quincy Railroad Company freight tonnage and revenue, 1936.

12

5. Liabilities and net worth, C. B. & Q., at the beginning and end of a quarter-century, 1874 and 1899.

13

6. Chicago, Burlington & Quincy Railroad Company funded and contingent debt as of June 30, 1899.

15

7. Condensed balance sheet of C. B. & Q. debt, June 30, 1907.

17

8. Outstanding C. B. & Q. bonds in 1908 specified for refunding by the General Mortgage.

17

9. Issue of C. B. & Q. General Mortgage bonds, 1908-1920.

19

10. The long-term debt account of the C. B. & Q. in 1931. 11. Funded debt as a percentage of property investment, C. B. & Q., competitive roads, and Class I roads, December 31, 1932. 12. The C. B. & Q. compared with competitive railroads: selected income data, 1928-1940.

25 30 36

13. T h e Burlington's competitive position in comparison with reorganized roads: 1940 and 1945 capital charges.

41

14. Capital structures for Class I line-haul railways in the whole United States and in the Western District, 1943 (selected items from balancesheet).

42

15. Chicago, Burlington and Quincy Railroad Company, net income and dividends, 1928-1944. 16. Comparison of the outstanding debt with the value of the security and the percentage of business carried for the Burlington's three mortgages, December 31, 1939. 17. Chicago, Burlington and Quincy Railroad Company, quarterly net earnings, 1941-1942, compared.

45

Si 70

18. Bond-purchasing program suggested by S. B. Payne, January 20, 1943. 19. Operating revenues, fixed and contingent charges selected Class I railroads; 1942 charges compared with average 1937-1939 revenues.

78 85

20. Gross operating income of the C. B. & Q. for selected months, 19421944, compared.

111

21. Morgan Stanley's alternative proposals for refunding plans, adapted from a memorandum prepared b y A. N . Jones, March 20, 1944.

122

22. The effect of Alternative C of J. C. James' compromise refunding plan as related to General and F & R Mortgage bonds outstanding.

132

TABLES 23. Comparison of net earnings, C. B. & Q., first quarter, 1944. 24. Chicago, Burlington & Quincy Railroad Company, pro forma statement of long-term debt, August 31, 1944. 25. Chicago, Burlington & Quincy Railroad Company, steps in 1944-45 refinancing. 26. Chicago, Burlington & Quincy Railroad Company, long-term debt and fixed charges 1940 compared with 1945. 27. Reduction of long-term debt, the C. B. & Q. compared with its competitors in 1945 and 1940. 28. Long-term debt and fixed charges 1940 and 1945, C. B. & Q. compared with Class I line-haul railways and for the Western District.

141 176 181 183 184 185

Appendix I V A. Monthly high-low prices on selected C. B. & Q. bonds. B. Semiannual yields, Illinois Division 3J^'s compared with Moody's Aaa rail bond yield averages. C. C. B. & Q. Railroad Company, reported cash assets monthly, 19431944-

203 209 210

Policy Formation in Railroad Finance

ABBREVIATIONS A. T. & S. F.

Atchison, Topeka and Santa Fe Railway Company

CBQ

Chicago, Burlington & Quincy Railroad Company

C. B. & Q.

Chicago, Burlington & Quincy Railroad Company

C. & E. I.

Chicago & Eastern Illinois Railroad

C. M. & St. P.

Chicago, Milwaukee, St. Paul and Pacific Railroad

C. & N. W.

Chicago and North Western Railway

C. & O.

Chesapeake & Ohio Railway

CR

Corporate Records of the Chicago, Burlington & Quincy Railroad Company. (For description of this material, see Bibliography.)

C. R. I. & P.

Chicago, Rock Island and Pacific Railroad Company

G. N.

Great Northern Railway

G. W.

Great Western Railway

I. C.

Illinois Central Railroad

Mo. Pac.

Missouri Pacific Railroad

N. & W.

Norfolk and Western Railway

N. Y. C.

New York Central System

N. Y. C. & St. L.

New York, Chicago and St. Louis Rail Road

Pa. RR.

Pennsylvania Railroad

S. P.

Southern Pacific Company

U. P.

Union Pacific Railroad

W. P.

Western Pacific Railroad

INTRODUCTION Every day many business enterprises find it necessary to turn to the money markets of the world in order to provide funds so that their operations may continue. T h e success or failure of business managers to make desirable financial arrangements is reported by the financial press, sometimes in a prosaic manner and sometimes luridly. When the failures lead to spectacular debacles, the public is informed, usually in considerable detail, of incompetent or inept or downright unlucky business decisions that led to the fiasco. But when the arrangements have been successful, the public learns from inconsequential press notices, or even hearsay, that such-and-such a company has completed "successfully" its efforts to raise new capital or refund existing obligations. What, then, are the facts that lie behind a successful rapprochement with the money market? The technical considerations that make for a satisfactory financial plan have been catalogued, reviewed, and evaluated b y numerous experts. Books on corporation finance, corporate financial problems, and financial policy delineate with care the ideal arrangements for which shrewd financial managers strive. Unavoidably, however, individual competitive problems, peculiar aspects of governmental business relationships, timing, and special considerations unique to a given concern all interfere with the easy attainment of this ideal. Y e t daily agreements are reached between representatives of the money markets and representatives of business seeking funds. B u t the press reports simply, " I t was done." This investigation proposes to examine as a case history the chain of managerial decisions that evolved an adequate financial policy for an important railroad corporation. It proposes to fill the gap that is implicit upon reading the two following quotations: the first of June 8, 1942, and the second of April 23, 1944. There is, finally, the question of how [The Chicago, Burlington & Quincy Railroad Company] is to refund over $84 million Illinois Division First Mortgage ¿yís and 4s due July 1, 1949. At this time there is no very clear evidence to support the view that seven years from now junior bonds could be issued and sold to provide funds for retirement of the Illinois Division issues. Thus, at present there would appear two alternatives: (1) to extend the maturity of the Illinois Division bonds, but since these might not be readily salable in 1949, payment of the principal due to the old bondholders

2

POLICY FORMATION IN RAILROAD FINANCE

unwilling to accept extension, might depend upon (2) financial assistance from some government agency . . . We feel it is quite possible that as maturity approaches there will be increasing question as to whether or not holders of the maturing bonds will receive prompt payment when due . . T h e foregoing quotation contrasted with the following notice reveals what progress had been made in the development of a successful financial program: Ralph Budd, president of the Chicago, Burlington & Quincy Railroad, announced today that the road had filed a refunding plan with the Interstate Commerce Commission to call all of its outstanding Illinois Division mortgage bonds. The plan constitutes the largest railroad refunding plan in recent years . . . Mr. Budd said the company had firm commitments from insurance companies to purchase at par the [proposed $30,000,000 of] collateral trust 3^2 percent bonds [to be used together with cash and $10,000,000 of serial notes in the retirement of all the Illinois Division bonds] . . ? Perhaps in amplifying the stark comment, " I t was done," sound precepts for managerial decisions in lines of endeavor other than railroad finance will be illuminated. M a n y of the problems faced by the Burlington were peculiar to its own circumstances, but in broad outline they were in no sense unique. W e have here, rather, a test-tube problem from which can be distilled the essence of managerial practice — principles frequently lost sight of in the day-to-day conduct of business affairs, but which in a cumulative manner create the policies upon which successful enterprises must be conducted. T h e material on which this history is based was made available subsequent to a conversation between President Ralph Budd and Mr. Richard C. Overton, officers of the Chicago, Burlington & Quincy Railroad, in the spring of 1944. After the refinancing plan for the Illinois Division bonds had been perfected, President Budd originated the idea of making a case study of the development of the adopted plan. Burlington officials were gratified with the achievement of a successful solution to their financial problem and understandably concerned by public attacks which were then being made upon the program. President Budd believed that an analysis of the motives and decisions associated with the creation and adoption of the plan would provide not only an adequate answer to public criticism but also an invaluable addition to the history of American business finance. Accordingly, President Budd made an impersonal suggestion to Mr. Overton that if some qualified scholar would agree to prepare a critical case history of the steps leading to the development of the Illinois Divi-

INTRODUCTION

3

sion bond refinancing program, the Burlington would in turn give unrestricted access not only to its correspondence and documentary files, but also, for any supplementary interviews deemed necessary or desirable, to those officers associated with the creation of the plan. It was this opportunity which made available to the writer the entire source material pertinent to the development of the Illinois Division bond refinancing program. The bulk of the material consists of letters, memoranda, and unpublished reports prepared by officials of the Burlington and by the railroad company's financial advisers. Almost all of these documents are on file in the law department offices of the Burlington, although some of the material is located in both the president's and secretary's offices. It has been the aim of the writer to select and synthesize chronologically that portion of these records which exhibit the slow, tortuous formation of a policy designed to provide for the refinancing of the Illinois Division bonds and to establish a tenable long-run financial structure. Although the files of the Burlington are remarkably complete in so far as the final stages of various plans are concerned, it is inevitable that certain omissions appear in connection with the origins or progressive development of a few significant decisions. Thus, the record is silent with respect to the railroad company's reasons for relying upon J. P. Morgan and Company rather than Morgan Stanley and Company in the early stages of the formation of its financial policy. Where available material does not permit indisputable inferences, the company's files have been supplemented by interviews with those officials associated with the problem under discussion. In this way the written record has been extended, amplified, and clarified, and in some instances modified on the basis of subsequent personal interpretations. In addition to the "internal" evidence bearing upon the formation of the company's financial policy, the writer has made use of contemporary published material, both relating to the financial position of the Burlington and bearing upon problems similar to those whose solutions were of concern to the Burlington's officials. Thus, decisions of the Interstate Commerce Commission, financial plans evolved by other railroads, and even the opinions of financial advisory services all had a discernible effect upon the policy created by the company. Although the primary emphasis has been to trace the steps in the formation and application of a financial policy developed to provide for the refinancing of $85,000,000 Illinois Division Mortgage Bonds, there has been undertaken a critical evaluation of the various phases of the developing plan in the light of financial expediency and suitability to the Burlington's needs. While the company's policy was forged to handle the Illinois Division bond maturity, it did in fact pro-

4

POLICY FORMATION I N RAILROAD FINANCE

vide the basis for extensive subsequent refinancing. Since the later modification of the company's capital structure represented merely the application of the ultimately created policy, it is not treated in detail in this study, but it is introduced to round out the picture of the beneficial results of the perfected financial program. It is not the purpose of this analysis to explore the desirability of applying other methods of refinancing than the one actually chosen by the Burlington's officers. Since, however, it is intended to examine the development of a policy to provide for the refinancing of maturing debt, it would perhaps be best to specify the meaning of the term as used in this history. As defined in Guthmann and Dougall's Corporate Financial Policy, refinancing ". . . involves the sale of securities to retire existing obligations." 3 In one sense the term as used in this paper is broader and in another narrower than the quoted definition. Since the purpose is to examine the Chicago, Burlington & Quincy Railroad Company's financial problems, "refinancing" will be restricted to mean the sale of new securities to provide funds for the retirement of debt obligations. The term is also used in connection with the renewal or extension of existing obligations, since this action frequently creates a security with "new" characteristics, and is tantamount to the "sale" of a new issue to replace an old one. The concept of refinancing thus employed may conveniently be clarified by a simple illustration. An enterprise decides to borrow from some source certain funds which it intends to use in its business. The terms of the loan may be such that the entire amount borrowed becomes due at a specified future date. If we assume that the firm decides during the life of the loan that it prefers to retain in its business the funds supplied by the lender for a longer period than the original maturity date would permit, the enterprise must either make new arrangements with the original source or find a new source of funds. (Of course, the borrowing firm may have intended initially to retain these funds permanently.) The effort to renew the loan, or find a new source of funds outside the business is the meaning ascribed in this paper to "refinancing." Naturally there are several methods that may be followed to accomplish this refinancing. If the corporation intends to avoid bankruptcy, there would appear to be three courses of action from which to choose. First, the managers of the enterprise might elect to pay off the debt entirely. Second, they might seek to obtain the consent of the lender to an extension of the maturity date. Third, they might choose a compromise plan, paying part of the loan and renewing the balance. To obtain funds for entire or part payment, the company might, of course,

INTRODUCTION

5

use its own cash beyond the amount needed in its daily operations, or raise new funds either by borrowing from some other source or by obtaining equity funds from existing or new owners. Since the first of these methods, retirement of the debt, may be accomplished by applying funds previously accumulated for the purpose from daily operations, this procedure is excluded from the meaning here ascribed to refinancing. But if the decision to retire all or part of the loan requires the provision of funds from some external source, then the case is properly considered one of refinancing. The foregoing simplification of the methods that may be followed in refinancing maturing debt must be supplemented in two important respects before it can be held to conform to the reality of a refinancing operation such as that faced by the managers of the Burlington. First, there is the matter of the timing of the refinancing operation, whether before or at maturity. Second, there is the matter of the form of the financial instruments that will be used to provide the funds needed to replace the maturing debt. The method of refinancing to be followed may be influenced by the ability of the borrower to take action before the maturity date specified by the loan. That is, when a loan is created, its terms may give the borrower the option of repaying the debt before maturity. The bonds issued in evidence of the debt may thus be made "callable." This option to call outstanding bonds has itself a dual nature. That is, the privilege may be exercisable only if the entire loan is paid before maturity, or it may be exercisable with respect to only a fraction of the entire loan. If the loan is callable in part, the borrower obviously faces a more flexible situation in that his decision to refinance before maturity can be made with reference to a relatively small amount of the funds he has borrowed. Yet, on the other hand, the loan created may not have included any provision for retirement before the specified maturity date. This, however, would not absolutely prevent the borrowing corporation from paying its debt in advance of the maturity of the loan. Such a possibility follows from the fact that the loan may be in the form of small "pieces" that are traded in the financial markets subsequent to their original issuance. Hence, the borrowing corporation may simply buy up its outstanding "pieces" of loans, or bonds, from those holders who wish to obtain cash without waiting until the specified maturity. If a broad and free market exists for a corporation's bonds, even though they are not callable, it follows that refinancing might be undertaken prior to maturity. However, the corporation is not protected by a specified price at which it may purchase these securities, as in the case of callable bonds, and therefore may discover that its efforts to purchase

6

POLICY FORMATION IN RAILROAD FINANCE

outstanding bonds as part of a refinancing program serve to force the price of its bonds up to levels where the cost of obtaining them nullifies any advantage that might be derived from purchasing and retiring those bonds before maturity. T h e problem of refinancing maturing debt thus narrows down ultimately to three decisions. First, shall the loan be refinanced before maturity? Second, what particular sources shall be utilized to obtain the funds for refinancing the maturing debt? Third, what particular financial instrument shall be created to obtain the needed funds? Decision on this final query is closely connected with that which must be made as to sources of funds. Initially there is the question as to whether equity capital will be utilized or whether the new funds will be in the form of loans. In the former instance, new issues of common or preferred stock may be sold, and in the latter the problem is one of deciding on bonds secured by a mortgage on property, or secured b y hypothecated collateral, or secured by the general credit of the corporation alone. T h e decisions of the Burlington's officers upon these several problems entered into this case as the company's financial policy was being developed. An attempt will be made to evaluate critically the extent to which one plan rather than another was considered by the Burlington's executives as appropriate to the company's needs. B u t it is outside the scope of this study, which seeks merely to trace the formation and application of a specified financial policy, to argue the merits of any method of refinancing that might have been followed, but wasn't, against those of the method that was followed.

Chapter One

THE PROBLEM AND ITS BACKGROUND The problem faced by the Chicago, Burlington & Quincy Railroad in the years preceding the maturity in 1949 of its Illinois Division bonds was not at all unique in the history of American railroad finance. Like all large carriers, the Burlington had relied during its period of expansion more upon borrowed capital than the sale of stock to finance its growth. 1 The funded debt created, however, did not grow to unmanageable proportions, as was the case with numerous less fortunate roads whose earnings proved insufficient to meet the burden of fixed charges in times of economic stress. Nevertheless, the contracts under which the Burlington obtained capital were characterized by rigidities that have been associated with financial practices of weak roads.2 It was in the year 1936 that the management of the Burlington first called attention in its Annual Report to the financial problems presented by certain rigidities in its debt structure. According to the report of that year the funded debt of the Burlington amounted to $223,622,000 as is shown in Table 1. The rigidities of this 1936 debt structure grew out of inflexible call provisions which as early as 1932 were recognized by the management as a matter of increasing financial concern. Of the obligations3 listed in Table 1, the General Mortgage bonds and Equipment Obligations, or approximately 31 per cent of the total, were noncallable. The Illinois Division bonds, nearly 38 per cent of the total, contained call provisions, but these were available only if the entire issue were redeemed at one time. The remaining debt was likewise callable as a whole only, though not beginning until 1942 for the Series A and until 1952 for the Series B First and Refunding Mortgage bonds.4 The maturity dates of these issues reveals, moreover, that from the beginning of 1937 only twelve-and-one-half years remained to provide for the maturity of over eighty-four million dollars or 38 per cent of the Burlington's outstanding debt.

8

POLICY FORMATION IN RAILROAD FINANCE

Table I. Funded debt of the Burlington, 1936 Date of maturity Mortgage bonds Illinois Division 3^2's and 4's General Mortgage 4's First and Refunding Series A 5's Series B 4>i's

Amount outstanding

$ 84,425,000 65,247,000

July I, 1949 March 1, 1958 February 1, 1971 February 1, 1977

40,000,000 30,000,000 $219,672,000

Equipment obligations Equipment Trust of 1936

Annually $395,000 to M a y I, 1946

3,950,000

Total m D a t a taken from Chicago, Burlington & Quincy Railroad Company, Eighty-Third Ï93 6 ), P- 20.

$223,622,000 Annual

Report (Chicago,

In the simplest terms, the financial problem faced in 1936 by the Burlington was that of laying the groundwork for" refinancing or retiring its sizable Illinois Division Mortgage bonds. The solution to this problem, moreover, was inextricably associated with the historical background which gave rise to the maturing securities. A . PHYSICAL DEVELOPMENT OF THE BURLINGTON SYSTEM

The Chicago, Burlington & Quincy Railroad Company (or, more simply, the Burlington) is the corporate outgrowth of four separate Illinois railroad companies, three of which were granted charters in 1849 and the fourth in 1851. 5 In 1856 two of these original companies consolidated under the name of The Chicago, Burlington and Quincy Rail Road Company. 6 Six years later, in 1864, the enlarged company purchased at a receiver's sale7 the property of one of the remaining roads and upon receiving title changed its name to the present corporate form.8 Finally, in 1865, the last of the original roads was absorbed by the Burlington 9 and the title of the railroad — Chicago, Burlington & Quincy — almost exactly described the territory served by the company's lines. Thus, by the end of the Civil War, the Burlington was a singularly clean and straightforward railroad property passing through the heart of the rich Illinois prairie land. From Chicago, the main line extended westward through Aurora, Mendota, and Galesburg to a point on the Mississippi at East Burlington. From Galesburg, one leg dropped southwestward to another point on the Mississippi at Quincy and the other

T H E PROBLEM AND ITS BACKGROUND

9

leg southeastward from Galesburg to Peoria. 10 A branch extending 30 miles south from the Peoria leg completed the property, making a system whose over-all length was 400 miles. 11 From 1866 to 1940 the growth of the Burlington may be broken into three overlapping but reasonably distinct periods. Between 1866 and 1875 the company was engaged in developing its lines westward through Iowa and across the Missouri River from Plattsmouth to a connection with the Union Pacific at Fort Kearney, Nebraska. 1 2 This period also was characterized by the perfecting of its railroad network in Illinois, particularly in reaching farther southward to the all important Illinois coal fields. During this nine-year interval the mileage operated by the company increased from 400 to 1297. 13 T h e second of these three periods, from 1876 to 1900, was marked by intensive expansion to the north, south, and west. During these years the Burlington added the greatest portion of its existing mileage. Minneapolis and St. Paul to the north of Chicago were rapidly growing in importance as market and transfer points for forest products and items of import trade originating on the transcontinental Northern Pacific Railroad and the subsequently named Great Northern Railroad. Since many of these products were destined for Chicago and the East, the Burlington sponsored an entirely new road, the Chicago, Burlington and Northern, to connect Chicago with the Twin Cities. 14 T o the south, branches were built in southern Iowa and Missouri, while in the latter state the Hannibal and St. Joseph Railroad was purchased as a going unit. 15 In Illinois, lines were extended southward to tap the coal regions around Centralia. T o the west the Burlington reached the Rockies by completing in 1882 its main line to Denver, where subsequent connection with the Colorado and Southern Railway Lines gave ultimate access to Texas and the Gulf of Mexico. In the northwest the road was pushed through Nebraska, South Dakota, and Wyoming to a connection with the Northern Pacific at Billings, Montana, while another branch through central Nebraska reached a terminus at Cheyenne to make additional connections with the Colorado and Southern and also with the Union Pacific. In all, the owned mileage increased from 1297 to 7661 16 during this middle period of 25 years. T h e Burlington left its era of youthful growth with the arrival of the twentieth century. In fact, the net growth of operated lines was only 1297 miles during the following 39 years to reach the 8958 operated at the end of 1940, and these miles were mainly added to improve the coverage of the existing property. T h e retardation in the rate of expansion, however, was only outward evidence that the Burlington had entered a new stage in its historical development. T h e real reason the C. B. & Q. did not continue its trek westward to the Pacific,

10

POLICY FORMATION I N RAILROAD FINANCE

Table 2. Growth of the Burlington System to IÇ40. Mileage operated 4

E n d of period Formative period 1 8 4 9 - 1 8 6 5 Network to Missouri River 1 8 6 6 - 1 8 7 5 . . . . Extension of system 1 8 7 6 - 1 9 0 0 Control by Northern lines 1 9 0 1 - 1 9 4 0 . . . .

400 1297 7661 8958

Average annual growth

25

90

253 33 b

• Mileage d a t a from C B Q Annual Reports of 1866, 1876, 1900, and 1940. b While the values for average annual growth over the 1 8 4 9 - 1 9 0 0 interval do accurately reflect the policy of expansion for the period, the average of 3 3 miles per year from 1 9 0 1 to 1940 is somewhat misleading. Mileage grew steadily, in f a c t , to 9282 operated at the end of 1908, an average of 203 miles per year for the eight years. T h i s increase in mileage, however, represented for the most part the completion of plans put into operation prior to 1 9 0 1 . Subsequent to 1908, mileage declined to 9074 in 1 9 1 2 , increased gradually again to a peak of 9406 in 1923, and since that time has fallen off to the 8958 miles operated at the end of 1940. (See C B Q Annual Reports, 1900 et, seq.)

as so many of the Midwestern trunk lines had done, lay in a change of ownership of the line which took place in 1 9 0 1 . 1 7 It was that year when the modern era of the Burlington began. A s the final period got under way, there were to the north of the territory served by the C. B. & Q. two railroads operating from Minesota to the Pacific: the Great Northern and the Northern Pacific systems. In 1897, both of these so-called Northern lines were controlled by James J . Hill, but neither road had access to Chicago (and hence the E a s t ) over their own or controlled right of way. In casting about for some railroad that would provide the desired access, Hill decided upon the Burlington. After securing backing from J . P. Morgan and Company, Hill used the credit of the Northern lines jointly to effect the purchase of a majority of the outstanding C. B . & Q. common stock at a price of $ 2 0 0 a share. Completion of the acquisition by J u l y 3 1 , 1 9 0 1 , resulted in the issue of Northern Pacific and Great Northern 4 per cent joint C. B. & Q. Collateral Trust bonds of 1 9 2 1 against Burlington stock as shown in Table 3. Thus, for 2 1 5 Table 3. Northern lines' participation in the Burlington in igoi.

Company Northern Pacific Great Northern Other holders Total

Par value of bonds issued

Control of shares of C.B.&Q. stock

Percentage of total shares

$107,577,200 107,577,200 —

537,886 537,886 30,005

48.64 48.64 2.72

$215,154,400

1,105,777

100.00

T H E PROBLEM AND ITS BACKGROUND

II

millions of dollars the Northern lines obtained more than 97 per cent of the common stock of the C. B. & Q. and with it, control over the affairs of an excellently integrated property the lines of which were highly complementary to those of the new owners.18 In 1901, therefore, independent management of the Burlington terminated. The control exercised over the C. B. & Q. by its new managers resolved itself after initial adjustments mainly into direction of financial policy, while operating policy was left in the hands of the road's own administrative officers. There is, in fact, little incontrovertible outward evidence that the affairs of the Burlington were guided solely by the interests of the Northern lines. Yet, as described below, the Burlington's financial policy with respect to dividend payments and certain efforts to modify its financial structure appear conceived so little toward furthering the road's own self-interest (if not directly opposed to it) that it may be suggested that these decisions were affected primarily by the interests of the parent lines. As indicated in Table 2, expansion of the C. B. & Q. did not entirely cease in the years following change of control, but the policy followed was that of serving the existing territory more thoroughly. To that end, new feeder and connecting branches were acquired and built both east and west of the Missouri River. The only exception to this policy was the purchase of the Colorado and Southern Railway Company in 1908 which, as previously noted, provided the Burlington with connections from its western terminus to Texas and the Gulf. The interchange of business assured by the new relationship with the Northern lines, the purchase of the Colorado and Southern, and the intensive development of the territory already served by the Burlington suggest the diversity of traffic that characterizes the modern C. B. & Q. railway system. Because of its geographical location, the Burlington was clearly built to serve a region that was chiefly agricultural. Beyond operating simply as a carrier of freight and traffic, however, the company took an active and continuing interest in the colonization and agricultural development of the area. 19 Testimony to the importance which the Burlington assigns the prosperity of the farmer is to be found in the fact that the company's annual reports invariably devote a section to the consideration of agricultural conditions in the railroad's territory. Though the railroad is still classified as a Granger Road, the industrial growth of the Midwest, plus both the expansion of the Burlington into the Illinois coal fields and the railroad's traffic connections with the Colorado and Southern and the Northern lines, have deemphasized the quantitative significance of the Burlington's agricultural tonnage. Table 4 presents a breakdown of freight revenue and tonnage for the

12

POLICY FORMATION IN RAILROAD FINANCE

year 1936, a year typical for the ranking of the various freight classifications in the decade 1929-1938. Table 4. Chicago, Burlington & Quincy Railroad Company freight tonnage and revenue, 1936."

Tonnage

Category Agriculture Animals

Mines Forests Manufactures

Less-carload tonnage Total R

Revenue

{thousands of tons)

{per cent)

{thousands of dollars)

{per cent)

6,009 1,520

!9- 2 4.8

i4,32° 9,i34

i7-° 10.8

13,115

41-7

i7, 2 95

2

1,564 8,645

5.0 2 7-6

4,386 32,260

5.2 38.4

544

1.7

6,772

8.1

31,398

100.0

84,166

100.0

°-5

Based on data from C B Q Annual Report, 1936, p. 8.

T h e importance of agriculture has been surpassed in both tonnage and revenues since the early days of the Burlington b y products of mines and manufactures. In fact, soft coal was the largest single commodity carried; it was usually about twice as important as its nearest rival (petroleum products) for the years 1 9 3 1 - 1 9 3 6 inclusive. 20 T h e percentage of freight revenues attributable to the classes of products carried in 1936 as shown in T a b l e 4 highlights the well-balanced and diversified traffic achieved b y the Burlington during its years of growth. B y 1936 the Burlington, after nearly a hundred years of eventful history, was jointly controlled b y two railroads extending from L a k e Superior to the Pacific. A s a railroad system it operated lines from Chicago north to a connection with its parent lines, and from Chicago west its main line ran to Denver, where it connected with the Denver & Rio Grande Western Railroad, and met its subsidiary, the Colorado and Southern. Both from points on the Burlington's own lines in Nebraska and from the Colorado and Southern in W y o m i n g the company's right of w a y extended northwestward to a connection with the Northern Pacific at Billings, Montana. Finally a line south in western Illinois extended to Paducah, K e n t u c k y , through the Illinois coal region. T h e territory served, while highly productive economically, was also intensively covered b y competing railroads. Four systems provided the Burlington with its principal competition: the Chicago, R o c k Island and Pacific R a i l w a y , the Chicago, Milwaukee, St. Paul and Pacific Railroad, the Chicago and N o r t h Western R a i l w a y , and the

THE

PROBLEM

AND ITS

BACKGROUND

13

Illinois Central Railroad. According to an official of the Burlington, these competitors were considered of decreasing importance in the order named. 21 B.

FINANCIAL EVOLUTION

It would be both interesting and instructive to trace in detail the financial history of the Burlington from its beginning in 1849 through the 1944-1945 refinancing with which this study is concerned. Such a history, however, is sufficiently vast to form the subject of another book. Yet, in order to understand the nature of the problem faced in connection with the retirement or refinancing of the Illinois Division bonds it is necessary to examine briefly the circumstances leading to the evolution of the Burlington's debt structure as it existed in 1936. Developments,

1874-1899

The rapid physical growth of the Burlington in the last quarter of the nineteenth century meant that the company was facing a more or less continuous problem of obtaining funds for expansion. The extent of the increased investment in railroad property is summarized in Table 5, a condensed statement of liabilities and net worth for the beginning and ending of the period. 22 Table 5. Liabilities and net worth, C.B.&Q., at the beginning century, 18J4 and i8gg (thousands of dollars). December 3 1 , 1874 Liabilities Current and miscellaneous F u n d e d and contingent debt Bonded liability for branch roads. . . Net worth C a p i t a l stock Surplus and reserves Total

536 20,879 6,502

and end of a quarter-

June 30, 1899

15,116 126,438

13.440

26,639 5,829

93,725 56,265

60,385

304,984

Similar to the financial experience typical of American railroads in the period following the Civil War, the Burlington's growth had evolved a highly complex debt structure. B y 1874, however, plans had been laid for effective simplification of the various bond issues created to finance its expansion. In the preceding year, the Consolidated Mortgage 7's of 1903 were issued. As described in the Trust Mortgage of 1873, a lien was placed upon the entire railroad property to provide security for an authorized issue of 30 millions of dollars in bonds, of

14

POLICY FORMATION I N RAILROAD F I N A N C E

which 20 millions were to be used for refunding the indebtedness of the Burlington.23 This program would have provided for a simple debt structure of a single bond issue had only moderate growth been anticipated. However, the sixfold expansion of lines operated in the following twenty-five years supplied ample proof of the inadequacy of the 1873 refunding arrangements. The financial effect of providing for the mileage added by the Burlington between 1874 and 1899 is dramatically reflected not only in the absolute increase in funded debt from $21,000,000 to $126,000,000, but also in the multiplicity of bond issues created to provide the necessary funds. Table 6 reveals that by the end of the period the Burlington's own and contingent obligations consisted of eighteen different issues, sixteen of which came into existence after 1875. The financing medium provided in 1873 (the Consolidated Mortgage 7's of 1903) was almost completely utilized, yet it represented less than 23 per cent of the total debt. In addition to these obligations, there were outstanding $13,440,000 in bonds of branch roads which were controlled, though not fully owned, by the Burlington, as also shown. Upon completion of the purchase of these so-called "branch roads," these securities would, in line with previous policy of the Burlington, be reported as in Table 6 as part of the company's funded debt. Giving effect to such a transfer, there were actually outstanding in 1899 twenty-two separate bond issues. Creation of the Illinois Division Bonds:

I8QQ

There was, therefore, even more urgent need in 1899 than there had been in 1873 to adopt a financial policy that would lead to a less cumbersome structure of the funded debt. B y January, 1899, plans for creating a new refunding bond issue were already under way. 24 These plans culminated in the development of the Illinois Division Mortgage bonds, which were issued July 1 of that year. The new Illinois Division bonds were authorized in the amount of $85,000,000. It was intended that these bonds would be used in part to provide funds for the retirement upon maturity of the company's debt on its lines east of the Mississippi River. Specifically, the 1899 mortgage provided for the retirement of the following obligations: 25 C. B. & Q. Consolidated 7's of 1903, $28,924,000; C. B. & Q. Chicago & Iowa Division 5's of 1905, $2,320,000; C. B. & Q. Sinking Fund 5's of 1901, $2,315,000; Ottawa, Oswego & F. R. Valley 8's of 1900, $1,076,000; C. B. & N. First Mortagage 5's of 1899, $7,914,000; C. B. & N. Equipment Mortgage 5's of 1903, $908,000; Quincy Alton & St. Louis 5's of 1902, $840,000. The total, $44,297,000 represented

THE PROBLEM AND ITS BACKGROUND

15

Table 6. Chicago, Burlington & Quincy Railroad Company funded, and contingent debt as of June 30, i8çç (thousands of dollars).*

Name of issue

Year issued

Funded debt C.B.&Q. Consolidated Mortgage 7's of 1903 1873 C.B.&Q. Consolidated Mortgage Bond Scrip 1873 C.B.&Q. Sinking Fund 5's of 1901 ^1876 C.B.&Q. Iowa Division Sinking Fund 5's of 1 9 1 9 . . . 1879 C.B.&Q. Iowa Division Sinking Fund 4's of 1919. . . 1879 C.B.&Q. Sinking Fund 4's of 1921 1881 C.B.&Q. Sinking Fund 4's (Denver Extension) of 1922 1881 C.B.&Q. 5's of 1913 Debenture 1883 C.B.&Q. Nebraska Extension Sinking Fund 4's of 1887 1927 C.B.&Q. Convertible 5's of 1903 1890-92 C.B.&Q. Chicago & Iowa Division 5's of 1905 1895 Burlington and Missouri River in Nebraska Sinking Fund 6's of 1918 1878 Burlington and Missouri River in Nebraska Sinking Fund 4's of 1910 1880 Republican Valley Sinking Fund 6's of 1919 1879 Ottawa, Oswego, & Fox River 8's of 1900 1870 1896 Quincy Alton & St. Louis 5's of 1902 1885 Chicago, Burlington and Northern 5's of 1899 Chicago, Burlington and Northern Equipment 5's 1888 of 1903

Amount outstanding

28,917 7 2,315 2,765 8,874 4,300 7,968 9,000 26,077 3,543 2,320 13,464 3,347 1,078 1,076 840 7,9H 908 124,713

Contingent debt Atchison & Nebraska 7's of 1908 Lincoln & No. West. Sinking Fund 7's of 1910

1878 1880

1,125 600 1,725

Total main lines Funded debt of branch roads Hannibal and St. Joseph Mortgage 6's of 1911 Kansas City, St. Joseph and Council Bluffs Mortgage 7's of 1907 Tarkio Valley R . R . Mortgage 7's of 1920 Nodaway Valley R . R . Mortgage 7's of 1920 Total controlled-road debt Grand Total • Data based on CBQ Annual Report, i8gç, pp. 44, 46.

126,438

1881

8,000

1887 1880 1880

5,000 232 208 13,440 139,878

16

POLICY FORMATION IN RAILROAD F I N A N C E

slightly less than one third of the 1899 bonded debt of approximately $140,000,000, and it may be seen that prior to 1906 the terms of the Illinois Division Mortgage provided for the refunding of seven of the twenty-two issues outstanding in 1899. In addition to providing for the refunding of existing debt, the Illinois Division bonds made available nearly $41,000,000 to be used for capitalization of construction and for other purposes. B y the middle of 1907, however, when the entire issue was outstanding, the Burlingtons' funded debt had increased only 29 millions of dollars over the 1899 total to 169 millions of dollars. The difference of $12,000,000 may be accounted for by ordinary sinking-fund retirements and by payment at maturity of two bond issues 26 not included in the refunding provisions of the Illinois Division Mortgage. Although creation of the Illinois Division Mortgage represented an important step toward simplifying the Burlington's debt structure, it was not a fully effective device for obtaining this objective. In the first place, it was designed to refund debt on property east of the Mississippi River only. Secondly, bonds issuable under the mortgage were limited to $85,000,000, all of which had been utilized prior to 1907. Thirdly, the mortgage agreement contained restrictive provisions bearing upon the right of the management to redeem the issue prior to its 1949 maturity date. This final element of rigidity, which assumed great significance in subsequent years, will be more fully discussed in Chapter II. Development

of the General Mortgage Bonds:

1908

It will be recalled that control of the Burlington passed into the hands of the Northern lines in 1901. The new management inherited not only the benefits of the refunding contemplated when the Illinois Division bonds were sold but also the defects of a financial structure characterized by a hodgepodge of separate bond issues. Giving effect to the elimination of seven obligations through operation of the terms of the Illinois Division Mortgage and the retirement of two other bonds at maturity, there were outstanding in 1907 fourteen different obligations. A condensed balance sheet reflecting the aggregate amount of this debt on June 30, 1907, is shown in Table 7. The efforts of the new management were soon directed to the goal of providing a new refinancing medium that not only would lead to a much needed simplification of the Burlington's debt structure, but would permit the borrowing of such additional funds as might be required in connection with future growth of the company. For refunding purposes alone, the mortgage would have to provide for borrowing at least 169 millions of dollars. Apart from refinancing expenses that

T H E PROBLEM AND ITS BACKGROUND Table 7. Condensed balance sheet of C.B.&Q., Assets

June 30, igoj (millions of dollars). 8 Liabilities and net worth

Road and equipment Investments and sundry (fixed). . Trustees' funds Cash and miscellaneous (current) Total a

17

345 19 17 13

Funded debt Miscellaneous liability Capital stock Surplus and reserves

394

169 14 in 100

Total

394

Based on data in C B Q Annual Report, 1907, pp. 16, 17.

might be incurred, authorization

to b o r r o w more than this

amount

w o u l d r e p r e s e n t a n e s t i m a t e of f u t u r e p l a n s f o r e x p a n s i o n . A f t e r g i v i n g c o n s i d e r a t i o n t o v a r i o u s a s p e c t s of t h i s p r o b l e m ,

the

m a n a g e m e n t of t h e B u r l i n g t o n d e c i d e d t h a t t h e n e w b o n d i s s u e w o u l d b e a u t h o r i z e d in t h e a m o u n t o f $3C>o,ooo,ooo. 2 7 O f t h i s t o t a l ,

$6,000,-

000 w a s r e s e r v e d f o r c o s t s c o n n e c t e d w i t h r e f i n a n c i n g t h e

fourteen

o u t s t a n d i n g i s s u e s l i s t e d i n T a b l e 8. E v e n in t h e u n l i k e l y e v e n t t h a t the entire

$183,000,000

of liabilities reported in the

Table 8. Outstanding C.B.&Q. Mortgage.»

balance sheet

bonds in 1908 specified for refunding by the General

Title of issue Atchison and Nebraska 7's Lincoln & Northwestern 7's Burlington and Missouri River in Nebraska Sinking Fund 4's Hannibal & St. Joseph 6's C.B.&Q. Debenture 5's Burlington and Missouri River in Nebraska Sinking Fund 6's Republican Valley Sinking Fund 6's Iowa Division Sinking Fund 4's and 5's Tarkio Valley Sinking Fund 7's Nodaway Valley Sinking Fund 7's C.B.&Q. Sinking Fund 4's C.B.&Q. Denver Extension Sinking Fund 4's C.B.&Q. Nebraska Extension Sinking Fund 4's C.B.&Q. Illinois Division 3>^'s and 4's Total ft

1907

Data from C B Q Documentary History, I, 414.

Amount {millions of dollars)

Date of maturity

1.1 0.6

1908 1910

3.5 8.0 9.0

1910 1911 1913

13.8 1.1 9.6 0.1 0.1 4.3 8.0 24.5 85.0

1918 1919 1919 1920 1920 1921 1922 1927 1949

168.5

18

POLICY FORMATION IN RAILROAD F I N A N C E

should be refunded via the General Mortgage, the new vehicle would provide at least $111,000,000 for betterments or additions. Accordingly, on March 2, 1908, a new indenture was executed, placing a General Mortgage upon the whole railroad system then in existence, though subject to liens outstanding at the time. It was specifically provided, however, that ". . . all other railroads, extensions, property and franchises . . . hereafter acquired other than by means of the proceeds of bonds issued hereunder . . . shall be free from the lien of this indenture . . . " 2 8 With this reservation the limitation of $300,000,000 placed upon the issue would not prohibit future expansion, although, giving effect to the retirement of prior liens, it did set a definite limit to the amount of borrowed capital that could be raised on a first mortgage to improve the existing railroad property. Although it was soon discovered that the General Mortgage contained inherent weaknesses, it remained the primary financing medium until 1921. In that year its limitations led directly to the development of a vehicle to supplant it. Meanwhile, utilization of the General Mortgage bonds after 1908 had resulted in considerable simplification of the company's debt structure. Table 8 lists those obligations outstanding in 1908 which the General Mortgage bonds were specifically intended to refund. Prior to 1921, twelve of these fourteen issues had been retired, leaving only the Nebraska Extension and the Illinois Division bonds outstanding. Although the issues retired represented a total of $59,000,000, Table 9 reveals that General Mortgage bonds were used specifically to refund only 28.5 millions of dollars of this amount. Moreover, Table 9 indicates that prior to 1921 only 75.1 millions of dollars in the General Mortgage bonds had been issued and none at all after 1915. Of this amount, $9,900,000 were held in the company's treasury at the end of 192029 so that 65.2 millions of dollars' worth were actually outstanding in the hands of the public. Including the Nebraska Extension and Illinois Division bonds (but excluding equipment obligations) the Burlington's funded debt stood at $169,000,000 — almost precisely the same amount outstanding thirteen years previously in 1907. Weaknesses

in the General Mortgage Financial

Arrangements

Corporate records of the Burlington present no evidence that when the General Mortgage was executed in 1908 the management had any misgivings about its suitability as a financing medium. Y e t only twelve years later Mr. Hale Holden, who had become president of the company in 1914, singled out three features of the mortgage for criticism. 30 It was maintained that in fact the amount of bonds issuable under it

T H E PROBLEM A N D ITS

BACKGROUND

19

was insufficient for the company's needs; the maximum rate of interest provided for was only 5 per cent, a rate deemed too low; and bonds issued under its terms were required to be noncallable. While the noncallable feature in a bond issue may not by itself be a serious defect, it nevertheless introduces in the capital structure a measure of inflexibility which may be undesirable. In the case of the General Mortgage, however, the noncallable feature applied to bonds with a common maturity date and presented a significant potential danger. The indenture31 provided that while bonds might be issued in one series or several series and in varying amounts, as the directors Table 9. Issue of C.B.&Q. General Mortgage bonds, 1908-1920.'

Purpose of issue Reimbursement of treasury for past expenses Provision of funds for current additions Improvement to existing property Purchase of Colorado and Southern stock...

Period of issue

Amount (millions of dollars) 36.0

1908-1909 19x4 1910

S-o 5-6 10.6

Refunding medium Exchanged for bonds outstanding at or before maturity Exchanged for bonds purchased through Sinking Fund and/or paid at maturity

1909-1913

10.2

1909-1915

18.3 28.51

Total

75.1

* D a t a derived from C B Q Annual Reports, 1908-1920. b Reference to Table 8 reveals that between 1908 and 1915 only $22,200,000 of bonds actually matured. T h e discrepancy between this figure and the $28,500,000 of General Mortgage bonds issued over the period is accounted for by the fact that under terms of the mortgage, either bonds that had matured subsequent to igo2, or bonds that had been purchased previous to 1908 through sinking-fund operations, might serve as the basis for General Mortgage bonds.

from time to time might determine, all such series, whenever issued, would mature on March i, 1958. Thus, the managers of the Burlington, acting under the terms of the mortgage, might find themselves facing at one time the maturity of 300 millions of dollars' worth of noncallable bonds. This characteristic alone would make any prudent financial officer shudder with apprehension. The importance attached by the Burlington's management to the weakness of the call feature in the General Mortgage is made clear by the following testimony of President Holden made before the Interstate Commerce Commission in 1920:

20

POLICY FORMATION IN RAILROAD FINANCE

Pres. Holden: . . . We should have a more flexible mortgage structure, so that we can either issue bonds in short series, or with the call privilege, so that as the cost of money changes from time to time during the future years, the company may have the opportunity to call in and refund at a less expensive rate. Director Colston: Are the financial managers of the company practically unanimous in that belief? Pres. Holden: Yes, sir . . ,32 T h e significance to be attributed to the criticism of the maximum 5 per cent interest rate which General Mortgage bonds might bear is less clear. T h e danger of this upper limit would lie in the fact that managers of the Burlington might find it necessary to raise funds through sale of General Mortgage bonds at a time when the security markets would demand, say, 7 per cent for bonds of comparable quality. A t such a time, General Mortgage bonds bearing a 5 per cent coupon could be sold only at a sizable discount. If the bonds had to be sold under such conditions to provide cash for refunding a maturing bond issue, the cash realized from a given face amount of General Mortgage bonds would be inadequate to retire a similar face amount of the maturing issue, and the company would be forced to make up the difference b y supplementary funds. Prior to 1920, market conditions and the financial requirements of the Burlington were such that the alleged defect of the 5 per cent maximum was never tested. T e s t i f y i n g before the I C C in 1920, however, President Holden indicated that at that time the limitation on the interest rate would present a very serious problem. H e asserted that if General Mortgage bonds were then issued, they would necessarily be sold at a "larger discount than we should prudently suffer . . ." 33 Director Colston thereupon interrupted him: Q. At that point, can you state on what basis you feel you could market these bonds . . . ? A. I couldn't state that, because I haven't made any investigation, except to be told by those who advised us in financial matters that they are not a salable bond. Q. Don't let me interrupt the thread of your testimony. A. They said it would require too large a sacrifice, and they said we should turn at once to a better plan, and that is what has brought to our attention the necessity of having a more modern and better financial structure.34 T h e third criticism made of the General Mortgage — that the $300,000,000 provided for was inadequate for the company's needs

THE PROBLEM AND ITS BACKGROUND

21

— appears to have little, if any, validity. The question of adequacy can be examined from two points in time: first, when the limit of $300,000,000 was decided upon in 1908; and second, from the viewpoint of 1920 when President Holden argued the need for a mortgage with a "larger maximum borrowing power to carry us over a longer period of years." 33 It is true that on the basis of the 1907 investment in road and equipment of $345,000,000, the implied minimum amount of $111,000,ooo36 that could be employed for expansion or betterment was not extravagant. Yet there was little need in 1907 to plan for extravagant growth if the Burlington's new owners intended to utilize the railroad as a complementary system to the transcontinental Northern lines. Some growth could naturally be expected to take place as the new subsidiary added feeder lines in order to exploit its own territory as effectively as possible. To take care of this potential intensive development, an allowance for an increased investment in road and equipment of about one third (assuming that all funds were borrowed) would not appear unreasonable. On the other hand, if it were the aim of management to provide a basis for financing future growth while maintaining a sound capital structure, the authorization of a bond issue up to 300 millions of dollars suggests the possibility of a most generous estimate of expansion possibilities. According to modern standards, at any rate, the funded debt of a conservatively financed railroad should not exceed the equity investment.37 On.this basis, full utilization of the General Mortgage bonds would have permitted the management of the Burlington to have counted upon capital of 600 millions of dollars for future betterments and additions even if no additional borrowing were undertaken. This amount would represent an increase of nearly 60 per cent over the 1907 total of funded debt and equity of $380,000,000. At a time when the rail network of the Burlington was substantially completed, the allowance for this magnitude of growth could hardly be condemned as shortsighted. Yet the fact remains that in 1920, the General Mortgage of 300 millions of dollars was condemned as providing inadequately for the company's needs. The criticism was made, moreover, despite the fact that at the end of 1920 the funded debt of the Burlington was substantially unchanged from the $169,000,000 outstanding in 1907. It is evident that demands for funds to finance expansion in the intervening years had not pushed the Burlington to the limit of its General Mortgage borrowing capacity. It may be noted, moreover, that even by 1936, when the management again expressed concern over problems presented by the Burlington's debt structure, the total funded debt

22

POLICY FORMATION I N RAILROAD FINANCE

was less than 224 millions of dollars, and still under the 30o-milliondollar General Mortgage maximum. The conclusion appears inescapable that from the viewpoint of 1920 as well as from that of 1907 the borrowing limit of the General Mortgage should have proved adequate in the absence of any abnormal demand for funds. Creation oj the First and Refunding Mortgage:

1Q21

From the circumstances surrounding the development of the First and Refunding Mortgage, it is clear that unusual external considerations played as great a part as, if not greater than, internal requirements of sound financial policy would dictate in determining the need for a new financing medium. These external factors grew out of the relationship existing between the Burlington and its owners, the Northern Pacific and Great Northern railroad companies. It will be recalled that the Northern lines financed their purchase of the Burlington with funds realized from the sale of joint bonds of twenty years' maturity. The year of reckoning for these bonds came in 1 9 2 1 , a time in which business conditions and the security markets were undergoing the severest depression in more than a decade. Faced with the need of refunding their $ 2 1 5 , 2 2 7 , 0 0 0 Collateral Trust Joint Bond issue during these unsettled conditions, it is to be expected that the parent companies would look to their subsidiary for whatever aid they might obtain from this supplementary source of credit. If the management of the Burlington were to make an effort to render effective financial assistance to the Northern lines, quite likely this assistance would take the form of paying a substantial dividend to the company's owners. Inasmuch as the company's cash account at the end of 1920 was under 1 0 millions of dollars, one would assume further that the dividend might take the form of an issue of the Burlington's own securities. In the light of subsequent events, these considerations did assume great significance in shaping the company's debt structure. An examination of the hearings in 1920 before the Interstate Commerce Commission in connection with the Burlington's application for approval of its First and Refunding Mortgage proposal 3 8 reveals that the desire to pay a bond dividend was, in fact, a basic motive leading to the development of the new financing medium. It was specifically requested that 80 millions of dollars of the proposed issue should be reserved to be used as a dividend to the company's owners. 39 As has already been pointed out, the Burlington itself was not at that time faced with an immediate need for raising additional capital, and so the existing debt structure, even with its imperfections, need not have been disturbed. With the development of this extraordinary need to issue

THE PROBLEM AND ITS BACKGROUND

23

$80,000,000 in bonds in the midst of highly unsettled business conditions, however, the weaknesses and inflexibility of the General Mortgage took on foreboding significance. It was against this background that President Holden argued before the I C C in 1920 that a complete revision of the Burlington's debt structure was mandatory. In amplifying the need for an improved mortgage setup, President Holden pointed out that if the General Mortgage were used to refund the outstanding debt and pay the dividend of $80,000,000, only $51,000,000 would be left for other expenditures and improvements. " A t the average current rate," he continued, this amount "would only last, say, four or five years . . . Any further capital would have to be raised on a fourth mortgage which would not be a practical proposition at all. In other words, we feel we must get away from piling one mortgage on top of another . . ." 40 The foregoing remarks lend emphasis to the possibility that had there been no desire to lay plans for an eighty-million-dollar bond dividend in 1921, the Burlington, as an independent system, might well have been content to leave its debt arrangement unaltered. Undoubtedly a more flexible debt structure was a desirable goal, but its inadequacy became critical when called upon to meet the unusual demands placed upon it at a most unpropitious time. As President Holden himself stated, "that is what has brought to our attention the necessity of having a better financial structure." 41 Mr. Holden . . . Therefore we have worked out this plan, which is in keeping with plans of modern mortgages on a number of large railroad systems. Q. (Mr. Colston) Well, it is substantially the general plan of mortgage adopted by all large systems now? A. Yes. We have an open mortgage provision, so that ultimately, and as rapidly as may be it will become the one mortgage on the property, and get away from this old practice, which experience has shown spells difficulty, if not disaster, of piling one mortgage on top of another. This plan which we are proposing, as I say, will in time and as rapidly as possible refund the underlying liens, and the [new] first and underlying [sic] mortgage will be the one mortgage on the property. And having no fixed limit on the bonds, but only its relation of three to one stock, we shall keep it as the single lien on the property and therefore the bonds in time will be bonds available for the classes of trust investment and so forth. 42

Ironically enough, although the I C C approved the proposal of the Burlington to go ahead with creation of a more flexible debt structure, it denied the company the right to use any bonds issued under the

24

POLICY FORMATION IN RAILROAD FINANCE

new mortgage as dividends. Instead, the ICC gave the Burlington authority to issue $60,000,000 of common stock for this purpose.43 Thus it came about that on February 1, 1921, a First and Refunding Mortgage was executed,44 designed to replace the General Mortgage of 1908 as the Burlington's primary financing medium. While ostensibly adopted as a step toward financial modernization, undoubtedly the new vehicle was born of a kind of financial desperation on the part of the controlling Northern lines. Yet, once delivered, it remained as a tangible factor in the financial policy passed on to subsequent managers of the C. B. & Q. Railroad. Just as the General Mortgage of 1908 had made specific provision for the retirement of debt existing at the time that refunding plan was adopted, so the First and Refunding Mortgage reserved a sufficient amount of bonds to provide funds for retiring directly the General Mortgage, Illinois Division Mortgage, and the Nebraska Extension Mortgage bonds.45 There was, moreover, a specific alternative procedure prescribed for the retirement of the Illinois Division bonds whereby General Mortgage bonds might be issued and they in turn pledged as security for the new First and Refunding issue, the latter then to be used as the actual financing medium.46 Other features of the new mortgage provided that bonds issued under its terms might be made callable in whole or in part, might be issued in series and with varying maturities and interest rates, and were not limited in amount to a specific dollar figure. Prior to 1930, First and Refunding Mortgage bonds were issued in two series. Series A, bearing a coupon rate of 5 per cent and made callable as a whole on any interest date after 1942 upon 60 days' notice, was sold to the full authorized amount of 30 millions of dollars during 1922. 47 An additional $10,000,000 was authorized and sold during 1924. 48 Series B, with a coupon rate of 4 ^ per cent and the same general provisions as Series A, was authorized and sold during 1927 in the amount of $30,ooo,ooo.49 Of this amount $16,384,000 was required to retire the maturing Nebraska Extension Mortgage bonds. By December 3 1 , 1930, the debt structure of the Burlington had thus been modified from that of 1920 only to the extent of substituting First and Refunding bonds for the matured Nebraska Extension issue. Additional capital, however, had been provided by the sale of the new bonds, so that the funded debt at the beginning of 1931 totaled $220,000,000, approximately $51,000,000 greater than a decade before. Specifically, the long-term debt account was as shown in Table 10. While it can be no more than coincidence, it is worth passing notice that the increase of $51,000,000 in debt for the decade is exactly the amount which President Holden had testified in 1920 would be needed

T H E PROBLEM AND ITS BACKGROUND Table 10. The long-term debt account of the C.B.&Q.

Bond Issue Illinois Division Mortgage General Mortgage First and Refunding Mortgage Series A Series B Total

25

in 1931 (millions of dollars). 0

D a t e of maturity

Outstanding in hand of public

1949 1958

84,425 65,247

1971 1977

40,000 30,000 219,672

* Data from CBQ Annual Report, 1930, p. 40.

for improvements over the following four or five years. And still the total debt was $80,000,000 short of the maximum amount that had been authorized under the General Mortgage in 1908. Once more it may be observed that the alleged defects of the 1908 plan were never more than hypothetical as far as the management of the Burlington itself was concerned. Thus, the limit of $300,000,000 had proven adequate until as late as 1930 (and remained adequate even until the refinancing of 1944-45). Moreover, while sharp criticism was levied against the 5 per cent maximum limit on interest rates, still a junior issue bearing a coupon of 5 per cent was sold in 1922. In the third place, the replaced mortgage was criticized on the grounds of its being noncallable. Although the new mortgage bonds were made callable,50 the first two series of bonds issued under its terms were callable as a whole only. In practice this provision is frequently tantamount to making bonds noncallable, although it cannot be denied that the redeemable feature does provide management with a measure of flexibility lacking in the noncallable bonds. Finally, however, the First and Refunding Mortgage did offer a decided improvement over the General Mortgage with respect to maturity dates. The latter, of whatever series, would invariably mature in the same year, 1958. The new bonds, in contrast, might be made of any maturity, prior to the maximum life of February 1, 2121. 51 Whether the arrangements of 1921 were entered into as a conscious effort to revise the existing debt structure with an eye to the future, or whether the plans were made in response to immediate demands of the Burlington's parent roads for a structure that would enable the Burlington to declare an eighty-million-dollar bond dividend cannot be unequivocably answered. But on balance, the new mortgage structure did definitely mark a forward step by providing for bonds of far greater flexibility than possible with those issuable under the General

26

POLICY FORMATION IN RAILROAD F I N A N C E

Mortgage. Yet, from one point of view, the revision of the mortgage structure in 1921 was a premature financial arrangement, since it meant that when the time arrived for refunding the original underlying mortgages they would necessarily be switched from senior positions in the mortgage structure to a position following the security of the General Mortgage bonds outstanding at that time.

Chapter Two

THE APPROACHING MATURITY OF ILLINOIS DIVISION BONDS A.

DEVELOPMENTS UP TO 1 9 3 6

When the refinancing program of 1921 was consummated, the maturities to be provided for were respectively six, twenty-eight, and thirty-seven years in the future. As far as prudent management could foresee, the new vehicle was perfectly adequate and sufficiently flexible to meet whatever eventualities might arise with respect to financial needs over the ensuing years. The decade of the twenties saw the new medium successfully used both to provide additional capital and to provide funds for retiring the first of the three maturities, the Nebraska Extension Mortgage bonds. Beginning in 1928, then, there remained only two mortgages outstanding to be brought under the First and Refunding paper which President Holden had fought for before the Interstate Commerce Commission in 1920. The immediate line of financial management was temporarily broken by the resignation of President Holden in 1928. Mr. F. E. Williamson, who had previously been an operating officer with one of the Burlington's controlling roads, the Northern Pacific, was appointed to succeed Mr. Holden as president. Mr. Williamson's tenure of office lasted only three years and was too short for the development of any new financial policy. B y the end of 1931, when Mr. Williamson left the Burlington to assume the presidency of the New York Central, there had arisen neither the need nor the opportunity for important financial decisions. In the opinion of an officer of the Burlington, moreover, President Williamson was never very anxious to open matters relating to the refunding of the company's debt; he did not think the time appropriate. 1 As of January 1, 1932, Mr. Ralph Budd, who had been president of the Great Northern Railway since 1919, was selected to succeed President Williamson. Although Mr. Budd, like Mr. Williamson, was new to the Burlington as a corporate officer, he had been a member of the

28

POLICY FORMATION IN RAILROAD F I N A N C E

board of directors of the railroad since 1917, and of the executive committee since 1919. Evidently the new president assumed his duties with an intimate firsthand knowledge of the affairs and problems of his company. Moreover, President Budd had appeared before the I C C as a representative of the Great Northern in 1920 when Holden made his plea for a revised mortgage structure, and as an officer of one of the two parent roads he had tacitly approved the arguments then made by President Holden. In a very important sense, then, President Budd's election marked the resumption of the line of financial policymakers broken by the resignation in 1928 of President Holden. A t the time, the main problems of the Burlington, in line with those of other business enterprises, were those arising from the curtailed revenues resulting from the growing severity of the economic depression which followed 1929. The annual report for 1931, which was the first signed by Mr. Budd as president, shows great concern over the "steady decline in gross revenue" and discusses the efforts made by the company to bring expenses into line with reduced income. T h e report lists reductions in payroll and material expenditures, reductions in train miles through schedule revisions, and a vigorous fuel conservation program, but nothing is mentioned to indicate that the financial policy, with respect to dividends or capital structure, was being considered as subject to revision as part of the general program of retrenchment. T h e year 1932, the first under the direction of President Budd, intensified the difficulties of the Burlington as operating revenues declined a sharp 28.5 per cent below those of 1931. T h e report of the president for 1932, however, reveals that the financial policy of the railroad had by then come under managerial scrutiny. Under the heading of general remarks, Mr. Budd stated: The financial structure of the Burlington has not changed during the year. So much is being said about the scaling down of fixed charges of railways that it may be well to state the investment, debt, and annual interest of the Burlington now and at the beginning of the World War: Year

Property Investment

Funded Debt

Annual Interest

1915 1932

$444,699,875.48 608,163,892.55

$181,325,900 219,672,000

$7,077,551.97 9,084,635.00

Net Railway Operating Income, which is before any interest charges, was $28,319,579.51 in 1915 and $9,592,497.32 in 1932. The return on investment was 6.37% and 1.58% in those years respectively. In considering earnings per share of Burlington its small interest charge should always be kept in mind as well as the fact that there are only 1,708,391 shares of stock. In other words this property is greatly undercapitalized and the Company has

APPROACHING MATURITY OF ILLINOIS BONDS

29

made it a practice to capitalize only a conservative portion of Additions and Betterments.2 It is evident, therefore, that by 1932 the management of the Burlington was giving thought to the question of "scaling down fixed charges." By examining such expenses as a function of the relation between funded debt and property investment, it was concluded, however, that since property investment was actually undercapitalized, the Burlington's fixed charges, by inference, were believed to be sufficiently moderate. The statement by Mr. Budd that the Burlington was undercapitalized is in agreement with a report issued eleven years earlier in 1921 by the Interstate Commerce Commission when it was found "that the present capitalization is far below the actual investment or any fair value for rate making purposes which we may subsequently fix under the valuation act." 3 Furthermore, in 1927 the Commission had found that the cost of reproduction new of the carrier as of 1917 was $563,217,613, an excess of more than $100,000,000 over the company's own 1917 reported investment.4 Examination of the changes which had taken place in the capitalization of the Burlington lends additional support to Mr. Budd's observation in 1932. Between 1920 and that year, common stock had increased by 60 millions of dollars, and funded debt by 46 millions of dollars, while reported gross investment in road and equipment increased from 506 millions of dollars to the 608 millions of dollars mentioned in the president's report in 1932. The slightly greater growth in capital of 4 millions of dollars over the period can hardly be said to represent full capitalization of the differential noted by the Commission in 1921. It is also true that the funded debt5 of the Burlington in 1932 was a smaller proportion of property investment than for any of its main competitors, as shown in Table 1 1 . Nothing further is mentioned in the company's annual reports bearing upon the financial policy of the Burlington until 1936. In his message of that year to the stockholders, President Budd wrote, "There was no retirement during the year of outstanding bonds, the same being impracticable under the call provisions of the various mortgages." 6 Here for the first time there appears in the record the implicit admission that although the financial plan of 1921 had been designed as a medium to provide greater flexibility than the General Mortgage, the Series A and Series B bonds that had been issued under it were drawn with such call features7 as to retain in the company's mortgage structure a large measure of the inflexibility it sought to avoid. Of course, the underlying Illinois Division bonds were likewise callable as a whole

30

POLICY FORMATION I N RAILROAD FINANCE

Table n. Funded debt as a percentage of property investment, C.B.&Q., competitive roads, and Class I roads,» December 31, 1932.

Railroad C.B.&Q C.R.I.&P C.M.&St.P C.&N.W I.C All Class I roads" Class I — Western District"

Road and equipment b (millions of dollars)

Funded debt b (millions of dollars)

608.2 511-6 723-6 563-4 697.6 19,287,000 8,828,000

219.7 313-8 484.1 344-1 377-5 11,248,000 5,360,000

Ratio of debt to property (per cent) 36.1 61.3 66.6 61.i 54-i 58.3 60.7

» Based upon consolidated figures and includes equipment obligations where present. See Chapter II, note 5. b Data from Moody's Manual oj Investments, Railroad Securities (New York, 1934), pp. 2060, 1007, T946, 357, and 1970 respectively. 0 Interstate Commerce Commission Statistics oj Railways in United States for 1932. Table 42, pp. 5-72, "General Balance Sheet Statement as of December 3 1 , 1932 for Class I Steam Railways."

only, and it will be remembered that the General M o r t g a g e bonds were nonredeemable. T h e retirement rigidities of the debt structure, in other words, were hindering the application of a debt-reduction policy. Y e t the implications of this statement of the impracticability of retiring any outstanding bonds are not altogether clear. T w o possible interpretations are suggested: first, it was in fact impossible to call for redemption either the noncallable General Mortgage bonds, or the callable First and Refunding bonds prior to their first redemption date of 1 9 4 2 ; second, it was deemed impractical to issue additional First and Refunding bonds to be used for the retirement of the callable Illinois Division bonds. Since the first suggested interpretation of the 1 9 3 6 statement yields no more than an official acknowledgment of an impossible situation, it is highly probable that the implications of President B u d d ' s remark related to the problem rapidly facing the Burlington growing out of the approaching maturity of the Illinois Division bonds. On this assumption, it was thus publicly admitted that the terms of the indenture of the 85 millions of dollars of Illinois Division bonds, providing as it did for redemption as a whole, were such that 1 9 3 6 was not a propitious year to put into operation the machinery necessary for refunding. T h e foregoing comments deal with the published lington's concern over its financial problems. While Burlington prior to 1 9 3 6 cast little additional light ment of the policy relative to the handling of the

record of the B u r private files of the upon the developredemption of the

32

POLICY FORMATION IN RAILROAD FINANCE

Illinois bonds, it is significant that for that year the railroad's records do contain evidence of the development of plans to meet the approaching bond maturities. Bearing upon the origin of these plans, President Budd wrote in 1945 a memorandum in which he stated, " T h e fact that the Burlington had a maturity of $85,000,000 in 1949 . . . was naturally the cause of increasing concern from the time I came here in 1932. For one, I had in mind taking advantage of the first opportunity to refund the bonds before maturity . . . " 8 Company records do not, unfortunately, reveal the exact steps taken in the initial development of plans for refunding. However, there seem to have been three courses of action which were being considered in 1936. T h e first of these was to wait until maturity in 1949 before refunding, and in the meantime reduce the principal amount outstanding through a bond purchasing program; 9 the second, to extend the maturity of the Illinois Division bonds at a lower interest rate; and the third, to redeem these bonds and sell First and Refundings "secured in part b y a first collateral lien on the redeemed bonds." 10 Correspondence on file, in addition to memoranda, point to the conclusion that active consideration was being given to all three of these alternatives. 1 1 Since, however, nothing was actually done during 1936 in the w a y of modifying the financial structure, the president and directors of the Burlington evidently decided, as stated in the annual report of that year, that the time was not propitious for any positive action. B . DEVELOPMENTS, 1 9 3 7 - 1 9 4 O A f t e r the discarding of immediate plans for refinancing in 1936, no overt action was taken until 1940 to develop a program for refunding the Illinois Division Mortgage bonds. Meanwhile, factors affecting the feasibility of such action were becoming sharply illuminated. Principally, these elements related to the financial condition and probable capital changes of the Burlington's competitors and also to the dividend policy and credit position of the Burlington itself. On the other hand, the precise characteristics of the Illinois Division Mortgage were recognized even more clearly during the period as presenting troublesome features standing in the w a y of any simple refunding operation. Retirement

Provisions

oj the Illinois

Division

Mortgage

T h e principal stumbling block offered b y the Illinois Division M o r t gage had a dual character. In the first place, bonds issued under its terms were callable as a whole rather than in part, and secondly, almost seven months were required to elapse between the time notice of intent to call was published and the effective date of redemption. T h e s e two provisions assumed grave importance when refunding plans fi-

APPROACHING MATURITY OF ILLINOIS BONDS

33

nally got under way, and were responsible for use of the epithet "complicated," which the management employed with increasing frequency to describe the nature of the financial problem presented. When the mortgage was drawn in 1899, consideration had been given to whether or not the $85,000,000 bond issue should be callable in entirety or whether any part of the authorized total might be called for redemption if deemed desirable.12 However — and the records of the Burlington are silent as to reasons why 13 — the decision was apparently reached to make the issue callable only as a whole in the event the company wished to exercise its right of redemption prior to maturity. Yet the language used in the indenture describing the call feature was not altogether free of ambiguity. The provision was drawn so that the company " . . . may redeem all the bonds" 14 which could mean that it was permissive that all (or not all) of the bonds might be retired. This question was actually raised in 1944 by interested analysts. On April 13 of that year, Mr. H. G. Smyth of the First Boston Corporation inquired of the Burlington's general counsel as follows: . . . While it would appear that the intended meaning of the phrase (above) is that all of the Illinois Division bonds of all the series outstanding can be redeemed as a whole only, and not in part, nevertheless, there would seem to be some basis for the argument that this provision is permissive rather than mandatory as to the amount of the bonds it may redeem. . . . Would it be possible to interpret the provision to mean that the Company, if it so elects, may redeem as many as all of the outstanding bonds, which automatically permits it to redeem less than all of the outstanding bonds? 1 5

Had the company construed the language of the indenture in the way suggested, many of the difficult issues later faced might well have been avoided. However, rather surprisingly, the Burlington's general counsel answered the foregoing inquiry on May 1 with the statement, "we have never considered the question you raise as to whether only a part of the Illinois Division Mortgage bonds could be called for redemption . . ." 16 And so the 1899 wording of the mortgage was interpreted by the Burlington's officers to preclude calling of part rather than the entire issue. The second provision, dealing with the notice required for redemption, also introduced a troublesome rigidity. If, for example, the directors of the Burlington wished to redeem the bonds on any interest date — say January 1, 1940 — six months' notice had to be given to the Illinois Division bondholders. Moreover, it was required that notice of this intention to call should be published in newspapers for four weeks preceding this six-month period. Thus, to redeem bonds on Jan-

34

POLICY FORMATION IN RAILROAD FINANCE

uary i , 1940, first publication of such intent must have been made in the first week of June, 1939, or nearly seven months prior to the effective date. 17 The effect of this second provision bore heavily upon the timing of a refunding operation based upon call of the Illinois Division bonds. The requirement presented two alternatives to the Burlington's directors. First, they might sell a new issue of refunding bonds at the stage of the market deemed most favorable for placing such securities, then publish intention to call the Illinois bonds, and pay interest on both the new issue and the called bonds for the seven months or more prior to redeeming the latter. Or, second, the management would have to assume the risk that the market would be favorable in its reception of the refunding issue seven months subsequent to the published intention of redeeming the Illinois bonds. The first alternative involved "double interest" — that is, interest on both the new issue and on the Illinois Division bonds during the time that must necessarily elapse before their redemption. Avoidance of the risk arising from the second alternative might mean the necessity of obtaining seven months' advance commitment from purchasers of the new refunding issue on the terms of their loan to the company. These characteristics of the Illinois Division Mortgage grew increasingly annoying and troublesome as the time approached for taking active steps to meet the problem of the eighty-five-million-dollar maturity. Had the bonds been callable in part rather than as a whole, the magnitude of a single refunding operation might have been scaled downward to a more manageable sum, and thus have been made a relatively simple task to be accomplished in stages. Further, had only, say, thirty days' notice rather than notice of some seven months been required for publication of intention to call the bonds, the refunding operation would have acquired far greater simplicity as a result of the flexibility presented the Burlington's managers in the selection of the most favorable time to institute their plan. In the absence of these flexible features, the problem faced by the Burlington, instead of being a simple refunding operation, was exceedingly complex, and this complicated aspect was largely instrumental in determining the final shape of the financial policy evolved to provide for the maturing Illinois Division bonds. The Financial

Condition

of the Burlington's

Competitors

The historical characteristics of the bonds whose maturity, in President Budd's words, gave "increasing concern from the time I came here in 1932" simply demarcated the stage upon which the drama of the development of a financial policy was to take place. A different

APPROACHING MATURITY OF ILLINOIS BONDS

35

security with different terms would have provided different exits and entrances, but the backdrop and stage property for the action were the financial position of the Burlington as it was related to its railroad competitors. As indicated above, the Burlington's principal competitors were the Rock Island, the Milwaukee, the North Western, and the Illinois Central. Prudent financial management would necessarily consider the effect of the Burlington's policy decisions upon competitive relationships with these rival roads. The factor of primary significance which gave concern to the Burlington's policy-makers grew out of the financial difficulties encountered during the 1930's by three of the company's four principal competitors. Ordinarily the ability of a firm to maintain its own profits while its competitors are faring badly is testimony to the soundness of the management of the former concern; and the profit realized is management's reward for its astuteness. However, President Budd interpreted the ability of his railroad to keep up its earnings while its competitors suffered losses as a long-run threat to the competitive position of the Burlington. The explanation of this seeming paradox lies in the characteristics of railroading as a regulated industry. Before we examine the implications of the regulated aspects of the railroad industry, a brief description of the Burlington's competitive relationships must be made, Table 12 17 presents evidence of the superior position of the Burlington compared to its competitors through 1940. From Table 12 it can be seen that the Burlington, when compared with its competitors, was alone in maintaining profits during the period of the thirties. In 1931 and for the following nine years, three of the company's main competitors lost money each year. The Illinois Central proved the most invulnerable rival from the standpoint of profits, but even that road lost money in four of the eleven years between 1929 and 1940. For the three hardest hit of the Burlington's competitors, the decade of the thirties spelled bankruptcy. Beginning in 1933, the Rock Island petitioned for reorganization under Section 77 of the Federal Bankruptcy Act, the North Western took similar action in 1935, and only one day later the Milwaukee followed suit.18 Of the five railroads in Table 14, only the Burlington and the Illinois Central were able to stay free of financial embarrassment. Rather than choosing to interpret the successful experience of the Burlington as a laurel sanctioning complacency, President Budd examined critically the implication of his success amid so much failure. Railroads other than the Burlington's rivals had got into financial difficulties as a result of the depression of the 1930's. For example, the

36

POLICY FORMATION I N RAILROAD FINANCE

Chicago Great Western Railroad Company had petitioned for reorganization in 1935, stating that it was unable to meet its debts as they matured. In 1938 the Interstate Commerce Commission approved its plan of reorganization, with obiter dicta which would give caution to all intelligent railroad management. Table- 12. The C.B.&Q.

compared with competitive railroads: selected income

data,

IQ28-1940.a

G r o s s o p e r a t i n g r e v e n u e s ( m i l l i o n s of Year

dollars)

C.B.&Q.

C.R.I.&P.

C.&N.W.

C.M.&St.P.

i.e.

170.55 171.36

180.98

1928

...

162.89

141.23

152.09

1929

...

162.41

147.72

1930

.

141.38

123.08

154-73 130.03 102.27

142.57 hi.42

148.46

99.07

89.31

.

HI.22

1931

179.61

116.79

1932

•••

79-54

70.78

72.49

84.90

1933

•-•

78.50 80.29

64.85

73-36

85-50

87.96

66.96

75-89

87.86

91.14

1934 ...

I93S 1936

82.93

67.12

97-50

78.07

77-35 91.97

92.47

98.08

109.14

114.96

1937

. ..

100.15

81.64

89.80

107.66

114.02

1938

••-

93-07

77.78

81.06

105.42

1939

•• •

96.13

1940

•••

97-63

78.47 80.70

87.25 92.80

99-44 106.88 114.38

114.27

•••

91-75

76.54

84.42

99-97

104.27

10-year a v e r a g e Ì 1931

1940

/

111.37

Fixed charges ( p e r c e n t a g e s ) b

Year

C.B.&Q.

C.R.I.&P.

C.&N.W.

C.M.&St.P.

I.e.

1928

10.52

13.27

17.49

10.32

15-52 15.61

15-88

1929

16.15

1930

10.32

17.36

19-33

14-05 14.85

17-13 17.02

1931

10.32

18.62

17-13

10.29

18.79

19-47 20.02

15-05

1932

17-15

1933

10.29

19-05

20.37

15-05 15.08

1934

10.28

18.57

19.88

14.99

17-03 16.71

10.28

19.04

20.09

14.90

16.62

1936

• •.

10.35

19.78

14.90

16.44

1937

• -.

19.78

14.90

16.05

1938

10.55 10.64

19-05 18.85 18.72

19.60

14.90

1939

10.52

18.57 18.32

19-50 19.49

14-74

15-83 15.66

14-55

15-73

I93S

1940

.. -

10.53

a Source: C.B.&Q data — Company Reports, 1928-1940; Rock Island — Standard Corporation Descriptions (New York, August 28, 1945), vol, 6, no. 35, sect. I, p. 4232; North Western — ibid., p. 4199; Chicago, Milwaukee and St. Paul — ibid., p. 4223; Illinois Central — ibid., vol. 23, no. 166, sect. 4 (New York, August 30,1945), p. 4848. b Fixed charges computed as percentage of average gross revenue for ten-year period, 1931-1940 inclusive.

APPROACHING MATURITY OF ILLINOIS BONDS Table 12

37

(continued). Net income (millions of dollars)c

Year

C.B.&Q.

1928

26.28

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940

29-58

c

21.98

13-32 i-5°

S-6o

4-45 1.84 5-i6

4-91 3-64 3-66 4-39

C.R.I.&P. 13-17

14.01 7.70 -0.39 -9.96 — 11.06 — 12.10 -15.02 -13.12

-9-SÖ -"•39 -8.34 -5.60

C.&N.W. C.M.&St.P. 12.06 15.60

8-34

-6.03 — 11.22 -7.88 -8.28 — II.07 -9.67 -14.81 -15.28 -9.II

— 5.22

9.26 7.07

-4-49

-13.81 -23.27

-14-41

-16.25 -18.01 -13.20 — 14.22 — 18.00 -14.42 -8.83

i.e. 13-52 9.29

-3-58 -3-Si

0.61 — 2.96 -9.84 0.86 2.06 1.22

2-33

1.30 10.56

Minus sign indicates loss.

In the Chicago Great Western case19 the Commission formally announced, " I t is apparent that, measured by earnings, a total capitalization equal to physical valuation of the property for rate-making purposes is not justified, and that the equity indicated by the [physical] valuation does not exist." 20 Thus the Commission gave voice to the mandate expressed in the Bankruptcy Act of 1933, wherein past and future earnings, in addition to physical valuation, were to be considered as bases for recommending an appropriate capitalization for reorganized railroads.21 The natural effect of this policy as enforced by the Interstate Commerce Commission was to reduce the stated capitalization of financially embarrassed roads to the point where "normal" earnings would give adequate coverage to a company's fixed-charge obligations.22 Table 12 reveals, moreover, that the Burlington's burden of fixed charges was a smaller proportion of its 1931-1940 average gross operating revenues than was true for any of its competitors. However, the proven policy of the Interstate Commerce Commission was toward a revision of charges of reorganized roads, a move which would put these companies out of danger of further financial embarrassment. Therefore President Budd confidently anticipated, as the thirties neared their end, that the Burlington's rival railroads would find their earning prospects improved through reorganization. In this manner the character of the railroad industry as a public utility colored the policy decisions of the Burlington's managers. The permanency of the Burlington's competitors as elements of the national

38

POLICY FORMATION IN RAILROAD FINANCE

transportation system was not to be questioned. Financial inefficiency, if such were the case, might force these rivals into bankruptcy, but would not eliminate them as competitors. If reorganization proceedings, by reducing fixed charges independently of property costs, were to place competitors in a position to show sizable earnings, a financial problem of the first magnitude would be created. This problem is intensified by the fact that in the railroad field fixed charges are a much larger proportion of total costs than is the case in many other types of business. T h e crux of the matter lay in the subsequent possible decisions of the Interstate Commerce Commission as it might permit more or fewer revenues to all railroads, whether reorganized or not. As President Budd later expressed the situation, " I t was clear that when [the bankrupt competitive] roads came out [of reorganization] it would be important for the Burlington to have a strong debt [position]. This would be especially necessary because of the rates which might be approved by the Commission, based not on value of properties but on necessities of income to meet mortgage bond interest." 2 3 Thus President Budd was strongly motivated to accomplish a reduction in the Burlington's interest charges to a point comparable with that of its competitors. T o revert to Table 12, if the Rock Island, Milwaukee, and North Western were to have their charges cut by reorganization proceedings, it would follow that these roads might be in a position to show earnings even in the face of further curtailment of revenues. T o take the extreme for purposes of illustration, if all the Rock Island's fixed charges should be eliminated by reorganization, recasting that railroad company's income account on this basis would show a net loss in only one of the ten years following 1930. Instead of a loss of 5.60 millions of dollars in 1940, profits would have been 8.42 millions on revenues of 80.70 millions. President Budd, contemplating such possibilities, saw rooted in this situation a threat to the rate structure of the railroad industry. If agricultural interests, for example, or any similar group of the industry's customers, in a later year of economic distress could point to the fact that railroads, freed by reorganization of the necessity of paying large amounts of fixed charges, were yet able to show comfortable profits on operations, pressure would undoubtedly be put on the Interstate Commerce Commission to reduce railroad rates. If the Burlington meanwhile had not voluntarily reduced its interest charges, the resulting loss of revenue from reduced rates might easily spell disaster. Unquestionably President Budd's analysis of the implications of debt reduction of the Burlington's competitors was acute and farsighted planning — if one grants his premise that the Interstate Com-

APPROACHING MATURITY OF ILLINOIS BONDS

39

merce Commission might set rates "on necessities of income to meet mortgage bond interest." However, there is no evidence that the Interstate Commerce Commission was actually considering the adoption of such a position as that foreseen by the Burlington's president. B y 1940 the Commission had made its stand clear in the Chicago, Rock Island and Pacific Railway Company reorganization proceedings. 24 There it was stated (p. 390) that Section 77 of the Bankruptcy Act specifies earning power as a factor to be considered in determining the value of a railroad property for reorganization purposes. However, the Commission pointed out that valuation on this basis is not contemplated in Section 19a of the Interstate Commerce Act, and would not represent value for rate-making purposes. Numerous cases in court were cited to uphold this position. This view was reaffirmed in the Rock Island case later. 25 ". . . Valuation for capitalization, consolidation, taxation, and rate-making purposes cannot all be made upon the same basis." T w o further instances may be cited to show that the Commission did not intend the reduction of capitalization in reorganized roads as a reduction of the base upon which rates would be established. In Ex Parte 138, "Opening Journal Entries for Reorganization of Chicago Great Western Railroad Company" (247 I. C. C. 193), the Commission pointed out on June 16, 1941, that for purposes of rate regulation the Supreme Court uses value as the amount upon which owners of the property are entitled, under the Constitution, to earn a reasonable return, of which it cannot be deprived by public regulation. T h a t amount is determined after giving consideration and weight principally to original cost, cost of reproduction of portion reproducible, present value of land, and extent to which properties have depreciated, ". . . whereas the value of railroad properties we endeavor to determine within maximum limits for financial reorganization purposes is the actual worth of property to its owners . . . [which] depends upon earning power, competition, and condition of facilities in the property." Finally in Ecker vs. Western Pacific Railroad Corporation (318 U.S. 448), where the right of the Commission to apply its rules for determining value on basis of earnings as opposed to its rate-making rules was contested, the Supreme Court upheld the Commission's prerogative, stating: 5. The phrase "compatible with the public interest" includes questions as to the character and amount of capitalization of the reorganized corporation; and so long as legal standards are followed, the judgment of the Commission in such questions is final . . . 7. Section 77(e) authorizes the elimination from participation in the reorganization of stockholders and creditors whose claims are valueless. Such

40

POLICY FORMATION IN RAILROAD FINANCE

authorization is a valid exercise of the power of Congress and does not deprive such claimants of property without due process of law. The evidence indicates that the Commission did not contemplate shifting its basis of establishing rates from those elements of value historically used. Nevertheless the Burlington's president is to be complimented for his foresight in seeking to establish a financial policy that would offer protection in the case that eventuality materialized. And it cannot be denied that, whether or not President Budd's premise was firmly established, efforts to reduce the Burlington's debt were influenced by his decision to create for the Burlington a debt structure as strong as any that its competitors might obtain upon their emergence from reorganization. Since, therefore, the probable burden of fixed charges of the reorganized Rock Island, North Western, and Milwaukee constituted a measuring rod for the policy President Budd intended to adopt, rulings of the Interstate Commerce Commission in reorganization proceedings of these roads assumed prime importance. B y the end of 1945, at which time the Burlington completed its refinancing operations, the Commission's plan for two of the roads had been approved by the courts and had been accepted, and the trustees had been discharged, but the Rock Island's plan was yet to be consummated even though it had received court approval.26 Recommended capital structures of these railroads and dependent fixed charges may therefore be compared with their 1940 charges as an index of the strengthened capital structure that President Budd would set as his goal. Table 13 brings out the obvious fact that the reorganized competitive railroads found their fixed charges reduced far below the 1940 level. However, one other important fact is revealed: the revised capitalization of these railroads (which encountered financial difficulties during the period the Burlington was being successfully managed) consisted of both contingent and fixed-debt obligations. An enigma is thus presented. Is the goal of debt reduction voluntarily sought to be one of establishing a comparable basis of fixed charges, or of all charges on debt? The answer to the enigma introduced must be based upon hypothesis. Three answers may therefore be proposed. The first assumption rests upon a literal interpretation of President Budd's analysis of the threat to the Burlington's competitive position. If, as was suggested, the Interstate Commerce Commission might set rates to assure no more than minimum earnings for coverage of "mortgage bond interest," just that aspect of the obligation of reorganized roads would need to be considered. On this basis the Burlington's goal would be a reduction

APPROACHING MATURITY OF ILLINOIS BONDS

41

Table i j . The Burlington's competitive position in comparison with reorganized roads: and IQ45 capital charges.

IQ40

C.B.&Q.

Charges

C.R.I.&P. b C.M.&St.P. c

C.&N.W. d

Fixed charges (millions of dollars) 9.66 X

1940 I94S

14.02

3 46

14-55 4-03

16.45

6.99

9.90

6.81

18.32

14-55

19.49

X

4-52

4-°3

3-3°

X

9.14

9.90

8.19

A l l charges (millions of dollars)

1945 Fixed charges as ratio of 1931-

X

2.79

1940 r e v e n u e s (per cent)

1940 a 1945 (excluding contingent interest) 194S (including contingent interest)

IO-S3

» From Table 12. b 194s data estimated as follows from Standard Corporation Descriptions, vol. 7, no. 35, sect. 1 (New York, August 20, 1946), p. 2817. Fixed charges

Other charges

I C C Modified Plan Contingent interest $3,330,322 Fixed interest on debt. . $1,544,877 Fixed interest sinking Capital fund 1,614,038 fund 200,000 1945 Reported charges (from Moody's Steam Railroads, 1946, p. 385). Leased line rentals 265,556 Other interest 30,908 Total fixed charges c d

$3,455,379

Total other charges

$3,530,322

1945 data from Standard Corporation Descriptions, vol. 7, no. 41, sect. 1 (New York, October 23,1946), p. 2598. 1945 data from ibid., no. 29, sect. 2 (New York, July 15, 1946), p. 44.

of fixed charges from the 10.53 P e r c e n t l e v e * oi 1940 to, for example, a basis of around 3.5 per cent of the average revenue of the years 1 9 3 1 - 1 9 4 0 . With the average annual gross revenues for the period at $91,750,000 this would mean fixed charges of some $3,211,000. Presumably 1940 charges, excluding interest obligations, would not be affected by this hypothetical revision, and, therefore, this assumption would mean a fixed interest burden of no more than $3,000,000. 27 Finally, if this $3,000,000 interest charge be capitalized at 4 per cent, President Budd's goal for a "strong debt" stands revealed as recommending in fact fixed interest obligations of approximately $75,000,000. For a property whose earnings before fixed charges had never fallen below $10,000,000 even during the depression of the 1930's (see Table 1 2 ) this would appear a most conservatively stringent requirement. Supporting this minimum earning power of $10,000,000 net before fixed charges were stated net tangible assets of $588,000,000 in 1940. 28 Carrying the implied capitalization a step further, it is evident that the difference between $588,000,000 and $75,000,000, or $513,000,000, would be in the form of equity instruments and surplus.

42

POLICY FORMATION IN RAILROAD FINANCE

Bonds would thus be approximately 13 per cent of total capitalization, compared, for example, with'a similar 1935 proportion of 15 per cent for the iron and steel industry and 13 per cent for the petroleum industry. 29 Although no proof can be adduced to demonstrate the unquestionable conservatism of such a recommended railroad capitalization, the fact remains that in 1943 all Class I line-haul railways had far different capital structures. Table 14 presents the capital structures in that year both for the Western District and all Districts in the United States. Table 14. Capital structures for Class I line-haul railways in the whole United States and in the Western District, 1943 (selected items from balance-sheet)." All districts

Items Long-term debt Capital stock. . Surplus Total

(millions of dollars)

(per cent)

10,463

47.1

7,975 3,749

36.0 16.9

22,187

100.0

Western district {millions of dollars)

{per cent)

5,068 3,462

51.4 35.1

1,326

13.S

9,856

100.0

6 D a t a taken from Interstate Commerce Commission, Statistics of Railways in the United States for 1943 (Washington, 194s), Table 128, p. 115.

Another estimate of the Burlington's ultimate capitalization may be derived from these data. If the implied $75,000,000 debt of President Budd's goal were planned as, say, 50 per cent of the total, the Burlington's capital structure then would indicate assets with "actual worth to the owners" of only $150,000,000. The least that can be said is that this figure would also represent a sharp understatement of the value of a railroad property whose net earnings before fixed charges had never fallen under $10,000,000, and averaged over 14 millions of dollars during the depressed decade 1931-1940. 30 A second assumption must be considered to answer the question of whether the Burlington should entertain as its goal of reduced charges only the fixed-charge basis of its competitors or their fixed plus contingent charges. Evidently President Budd's motive for revising downward the Burlington's fixed burden was related to the possibility that the Commission might establish rates on the basis of the reduced capitalization of reorganized roads. Disregarding the absence of evidence on this point of the Commission's intention, the fact remains that it was the total permissible capitalization of reorganized roads which the

APPROACHING MATURITY OF ILLINOIS BONDS

43

Commission allowed as evidence of the "actual worth to owners" of railroad property. Even though funded debt might bear fixed or contingent interest, it was still funded debt, and thus represented "actual worth" that on any basis could be expected to have earning value. For this reason, a more appropriate comparison of the reduced fixed charges resulting from a policy adopted by the Burlington would be with fixed plus contingent charges upon the funded debt of reorganized roads. Even the reorganized competitors would find it impossible to avoid later bankruptcy proceedings if contingent interest charges were never earned, for such unfavorable experience with earnings would spell the impossibility of meeting the obligation of this form of debt upon maturity. A final assumption provides another answer to measure the goal of voluntary debt reduction flowing from President Budd's desire to make the debt burden of the Burlington comparable to its competitive roads. This last assumption simply ignores the rate-making aspect of the problem introduced in the preceding hypothesis. Assuming, narrowly, that the Burlington wished to place itself in the position of never having to pay more fixed interest than the least its competitors would have to pay, the goal of fixed charges excluding contingent interest is reestablished. On whatever basis the comparison is made between fixed charges of the Burlington and its competitors, the fact remains that a strong motive for voluntary debt reduction shaped the embryonic financial policy of the Burlington during the 1930's and subsequent years. The Burlington itself had withstood the vicissitudes of the decade, but three of its four principal competitors had succumbed to financial hardships. The poor credit position of the Burlington's competitors had forced them into bankruptcy and reorganization. But growing out of their reorganization experiences were new debt structures whose implications led the Burlington's president to seek the adoption of a financial policy that would offer protection against the threat he saw arising therefrom. The Burlington's Credit

Position

Undeniably the immediate financial situation of the Burlington had a profound effect upon the efforts of the company's officers to develop plans for meeting the maturity of the Illinois Division bonds. The factors affecting the credit condition of the railroad grew out of its earning record during the thirties and the payment of dividends to the parent Northern lines. One measure of this condition lay in the market's appraisal of the credit of the railroad as reflected by below parity quotations of the company's previously considered investment

44

POLICY FORMATION IN RAILROAD FINANCE

quality securities. These two elements of the Burlington's credit position will be reviewed briefly in turn. Earnings and Dividends T h e Burlington was one of the select few Class I American railroads to weather the depression of the thirties with a continuous record of profits. E v e n in 1932, the company's worst year of operations, fixed charges of $9,452,601 were covered 1.07 times, enabling President B u d d to report to stockholders earnings of $I,502,8I6. 31 However, the ability to show profits from operations was not permitted to strengthen the credit position of the Burlington. Rather than retain these modest earnings as extra funds to draw upon against contingencies, the directors decided in favor of liberal dividend disbursements to the company's stockholders. T h e pattern of paying dividends in excess of net earnings was set in 1930, nearly two years before President B u d d took over his duties as the Burlington's chief executive. W i t h the exception of 1933, dividends exceeded earnings in each year until 1937, and for the years 1933 and 1937 through 1940 payments were an exceedingly generous proportion of profits. T a b l e 15 presents the net income and dividend record of the Burlington for the years 1928 through 1944. For the first seven years of the application of the Burlington's liberal dividend p o l i c y — 1 9 3 0 through 1936 — payments to stockholders of $68,336,000 exceeded net income of $53,856,000 b y $14,480,000 or 27 per cent. T h e record for the crucial eleven-year period through 1940 shows excess disbursements of $11,545,000 or 16 per cent. During these years the problem of the $85,000,000 Illinois Division bond maturity was becoming even more acute, but it was the will of the Burlington's majority stockholders, the Northern lines, to utilize their company's earnings in the form of dividends rather than to permit the accumulation of a reserve fund to be used if necessary in refinancing the debt payable in 1949. A s revealed in T a b l e 15, dividends paid the Burlington's parent companies did not exceed the former's net income after 1936. T h e proportion of earnings paid out, however, remained at a high level until 1941. Y e t the policy followed had very serious repercussions upon the market's evaluation of the credit of the Burlington even b y 1938. For in that year the company found it necessary to resort to banks for a demand loan in excess of $6,ooo,ooo. 32 Bearing upon the implications of this transaction, Barron's, the financial weekly, reported: . . . Financial status of the Burlington undoubtedly would be far stronger than it is at present had not Northern Pacific and Great Northern drained it of a large part of its liquid resources to bolster their own reported earn-

APPROACHING M A T U R I T Y OF ILLINOIS BONDS

45

Table 15. Chicago, Burlington and Quincy Railroad Company, net income and dividends, 1928-IQ44.»

Net income {thousands of dollars)

Dividends (thousands of dollars)

Ratio of dividends to net income (per cent)

1928

26,278

17,084

65

1929

29,577

17,084

58

1930

21,980

25,626

117

1931

13,320

17,084

128

1932

1,503

5,125

341

Year

1933

5,598

5,125

1934

4,455

5,125

193s

1,843

3,417

185

1936

5,157

6,834

132

1937

4,907

3,417

70

1938

3,642

3,417

94

1939

3,66I

3,417

93

1940

4,393

3,417

78

1941

10,419

3,417

1942

28,647

5,125

33 16

1943

28,231

5,125

16

1944

24,647

5,125

21

92 " 5

* Data in CBQ Annual Reports, 1928-1944.

ings. Possibility of further such drains is the principal adverse factor for the road . . . [In 1938] the road found it necessary to borrow $6,000,000 from banks, but strong earnings recovery in second half of year permitted repayment of debt and disbursement of dividends.33 T h e onus of this loan "from banks" was not quickly forgotten — either by the impersonal financial markets or by President Budd. Four years later, on December 22, 1942, President Budd wrote President Gavin of the Great Northern, " E v e r since we borrowed money to pay dividends there has been doubt of the soundness of our fiscal policy." 3 4 Further, with moderate overstatement, President Budd wrote, "Prior to 1938 all Burlington bonds sold above par, on a yield basis, but in 1938 apparently primary emphasis was placed on security, and in 1939 all our bonds except the Illinois Division 4s went below par." 35 Market Quotations of the Burlington's Bonds The precise record of the market's evaluation of the Burlington's bonds is presented in Chart I. T h e pronounced drop in prices of the

APPROACHING

MATURITY OF ILLINOIS BONDS

47

principal Burlington bonds in 1938 is at once apparent. While it is not true that "Prior to 1938 all . . . bonds sold above par . . . ," that experience had held during the years 1935 through 1937. Comparison of the computed yield to maturity of the Illinois Division 3>4's of 1949 with Moody's average yields for Aaa rail bonds reveals, moreover, certain significant trends. From January, 1929, until January, 1934, there was close correlation in the movements of the two series. In the second half of 1934 and until 1938, the Illinois Division bonds sold on a lower yield basis than the average of Aaa bonds. Although prices of Moody's Aaa bonds (as measured by higher yields) dropped in 1938, the decline in the Illinois Division 3 ^ ' s was far more severe. Moreover, from January, 1939, until the Illinois Division bond-refunding plan was perfected in 1944, these bonds continued to sell on a higher yield basis than the computed average for Moody's first-quality railroad bonds. The market quotations of the Burlington's bonds seem to support President Budd's assertion that "since we borrowed money to pay dividends there has been doubt as to the soundness of our fiscal policy." But it was not until 1941 that the Burlington's owners, the Great Northern and Northern Pacific railroads, proved willing to forego large dividends and thus permit the market to revise its opinion of the soundness of the Burlington's credit.

Chapter

Three

FIRST EFFORTS TO FORMULATE A FINANCIAL PLAN A.

INTERNAL

CONSIDERATION OF THE

PROBLEM

Unsettled business conditions and uncertainties in the financial markets led the officers of the Burlington to postpone active consideration of plans for refinancing the Illinois Division bonds between 1936 and 1940. Meanwhile, factors affecting the credit position of the Burlington had proceeded apace in their development, and the magnitude of the problem presented by $85,000,000 of maturing debt less than a decade away had become even more sharply outlined. By January, 1940, the bond department of Shields and Company, for example, was advising its customers that ". . . Relative stability of [the Burlington's] bonds has inspired confidence that they can be refunded at maturity, but this confidence might disappear were the road to suffer [any] contraction of earnings. It is suggested, therefore, that the bonds be liquidated in favor of the many railroad issues of sounder quality which afford similar yields." 1 Preliminary Explorations Faced with the foregoing and similar appraisals by other analysts of the company's prospects, Burlington officials reopened the consideration of plans for handling the Illinois Division refinancing in 1940. First steps, quite naturally, consisted simply of an examination of the various methods available to the company under the terms of junior mortgages that had been executed subsequent to the issuance of the Illinois Division bonds. In the fall of 1940, the railroad's secretary was requested to submit a memorandum2 to the general counsel, summarizing these various alternatives. These points were made: 1. Refunding Possibilities — both General and First and Refunding Mortgages make provisions for Illinois Division bonds. A. General Mortgage bonds may be issued to refund prior debt,

FIRST EFFORTS TO FORMULATE FINANCIAL PLAN

49

provided they are pledged under First and Refunding bonds, which latter may be issued and sold to provide necessary cash. B. First and Refunding bonds may be issued and sold direct to provide funds for the Illinois Division maturities. Such redeemed Illinois bonds must be held alive until General Mortgage bonds are paid. 2. Extension Possibilities A. General Mortgage contains no provisions or restrictions relative to extension of Illinois Division bonds. Holders of 25 per cent of bonds, however, may institute proceedings to test legality of extension. B. Illinois Division Mortgage contains no provisions preventing extension. "Illinois Division bonds might be extended by securing the consent of 7 5 % of holders of Illinois Division and General Mortgage bonds." (p. 2). C. First and Refunding Mortgage allows extension of prior debt bonds. Preliminary examination of the courses open to the company thus suggested either refunding by First and Refunding bonds, or extension of the Illinois Division mortgage. Since, however, the F & R bonds were then selling on a current return basis (the price of F & R 4^2's of 1971 was 7424 on October 28, 1940 to yield 6.38 per cent to maturity) the memorandum left the distinct impression that extension of the Illinois bonds would be the only practicable procedure. The company at once began to investigate the alternatives mentioned in the secretary's memorandum. Less than two weeks later, the treasurer confirmed the impracticability of issuing new First and Refunding bonds by pointing out that the outstanding F & R 5's were then yielding in the market 6j4 per cent to maturity and a new series would probably have to bear at least 6 y 2 per cent interest. The treasurer pointed out further that if the refunding were carried through on such a basis, an additional $2,400,000 of annual interest cost would be incurred in refunding the Illinois Division bonds. However, keeping in sight the goal of reduced interest charges, Treasurer Williams indicated a compromise course of action. According to this plan, considerably less than $85,000,000 of new F & R bonds might be sold "to replenish working capital," and proceeds of this sale used in "part payment" (sic) of Illinois Division 3 ^ ' s and 4's. It is difficult to understand what the treasurer expected would be gained by this procedure save a reduction in the principal amount outstanding of the Illinois bonds. Surely if his previous analysis were valid there

SO

POLICY FORMATION IN RAILROAD F I N A N C E

would have been no reduction in interest cost by this method — rather, the increase would only have been smaller in absolute amount. It must be conceded, though, that the treasurer did not press the adoption of his suggestion, but quickly recommended that "extension of the present bonds would undoubtedly be a much more favorable arrangement for the Company . . ." 3 Meanwhile the company's contract attorney reported on the legality of entering into extension arrangements with the Illinois Division bondholders. After studying the pertinent law, Mr. Cubbage was led to the conclusion "that there should be no question but what extension agreements between Illinois Division bondholders and the C B & Q would be effective to preserve the first lien of the Illinois Division Mortgage." 4 Thus, prior to the board meeting of November, 1940, the Burlington's general counsel had canvassed the simple mechanics of refunding or extending the maturing bonds. The work, of course, was purely preliminary, and there remained the job of developing these mechanics into a smoothly formulated financial plan, or even of developing entirely new alternatives if such were possible. Appointment

of a Committee

to Create a Financial

Plan

It was the board meeting of November 26, 1940, however, that officially committed the Burlington to active consideration of the refinancing problems daily growing more imminent. B y resolution, the board of directors on that day appointed a committee of three to "look into the questions which will arise in connection with maturity of the Burlington Illinois Division Mortgage Bonds." 5 The committee membership consisted of the president of the Burlington, Mr. Budd, and the presidents of the Burlington's parent lines: Mr. Gavin of the Great Northern and Mr. Denney of the Northern Pacific. Thus President Budd, whose interest in the matter extended back over several years, officially accepted the responsibility of developing a feasible financial plan. Within the Burlington, the vice president and general counsel, Mr. J. C. James, was immediately delegated the task of organizing 6 the research that would form the basis of the committee's report embodying recommendations for the directors to consider at a subsequent board meeting. Initial study took the form of a careful examination of the physical value and percentage of total business on the property behind the three outstanding mortgages — the Illinois Division, the General, and the First and Refunding. Table 16 summarizes the rather interesting findings of this investigation. According to the analysis in Table 16, the Illinois Division mortgage was a first lien on 30.3 per cent of the property which supported 34.4

FIRST EFFORTS TO FORMULATE FINANCIAL PLAN

SI

Table 16. Comparison of the outstanding debt with the value of the security and the percentage of business carried for the Burlington's three mortgages, December JI, 1939. Principal amount outstanding® {millions Mortgage Illinois Division General M o r t g a g e . . . First and Refunding..

of

Value of first-lien security b

dollars)

(per cent)

Percentage of total business carried on first-lien property b

(millions

dollars)

(per cent)

84.4 65.2

34-2 37-6

69.8 219.4

of

211.0

3°-3

34-4

65.2

60.8

28.2

4S4-0 31-5

4-5

4.8

100.0

696.5

100.0

100.0

Memorandum from P. F. Mulkey to J. C. James, December 5, 1940 (CR). Memorandum of Engineering Department, December 18, 1940 (CR). The percentages of total business carried were derived from locomotive and car miles traveled in 1939 over the respective mortgaged properties. s

b

per cent of the company's business as measured b y locomotive and car miles — a relatively better showing than the General Mortgage property, where the figures work out to be 65.2 per cent and 60.8 per cent respectively. Although this crude basis of measuring the relative worth of the various mortgages was criticized b y the Burlington's officials, it was nevertheless used b y an economist in the company's tax bureau to allocate the earnings of the company to the various bonds. 7 T h e conclusion was drawn that it would be to the Burlington's greater advantage to issue First and Refunding bonds directly in order to retire the Illinois Division security than to issue Generals for such purpose and pledge them under new F & R bonds to be sold. For, it was pointed out, the former method would assign directly to the F & R bonds 34.4 per cent of the Burlington's earning power, thus increasing the first-lien earnings claim of the F & R bonds from 4.8 per cent to 39.2 per cent. T h e latter method would leave the F & R first-lien claim undisturbed at 4.8 per cent, but raise the earning power of the General Mortgage bonds to 95.2 per cent of the total. T h e effect of pledging under the F & R bonds $85,000,000 or 56.5 per cent of the Generals outstanding subsequent to this latter method was ignored. Such action would appear to assign 56.5 per cent of 95.2 per cent or 53.8 per cent of the company's earning power to the F & R bonds and thus improve their position. Directly, of course, the first-lien claim would remain at 4.8 per cent as stated. However, the general counsel's research was primarily directed toward investigating the possibilities of either extending the Illinois Division Mortgage bonds or of retiring them through open-market purchase rather than planning a refunding operation via the First and

52

POLICY FORMATION IN RAILROAD FINANCE

Refunding mortgage. The question actually raised for study thus became this: is the adoption of a policy leading toward extension more desirable than open-market purchase of the bonds? Development of the advantages and disadvantages of the two policies led to compromise alternatives. The first discussion of the question in the company's files took the form of a memorandum prepared by Mr. W. K. Bush, the company's tax economist.8 While conceding that a program leading toward extension would be entirely feasible, it was pointed out that to implement this policy effectively surplus cash should be earmarked to provide a fund which could be used if necessary to pay off those Illinois Division bondholders who might dissent to an extension proposal. Nevertheless, Mr. Bush was of the view that a preferable procedure would be to use surplus cash for open market purchases, not, however, of the Illinois Division bonds, but rather of the Burlington's higher coupon issues (First and Refunding bonds), which were then selling at a much greater discount.9 If funds were so applied, larger savings would be realized than either by holding surplus funds idle against the day when dissenters to an extension proposal would need to be paid off in cash, or in purchase and retirement of the Illinois Division bonds, then selling at 93 for the 3 J/2 per cent issue. On the other hand, it was the Illinois Division bonds whose approaching maturity was to be provided for. In a second memorandum prepared only three days later, Mr. Bush reported upon a plan for the open-market purchase of these securities, to be financed by the sale of new Serial Collateral Trust bonds.10 This compromise alternative is of decided interest, for in the record of the developing financial policy the first evidence is here found that the possibility of a collateral trust issue was being considered by the Burlington's management. On the assumption that $10,000,000 eight-year Serial Trust bonds could be sold at an interest cost of per cent, Mr. Bush calculated that interest savings arising from the purchase of $10,753,000 Illinois Division 3 ^ ' s at a price of 93 would result annually in approximately $301,000. Annual maturities on the new bonds, however, would drain the company's cash $1,250,000, so that the yearly net cash cost of such a program would be $949,000, disregarding tax consequences. As a compromise alternative, or means of providing for open-market purchases by partial refunding, Mr. Bush's memorandum was not warmly received. The Burlington's treasurer quickly pointed out that payments for equipment previously purchased and budgeted for the future would require $3,000,000 annually for reduction of principal of these obligations alone. He wrote, " I should regret to see any further commitments made that would necessitate repayment of the principal

FIRST EFFORTS TO FORMULATE FINANCIAL P L A N

53

sum [of new debt] on any fixed schedule." 11 However, the treasurer was not averse to open-market purchases of Illinois Division bonds, although he recommended that what surplus cash the Burlington found might better be used in the retirement of conditional sales contracts used to finance equipment purchases. The company's comptroller, Mr. H. W. Johnson, agreed that it would be unwise to incur additional annual charges such as would result from an issue of new eight-year Serial bonds. Rather than recommending open-market purchases of Illinois Division bonds on any basis, Comptroller Johnson went on record as strongly favoring arrangements to provide for extending the maturity of the issue. In his opinion, ". . . it would seem that the 'best bet' would be an attempt to persuade present holders to extend their [Illinois Division] bonds." 12 Ten days later, on January 30, 1941, the comptroller reaffirmed his position that the logical procedure would be extension of the Illinois Division bonds, and he strongly condemned the issuance of serial collateral trust debt to effect a partial purchase of the outstanding Illinois Division securities. In addition to the argument mentioned by the treasurer, a practical financial consideration was mentioned in support of this viewpoint: it was alleged (and rightly so in the light of subsequent developments) that the current market of 93 to 94 for the Illinois 3^>'s did not mean that large holders would sell at that reduced price. Comptroller Johnson maintained, in fact, that any sizable purchases of Illinois 3 ^ ' s would immediately force the price up toward par. 13 In the light of the opinions and analyses submitted to the vice president, it was tentatively concluded that extension of the Illinois Division debt would be the most satisfactory plan to adopt. Comptroller Johnson confirmed the decision reached by Vice President James in a memorandum addressed to the general counsel on March 14, 1941. The comptroller stated, . . it would be very much better and very much safer to conserve our resources and build up a cash working position rather than attempt to retire any of the Illinois Division bonds." Accordingly, on March 18, 1941, Vice President James submitted a memorandum of the data he had gathered to the general counsels of the Burlington's controlling roads, who had been requested together with James to advise the special committee appointed at the board meeting in November, 1940. In his letter to the other members of the advisory group, Vice President James affirmed his conclusion that "the Illinois Division Mortgage Bonds should be extended, rather than refunded, at maturity July 1, 1949." Furthermore, James wrote, ". . . I have reached the conclusion that the uncertainty of world affairs in general and our own financial condition in particular make it

54

POLICY FORMATION IN RAILROAD F I N A N C E

unwise to embark upon a bond-buying program at this time." And finally, voicing the opinion of Economist Bush, ". . . it seems obvious that refunding through the First and Refunding Mortgage alone would be preferable to refunding through the General Mortgage and the First and Refunding Mortgage." 14 Mr. F. G. Dorety of the Great Northern immediately answered Vice President James' suggestions by giving his unqualified approval. 15 But with respect to following a policy of building up cash resources, Mr. Dorety made the practical observation that he assumed " . . . in recommending a policy of building up cash as against using the cash for the purchase of bonds, you have reference only to surplus cash which may remain after payment of such dividends as may be determined upon." The general counsel of the Northern Pacific, however, did not react as favorably to the analysis submitted by James as had Great Northern's Dorety. On April 2 2, after having had James' proposals examined by one of the Great Northern's attorneys, 16 Mr. da Ponte wrote, . . I do not believe it possible to formulate a plan at this time which we expect to follow in 1949." 17 This verdict would seem to dismiss the entire investigation authorized by the Burlington's board of directors; but Mr. da Ponte was prepared to leave open for discussion the current policy that might be followed with respect to cash accumulation, or bond purchases, and thereby recalled for consideration, as had Mr. Dorety, the troublesome question of dividend policy. In Mr. da Ponte's opinion, "It seems . . . that the only question which can now be decided is whether to purchase the bonds at present prices or to accumulate cash, subject to whatever dividend policy is adopted. I note that you [Mr. James] and Mr. Dorety favor cash accumulation. But it seems to me that this question also depends on what will be done with the cash accumulations over the dividend requirements." 18 On May 7, Mr. James answered Mr. da Ponte's observations: " I have not understood that our Presidents expected any recommendations from us as to dividend policy, that being a matter for their determination." Mr. James reiterated the points originally embodied in his recommendation, and arranged for a meeting with the representatives of the Northern lines on May 9. As a result of the discussion held at that time, the advisory group agreed upon minor revisions in the original analysis, and drafted a letter of transmittal to accompany their report to the special committee of Presidents Budd, Denney, and Gavin. Although the proposed letter to be sent to the presidents was satisfactory to James and Dorety, 19 Northern Pacific's da Ponte insisted upon eliminating from the final recommendations any reference to the

FIRST EFFORTS TO FORMULATE FINANCIAL PLAN

55

plan of subsequently exploring the possibility of extending part of the Illinois Division bonds. He said, " I t occurs to me that it would be better to consider that matter when the occasion arises. It also seems to me that the idea is not practicable." 20 This objection was sustained on June 14 by F. G. Dorety, and at last the advisory group forwarded to the special committee the results of the investigation under way since November of the preceding year. The investigation itself explored objectively the various alternatives open, but the letter signed by the advisory group proposed adopting a watch-and-wait policy, meanwhile building up the Burlington's cash resources. 21 In its final form, the advisory group's report was accepted by President Budd on June 17, 1941, and in a letter of that date to the other members of the special committee he suggested ". . . that we adopt [it] as our report . . . and that we docket the report for discussion at the next Board meeting." The presidents of the Northern lines agreed to this proposal, and on June 24, 1941, the Burlington's secretary was instructed by President Budd to docket the study as agreed upon. The 1941 Financial Plan Developed

by the Special

Committee

While the separate alternatives open to the Burlington have been mentioned in the foregoing account of the development of the committee's report, it is important that the points brought out in the memorandum be kept in mind as indicative of the thinking of the Burlington officials in 1941. From the point of view of the finished financial policy ultimately developed, the 1941 conclusions appear almost amateurish. The principal shortcoming of the analysis made at that time lay in the failure to make a realistic projection of the company's financial prospects. The alternatives considered were, in truth, labeled "as of July 1, 1949," 22 but consisted of an analysis of the legal mechanics of these alternatives, without reference to the probable effect upon the company of any economic eventualities. Four possibilities were visualized for 1949: " . . . the Illinois Division Mortgage Bonds may be ( 1 ) paid, (2) extended, (3) refunded through the General Mortgage and the First and Refunding Mortgage, or (4) refunded through the First and Refunding Mortgage." 23 Considering these procedures, the report examined the legal possibility of extending the bonds and concluded that the only bar to such a plan would be obtaining the consent of 75 per cent of the holders of the Illinois Division bonds alone. As between the third and fourth alternatives an ingenious analysis was made to show that refunding through the First and Refunding bonds alone, alternative 4, would be more advantageous to the company in the sense that the earning power behind the First and Refunding Mortgage would be decidedly improved

56

POLICY FORMATION I N RAILROAD F I N A N C E

rather than only moderately so if alternative 3 were followed. F o r under this procedure, it was alleged that earning power behind the General M o r t g a g e would be diluted upon the issuance of these bonds to retire the Illinois bonds, and the subsequent pledge of General M o r t g a g e bonds behind new F & R bonds would only moderately improve the earning power of the latter. Y e t the fact that the preferred procedure of refunding directly through the F & R bonds would necessarily postpone a n y refinancing until twelve months before the Illinois Division bonds would mature was not considered as a serious defect of the plan. 2 4 Records do not reveal the direction taken in the directors' discussion of the special committee's report. T h e matter was considered at a meeting of the executive committee in August, and again b y the board of directors at their meeting on September 2 2 , 1 9 4 1 . N o formal action was taken, however, and the report was simply held b y the secretary among various other board papers awaiting disposal. 2 5 I t is probable that the possibility of extending the Illinois Division securities received favorable attention b y the board, for on November 7, V i c e President J a m e s raised the question with the general counsels of the Northern lines whether anything in the mortgages of the parent companies might preclude the extension of the Burlington's bonds. E v e n though there is no evidence that this inquiry was prompted b y a request of the directors, the timing of J a m e s ' query suggests some connection. Upon receiving advice from the counsels of the Northern lines 26 that there existed no covenants in their various mortgages which would in any w a y restrict the extension of the Burlington's bonds, the company was presented with a green light if it should decide to follow this procedure. B . RESUMPTION OF EFFORTS IN

1942

T h e development of a policy to take care of the maturity of the Illinois Division bonds remained at this stage until the spring of 1 9 4 2 . Some time in M a r c h of that year President Budd, ever mindful of the responsibility of making adequate provision for handling the 1 9 4 9 debt, again sought professional financial advice. In 1 9 3 6 M o r g a n Stanley and C o m p a n y had been asked to recommend courses of action, 2 7 and it was to that firm that M r . B u d d again turned six years later. A c cording to a memorandum in the files of the firm, President B u d d asked that a study be made of the Burlington's mortgage indentures with respect to extending the Illinois Division bonds, and thus, as far as the record indicates, the possibility of extension of the 1 9 4 9 maturities was still uppermost in the company's mind. On April 2 4 , 1 9 4 2 ,

FIRST EFFORTS TO FORMULATE FINANCIAL PLAN

57

Mr. J. M . Young of Morgan Stanley wrote Vice President James that certain analyses had been made in response to Mr. Budd's request, and invited Mr. James to discuss with the bankers the results of their investigation. T h e memorandum prepared at Morgan Stanley made no specific recommendation. Attention was called to the probable necessity of having General Mortgage bondholders agree to any extension plan involving the Illinois Division maturities, a matter that the Burlington's counsel had previously decided would be unnecessary (as indicated in the recommendations of the special committee). A new alternative was mentioned, however, when it was noted that collateral trust bonds might be issued on the security of the Illinois Division bonds to be retired. The possibility of a collateral trust issue was drawn to the attention of the Burlington's officers at the end of 1940, but only as a method of providing funds for the open-market purchase of Illinois Division bonds. T h e basis of Morgan Stanley's Collateral Trust proposal was the plan which had been similarly used by the Louisville and Nashville Railway in its 1940 refinancing, and the procedures developed there were almost precisely the same as those incorporated in the financing vehicle ultimately developed by the Burlington. 28 Meanwhile the increased level of business activity brought about by the war effort was being reflected in the Burlington's revenues and cash position. On the basis of the showing through the first three months of 1942, one investment service predicted that earnings for the year would "moderately" exceed those of 1941, a year which had been the best for the company since 1929. 29 "While expenses will continue heavier than in 1941, there is no indication that the increase will outstrip the gain in gross. High income taxes will limit earnings gains, however." 30 In the light of experience prior to 1940 such a sanguine earnings prospect would have meant the payment of increased dividends to the parent companies. However, whereas 1940 dividends had remained at the high rate relative to net income typical of the policy followed during the decade of the thirties, in 1941 dividends dropped from 78 per cent of net income to 33 per cent, the dollar amount remaining unchanged. 31 If this conservatism in 1941 signaled a reversal of the policy to which the company had apparently been committed over the preceding several years, there was every prospect in the spring of 1942 that the company would have considerable amounts of excess cash on hand by the end of the year. There is no internal evidence available to confirm the hypothesis that the Burlington actually adopted a new dividend policy in 1941.

58

POLICY FORMATION IN RAILROAD F I N A N C E

However, in the letter of June 3 of that year which had accompanied the special committee's report it will be recalled that it was recommended that the best policy to be followed would be to build up the cash position of the Burlington. And further it was stated, "Counsel for the two Northern lines suggest that, in dealing with the dividend policy . . . of the Burlington, the Illinois Division Mortgage should be considered the same as if it were a $42,500,000 Great Northern maturity, and an equal Northern Pacific maturity, in 1949." Although this report was not formally adopted by the directors, it is clear that acceptance of its terms would have led the Northern lines to forego reducing the Burlington's cash by drawing down large dividends. A t all events, instead of following up the study made by Morgan Stanley with respect to extending the Illinois Division bonds, on M a y 7, 1942, President Budd sought the approval of the presidents of the Northern lines for a program to utilize the Burlington's increasing cash position in the open-market purchases of the Illinois Division bonds. 32 Even though there had been no formal adoption of a policy to build up the Burlington's cash while awaiting the arrival of the time for arranging extension of the Illinois Division bonds, that had been the de facto financial plan since 1941. Thus President Budd's decision of M a y 7 amounted to the abandonment of the old and the adoption of a new policy for handling the troublesome 1949 maturities. In a subsequent interview 33 President Budd indicated that he was never greatly interested in the extension of the company's debt. In fact, he preferred to avoid extension, although he felt that it was good to know it could have been accomplished. T o President Budd the possibility of extension was rather an ace in the hole. In the light of this viewpoint, expressed ex post facto it is true, it is not surprising that, at the first opportunity, extension plans were discarded. With the improvement in earnings, and the withholding of improvident dividends, it was inevitable that the rapidly accumulating cash be used rather than allowed to remain idle in the banks. In his letter of M a y 7, 1942, to the presidents of the Burlington's parent lines, President Budd cited two principal reasons in support of the new policy he sought to have adopted. These reasons he enumerated as ". . . first, the actual money gain, since the yield at present quotations is 5 . 7 % , and, second, the improvement of Burlington credit by having a sustained market for its bonds, and also having some of the bonds out of the way and thus reducing the amount of the maturity." 3 4 President Budd further suggested that the Northern Lines' presidents approve the setting aside by the Burlington of $5,000,000 to be used for this purpose in 1942.

FIRST EFFORTS TO FORMULATE FINANCIAL P L A N

59

Immediate agreement to the new proposal was given by Great Northern's President Gavin, who expressed the view that " . . . the time has come when we should reduce the Burlington debt, especially now that we have a surplus of cash." 35 On the other hand, Mr. C. E. Denney, president of Northern Pacific, was reluctant to adopt the program proposed by President Budd. At first Mr. Denney suggested that action be deferred for two or three weeks pending a thorough appraisal of the plan, but President Budd immediately countered with an urgent reason for starting the program without delay. Mr. Denney's attention was called to the fact that the Treasury Department might urge the Burlington to buy new issues of Government obligations in the near future, and if the Burlington were able to represent in good faith that it had begun a program of debt reduction, the Burlington would have, ipso facto, justifiable grounds for postponing its participation in war financing. If the initial reasons urged by President Budd for adopting the bond-retirement program were as valid as they appeared, this later argument to obtain President Denny's approval seems altogether superficial. Yet it turned out to be sufficient for its purpose, for on May 15 President Denney agreed that the Burlington might institute "comparatively small purchases." 36 C.

A BOND-PURCHASING

PROGRAM IS

ADOPTED

In accord with the approval obtained from the Burlington's owners, President Budd inaugurated the program of bond purchases on May 22, 1942. Instead of making use again of Morgan Stanley and Company, Mr. Budd appointed J. P. Morgan as the company's agent in buying its Illinois Division securities. There appeared no significant reason for the shifting of bankers at this stage of the development of the company's financial policy unless it was because Mr. Arthur Anderson, the executive of J. P. Morgan and Company who dealt directly with the Burlington, was a director of the Northern Pacific Railroad, which was under the presidency of Mr. Denney. Whatever the motive for the change, President Budd wrote Mr. Anderson as follows on May 22: Our treasurer, Mr. Vickery, 37 is placing $2,000,000 deposit with you today . . . You are authorized to used $1,000,000 of our funds for the purchase of Illinois Division Bonds of 1949, preferably those bearing 4 % coupons . . .

The $5,000,000 requested originally by President Budd had thus been compromised to the "comparatively small" amount of $1,000,000.

6o

POLICY FORMATION IN RAILROAD F I N A N C E

Despite the relatively small size of the program, the most important implication of this procedure was, obviously, that the Burlington had at last begun a positive attack upon the problem of its 1949 debt maturity.

Chapter Four

INITIAL APPLICATION OF DEVELOPED FINANCIAL POLICY A.

DIFFICULTY IS ENCOUNTERED IN THE MAGNITUDE OF THE BOND-BUYING PROGRAM

The policy approved in May was not, however, administered without further debate. President Budd's original plan to purchase $5,000,000 of the bonds had been given President Denney's qualified approval in a much reduced amount, but $2,000,000 had been deposited with the bankers to purchase only $1,000,000 bonds. Evidently it was planned to step up purchases beyond the initial authorization as soon as President Denney could be persuaded to give his full agreement to the program. But these plans were destined to hit a snag, probably attributable in part to a very curious bit of financial misinformation. On June 8, 1942, just two weeks after President Budd committed his company to the policy of reducing the maturities of the Illinois Division bonds through open-market purchases, Moody's Bond Survey published an analysis of these securities. The analysis was primarily economic, drew unfavorable conclusions from the long-term trend of operating revenues, and forecast that over the period the Illinois Division bonds "may well exhibit further price weakness." 1 This prediction seems innocuous enough, and if the assumptions of economic deterioration were valid, there would appear, on the surface, no immediate argument over the guess that prices of the Burlington's bonds would go down. However, upon careful examination of Moody's data, an astonishing error becomes apparent, which may well have affected the published forecast. In tabular form, the Survey presented the following "information" : Yield Rating Baa Baa

Issue Illinois Division 1949 Illinois Division 4's, 1949

Recent Price 87X 93K

Current 4-oi% 4-26%

Maturity 4-92% 4.68%

62

POLICY FORMATION IN RAILROAD FINANCE

With a yield to maturity of just under 5 per cent for these bonds, it might easily happen that the market's discounting of the company's less favorable outlook would bring about a higher yield — up to 6 per cent or more, for example. Such a revised evaluation of the credit risk could easily result in "price weakness" as alleged. But the error in this analysis is that Moody's computed incorrectly the yield to maturity on these bonds: the published figures imply eleven-and-onehalf years to maturity on the 3^2's and twelve years on the 4's. On the true basis of seven years to maturity, these yields would have been 5.73 per cent on the 3>4's and 5.11 per cent on the 4's. Now, if the argument of "further price weakness" had been applied to these values, the nature of the forecast is astonishing indeed. For if the credit risk of the railroad were to deteriorate to, say, a point supporting a yield of 6 per cent, the reduced term to maturity as such deterioration took place would of itself naturally reinforce the price. Conversely, if the price of the 3>4's were at the same 8 7 ^ quotation two years after Moody's forecast, the yield would have increased from Moody's "yield" of 4.92 per cent to 6.42 per cent, perhaps full measure of the implied deterioration anticipated. Any other interpretation of the kind of "price weakness" expected would unfold into an unusually harsh forecast of probable bankruptcy. If this had been in the mind of the writer of Moody's Survey, it did not appear to be supported by the data submitted in evidence. B y June 11, 1942, Moody's analysis had come to the attention of Northern Pacific's President Denney. At once he wrote President Budd to reopen consideration of the bond-purchase program. Denney recalled that he had seen no objection originally to the purchase of maximum $1,000,000 in Illinois bonds. He continued by strongly reiterating his unwillingness to approve the purchase of any more than that amount. "We all realize the difficulty of forecasting railroad conditions after the war, particularly during the so-called period of adjustment. I venture the opinion, however, that these bonds can be purchased after the war at prices lower than those quoted today. This is supported by the statement from Moody's bond survey . . . reading 'Over a period they may well exhibit further price weakness.' " 2 T o what extent President Denney's objection to the enlarged bondbuying program was influenced by this bond survey cannot be judged. The implication, however, is irresistible that Mr. Denney was unwittingly trapped by the fallacious reasoning of the Moody analysis. President Denney's expressed opinion, moreover, was even more inconsistent than Moody's Survey. In 1942, it was generally believed that the war might last another three or four years, and even, by some "experts," longer. B y 1946, only three years would remain until matu-

INITIAL APPLICATION OF DEVELOPED POLICY

63

rity on the Illinois Division bonds. If, as Mr. Denney believed, the prices would at that time be less than 87, the only possible inference would be that the financial community would then be entertaining very grave doubts as to the ability of the Burlington to take care of its maturing obligations. And if there were justification of a price under 87 for these bonds, it follows that the Burlington would at that time be, most likely, in no financial condition to spare cash for open-market purchases of its securities. As soon as President Budd was apprised of Denney's position, he prepared a forceful memorandum developing the logical implications of the possibility of further price weakness in the Burlington bonds. The prospect of lower bond prices was recognized at once as a highly critical danger signal. " A s the maturity date nears, a decline [in price] would occur only if credit becomes poorer, and a credit poorer than at present would mean that the refinancing could not be successfully accomplished because of the prohibitive interest rate. Even if the Company should be willing to undertake an increase in the interest rate to the extent indicated, it seems quite certain that the Interstate Commerce Commission would not permit securities to be put out at such rates." 3 This was strong language indeed. N o t only did President Budd's analysis expose the incongruity of the premise that bond purchases should be postponed until prices went lower, but it went ahead and presented for the first time a succinct statement of the financial policy that had been slowly and tortuously evolved to handle the problem presented by the maturing Illinois Division bonds. " I t seems imperative," President Budd wrote, "to give consideration now to the formulation of some plan to meet the 1949 situation. If the reduction of interest through involuntary or bankruptcy proceedings is considered the likely procedure . . . it might well be better to accumulate cash rather than buy bonds." However, he continued, ". . . bankruptcy seems unnecessary, especially if a plan is formulated now to take care of the 1949 maturities, and every effort made to carry it through." Although President Budd did not state unequivocably that his ultimate goal was extension of the Illinois Division maturities, 4 his defense of open-market purchases was tied in with the possible adoption of such a plan: An extension plan doubtless could be worked out more successfully if a substantial payment were made on each maturing bond; and if this reduction were made in principal, rate of interest might be substantially lower than if the extension covered the full amount. In such a plan, however, there is an opportunity to make a substantial saving by using some cash now to buy in bonds at less than par, and also by having some cash for partial payment on the remaining bonds at their maturity. For example, the principal

64

POLICY FORMATION IN RAILROAD FINANCE

could be reduced to $60,000,000 by purchasing $24,000,000 of bonds at present prices for about $21,500,000. Payment of 25% on the remaining $60,000,000 would take $15,000,000, or a total of $36,500,000. The interest to maturity on the $24,000,000 of bonds might be as much as $2,500,000 or $3,000,000, depending upon how early the purchases were made, reducing total cash requirements to perhaps $34,000,000. This would require the use or accumulation of an average of about $5,000,000 a year from now until 1949.® Besides mentioning the possibility of extension, this memorandum of June 13 set forth the ultimate magnitude of the debt reduction contemplated. Y e a r l y purchases over the seven-year interval prior to maturity were suggested in order to diminish the volume of debt to $60,000,000. A 25 per cent payment on top of this program would reduce the volume of debt to be refunded, b y extension or otherwise, to $45,000,000. In addition to the initial reaction summarized b y the foregoing quotations, President Budd prepared two additional memoranda for the consideration of the Burlington's owners, the Northern lines. T h e first of these was dated June 20, 1942, one week later than the analysis quoted above, but it actually did little more than moderate the language of the point of view which originally was so forcefully expressed. T h e second memorandum, also dated June 20, did, however, introduce new arguments in favor of immediate action to improve the Burlington's financial prospects. While there is no evidence to suggest what use was actually made of this latter proposal, two conclusions expressed therein are of distinct significance insofar as they represent the thought of the Burlington's financial leader in mid-1942. President Budd's rejoinder to President Denney of June 13 had made a kind of reductio ad absurdum analysis of the bankruptcy implication following from expected "further price weakness" in the Burlington's bonds. In his second memorandum of June 20, however, the prospect of implied bankruptcy was seized upon and developed as a positive threat to the entrenched position of the Burlington's owners. President B u d d pointed out that the recent policy of the Interstate Commerce Commission had been to reorganize bankrupt roads on the basis of capitalized earnings, rather than investment value. 6 H e continued: If the maturity of the Illinois Division Mortgage should result in bankruptcy reorganization of the Burlington, it seems probable that the Illinois Division Mortgage bonds would receive favorable treatment, but the [junior bonds] might be in a precarious position, particularly because the Courts require payment of the senior liens [first]. Thus the credit of the

INITIAL APPLICATION OF DEVELOPED POLICY

65

Burlington and its ability to meet maturity of the Illinois Division Mortgage is of great importance to the junior bond holders . . . In a reorganization the stock would come after the mortgages and equipment obligations, and the tendency oj the Commission and the Courts seems to be to penalize the stockholders severely,7 Thus, the Burlington's financial administrator made permanent record of the fact that if the Burlington's owners should adopt a policy which even suggested proceedings of bankruptcy for its subsidiary, it was they, the stockholders, who stood the risk of severe penalty. President Budd was not, moreover, content to let his dire observation rest upon this lone point. In what appears to be considerable resentment, he concluded his final memorandum of June 20 with this second consideration: The Burlington, due to the nature of its ownership, is subject to the claim that its Directors are agents of the owning roads. While this would in no way relieve the Directors of personal responsibility for proper management of the financial affairs of the company, it would place ultimate responsibility on the owning companies. Mr. Adolph Berle has gathered court decisions pointing out this responsibility of parent companies. No one questions the right of the owners to participate, through dividends, in earnings of the Burlington, and no one doubts their right to direct the financial and other affairs of the Burlington. However, the exercise of these rights is coupled with a responsibility not to impair the security oj the bonds, particularly through any action in the immediate interest oj the owning companies.8 There is no evidence, however, of what use was made of the acute analyses which Mr. Budd prepared under attack by Northern Pacific's President Denney. T h a t these memoranda represent invaluable insight to the stage of development of the Burlington's financial policy cannot be denied. And if judgment need be passed, it seems obvious that the Burlington's interests would have been bettered to a much greater extent by adherence to the policies and procedures suggested by President Budd. In substance, President Budd recommended openmarket purchases, and pointed out two primary benefits to be derived from such a policy: (1) The amount of the maturing debt of Illinois Division bonds would be reduced, leaving a more manageable sum to be handled at the 1949 refunding date.9 (2) Open market purchase of bonds would tend to support prices of Illinois Division securities. With apparent improvement of market estimation of Burlington credit, it would be possible to obtain lower interest rates in whatever refunding plan might ultimately be adopted.10

66

POLICY FORMATION IN RAILROAD F I N A N C E

Aid Is Sought front Bankers

in Furtherance

of the Program

The delineation of a logically defensible course of action is not in practice the same thing as the adoption and prosecution of that policy. Specifically, the acceptance of the Burlington's developing financial program was initially dependent upon the concurrence of the company's majority stockholders — the Northern lines. President Denney, it will be recalled, had opposed the policy which was being shaped in the hands of Burlington's President Budd. As means to the end sought, it therefore became President Budd's problem to convince the Burlington's owners of the soundness and financial merit of the plan he favored. Although direct conference in the meetings of the executive committee and board of directors was a natural focal point of the discussions held on the suggested program, President Budd, certain of the pressing urgency of his plan, went beyond the usual channels. Prior to the June board meeting President Budd again sought expert financial advice, and enlisted the aid of bankers in furtherance of the program he intended the Burlington to adopt. T o obtain the aid he believed he required, President Budd first turned to Morgan Stanley and Company and received from that firm a report dated June 23, 1942. The evident purpose of this analysis was to present as strong an argument as possible in favor of the continuance of the bond purchasing program instituted a month earlier. The report was written by one of the partners of the investment banking firm, Mr. A. Northey Jones, who subsequently stated that he had " 'poured it on' so that it would help Budd" to overcome whatever stubborn opposition he might encounter. 11 Eleven points were made in the memorandum, none of which were new, save in their strikingly forceful phrasing. For example, it was pointed out that "the Burlington has cash now which it can devote to debt reduction. The present is a God-given opportunity for railroads when despite their good earnings and relatively favorable cash positions railroad bonds are selling at lower levels than they have in recent years . . ." And again, "if the railroad wishes to acquire bonds the time to do it is immediately when it has the money and when bonds are available, rather than to procrastinate. If anyone is to start a program it must be started, or otherwise nothing ever gets done." Once more, "the fact that the Burlington is reducing its debt rather than paying excessive dividends to its stockholders would improve the credit standing of the Burlington." The bond-purchasing program was an important subject discussed in the June meeting of the board of directors of the Burlington. President Budd was prepared with the Morgan Stanley analysis, which in no uncertain manner gave support to the policy he was seeking to have

INITIAL APPLICATION OF DEVELOPED POLICY

67

fully confirmed. T h e meeting was also attended by Vice President J. M . Meyer of J. P. Morgan and Company, whose firm had likewise been asked to prepare a report on the matter. 12 N o stenographic minutes were taken of the board meeting, but it is clear from subsequent developments that the policy sponsored by Mr. Budd was still not received without qualification. Soon after the June board meeting, J. P. Morgan and Company delivered its report to Mr. Budd. T h e memorandum was prepared by Vice President Meyer, and unlike that written by Morgan Stanley's Jones, was a detailed analysis of the factors bearing upon the Burlington's future financial prospects, and presented a specifically recommended policy. Apparently J. P. Morgan's analysis was based upon the memoranda which had been written by President Budd on June 13 and on June 20, 1942, which were discussed above. 13 A t all events there is strong coincidence in organization between the reports, and the same principal points were touched upon. Meyer's analysis, however, made detailed examination of Moody's Bond Survey's point, which had been made capital of by Northern Pacific's Denney. A historical examination of prices of the Illinois Division bonds together with the maturity date and the Burlington's financial outlook led the J. P. Morgan memorandum to the conclusion that these bonds ". . . need not necessarily sell lower in the future even if the Burlington's credit continues to deteriorate." 14 Further, it was pointed out that even if the bonds did sell lower ". . . it would be a welcome opportunity to obtain a better average price [since] any purchases made must be made over a period of time." 15 T h e policy recommended coincided exactly with that developed by President Budd in his memorandum on the subject: Now, what can be done? The following plan is suggested which, of course does not represent fixed commitments, but merely a general program which the company can try to undertake if conditions, as time goes on, warrant. (a) Each month between now and July 1, 1949 the railroad to acquire bonds (b) Over and above these purchases (particularly after relatively substantial purchases have been made) a certain amount of cash could be accumulated to enable a cash payment upon maturity of the bonds.16 The disposition of this report prepared for President Budd throws interesting light upon the method followed to obtain President Denney's approval of the bond-purchasing program. It was noted above that there was no evidence of the use made of the memoranda written by President Budd. In his letter forwarding the J. P. Morgan analysis

68

POLICY FORMATION I N RAILROAD F I N A N C E

to Budd, Mr. Meyer wrote, "If by any chance you would like me to show it to Mr. Denney on my own, I could send it along with a note somewhat as follows: Following our discussion the other day at the Burlington's Board meeting, I tried to crystallize the discussion even further and, consequently, I put some of the ideas down on paper. For what they are worth I am sending them to you. . . . " 1 7 Hence there is the implied possibility that President Budd's analysis did form the basis of the discussion at the June board meeting. If not, however, J. P. Morgan and Company, with its weight of financial experience, was volunteering to furnish the views originally developed by President Budd for the consideration of Northern Pacific's Denney. Since these views would be received by President Denney as those of J. P. Morgan's Vice President Meyer, the full impact of the aid Budd had solicited from this banking firm would be neatly delivered. On June 29, upon receipt of Mr. Meyer's letter, President Budd answered, " . . . the memorandum which you enclosed seems to me a very good one, and I think it would be appropriate to send one to Mr. Denney." 18 B . AN AGREEMENT IS REACHED TO CONTINUE BOND PURCHASES

T h e Burlington's files are silent with respect to the manner in which Northern Pacific's Denney may have reacted to the various arguments in favor of bond purchases as expressed by President Budd's memorandum and the others he had had prepared. Debate over the merit of the bond-purchase program, which had been started by President Denney's letter of June 11, 1942, quite naturally retarded any vigorous attack upon the Illinois Division debt. In the application of the program, slightly less than the authorized $1,000,000 was spent in the purchase of the Illinois securities between M a y 22 and August 7, 1942. 19 Without doubt, Mr. Denney's disapproval of any large-scale program had momentarily restrained the Burlington from using any part of the extra $1,000,000 that had been deposited with J. P. Morgan and Company. Y e t some basis of agreement must have been reached either in the special meeting of the executive committee held on June 22, 1942, or in the regular meeting of the executive committee held in New Y o r k on June 24. For on the latter day, J. P. Morgan and Company had acknowledged instructions received from the Burlington's Vice President James to expend $4,000,000,20 in addition to the $1,000,000 authorized on M a y 22. When, subsequently, President Budd asked an

INITIAL APPLICATION OF DEVELOPED POLICY

69

official of the Burlington to uncover the various resolutions of the Burlington's board empowering the purchase of the Illinois bonds, no authority could be located for the action of June 24 by Vice President James. T h e memorandum prepared in answer to Budd's inquiry pointed out: Mrs. Alden [the company's secretary] advises that she was instructed not to keep any official record of Board authorizations for purchases of these bonds; also not to keep any memorandum of such authority in the Board papers. However the correspondence files in this office and in Mr. James' and Mr. Vickery's offices contain [some] record of authorities which, in some instances, give reference to Board action.21 T h e action taken by James, as stated, was one of those for which no authority could be found. T h e memorandum, considering specifically the absence of these instructions, noted, " M r . James thinks probably handled by telephone." With the implication of the facts of this record, that authorizations for bond purchases had been increased to the $5,000,000 originally asked by President Budd, it is rather surprising that only 83 per cent 22 of the initial $1,000,000 authorization was expended prior to August 7, 1942. T h e explanation of these comparatively small purchases, however, seems to rest in the condition of the bond market during the weeks following June 24. On June 30, J. P. Morgan and Company advised President Budd as follows: . . . As you can imagine, the bad war news had led the enthusiasts who believe in an early peace to . . . postpone their ideas as to the date of a successful conclusion. One of the results of this has been increased prices for most railroad securities. Burlington Illinois Division bonds have been no exception. [This has led to] two pieces of rather bad news . . . The one possible seller of 550 bonds, whom I talked to you about, has definitely concluded not to sell, and another possible seller who holds about one million has reached the same conclusion. . . . Of course we do purchase some bonds every day and are still working away . . . 23 Again, in a so-called "current report" of a week later, the banking firm pointed out, " . . . T h e market on Illinois Division bonds is quite thin in that relatively few offerings have come into the market." 2 4 Meanwhile, news of the Burlington's decision to purchase its bonds was making the rounds of the financial community. In increasing volume offers to sell Illinois Division securities were being sent directly

70

POLICY FORMATION IN RAILROAD FINANCE

to the Burlington by various security dealers. Since J . P. Morgan had been made agent of the company in the bond purchase program, the Burlington adopted the policy of referring all such information to its N e w York banker. Whether or not these "assists" as such changed the character of the market in the Illinois Division bonds cannot be stated with certainty. But during August and September the volume of bonds purchased by J . P. Morgan for the account of the Burlington showed marked increase over the amounts purchased in the first six weeks of the program. B y the middle of October nearly all of the original $5,000,000 earmarked for bond purchases was expended. On M a y 7, it will be recalled, the purchase of this amount had been set as the 1942 objective. And in the memorandum President Budd prepared on June 1 3 , arguments were presented in favor of a program of $5,000,000 annual purchases until 1949. But earnings, in the meanwhile, were continuing ahead of those in the preceding year at an even greater rate than for the first two quarters, as is shown in Table 17. With the improved Table 17. Chicago, Burlington and Quincy Railroad Company, quarterly net earnings, IQ41-IQ42, compared (thousands of dollars).' Quarter First Second Third Fourth Total for year • D a t a from

1941

1942

1942 increase

2,810 162 5,048 2,399

3,59i 3,490 10,178 —

781 3,332 5,130 —

10,419

Monthly Earnings Record, 1942,

vol. 1 5 . nos. 3, 5, 8, 1 1 , page 1 0 (in each).

earnings outlook, there would naturally be a marked increase in the cash held by the Burlington, and, if the dividend payments to the Northern lines were to remain at the conservative level of 1 9 4 1 , considerably more accumulated cash would be available for bond purchases than had been foreseen five months earlier. Accordingly, it was decided in the board meeting of October 26, 1942, to step up the purchase of Illinois Division bonds. 25 On the following day, President Budd wrote the company's N e w York banker as follows: Bert Vickery will deposit another $5,000,000 with you for the purpose of continuing the purchase of the Illinois Division bonds to that extent. I

INITIAL APPLICATION OF DEVELOPED POLICY

71

hope that the good work will continue, and have been quite gratified at the results thus far. Hope they may come in even faster in the future, and we will then try to find another Five Million.28 The accelerated program was immediately put into effect by J. P. Morgan and Company, and less than three weeks later all but some $250,000 of the $10,000,000 appropriated had been expended in the purchase of $10,250,000 par value of Illinois Division bonds.27 In line with President Budd's statement that upon the exhaustion of these authorizations, "we will then try to find another Five Million," the matter of increased appropriations again came up for consideration in the board meeting of November 20. Afterward, "On [Mr. Budd's] instructions, Mr. James advised Morgan & Company that at Board meeting that date another appropriation of $5,000,000 was authorized." 28 This latter authorization thus increased to $15,000,000 the amount of Illinois Division bonds which the Burlington might purchase in 1942. Since, however, the annual report for that year revealed that only $10,993,000 par value of the Illinois bonds were reacquired during the period and canceled,29 bonds with a par value of less than three quarters of a million dollars were evidently purchased between November 16, 1942, and the year's end. The retardation in the rate of bond purchases may have been attributable to the question of whether the securities purchased during 1942 should be canceled and retired, or held alive in the Burlington's treasury. As early as November 5, 1942, J. P. Morgan's Vice President Meyer had passed along to Mr. James the opinion that if the bonds purchased in 1942 "were acquired for the purpose of reducing 1942 excess profits tax, then they should probably be cancelled prior to the year end to assure that credit." 30 However, if it were simply a question of eliminating from taxable income the difference between cost price and original issue price on bonds purchased, there was no need for cancellation.31 This expression of opinion set off a not inconsiderable debate on the question whether to cancel or not to cancel the reacquired Illinois Division bonds. The development of the legal points affecting this problem from the taxation angle reached the conclusion that ". . . it would be much more desirable from the tax standpoint to cancel the bonds which were purchased, in order to be more certain that the difference between the purchase price and the issuing price will not be considered income during 1942." 32 Since whatever action might be taken could result in the saving or loss of $160,000 through income

72

POLICY FORMATION I N RAILROAD FINANCE

tax liability, President Budd recommended on December 10, 1942, to the Northern presidents that the sure course, cancellation, be adopted to save the potential tax liability. 33 Northern Pacific's Denney gave his immediate approval to the proposed retirement of the purchased bonds, 34 but President Gavin of the Great Northern saw more in this projected procedure than a simple saving of tax liability. He objected to the Burlington's forfeiting its right to resell the purchased Illinois Division bonds in order to gain the relatively small saving of $160,000 on the approximately $11,000,000 of bonds purchased. Specifically, Great Northern's Gavin observed: Before the bonds are cancelled, believe careful consideration should be given to the possible advantages from a literal compliance with the income tax law as compared with the disadvantage of issuing First and Refunding Bonds [which were junior securities] at higher rates, versus issuing [the purchased] Illinois Division Bonds at lower rates, should additional financing be necessary.35 And again, on December 23, Mr. Gavin restated the problem very neatly: The question seems to be risking a possible increase in taxes of $160,000 against the advantage of having underlying bonds available for future financing (not only between now and 1949, but during the life of these bonds if extended beyond that date) instead of issuing First & Refunding Bonds. The Illinois Division Bonds are now selling on a yield to maturity basis of 4.50% against 7.35% in the case of First & Refunding Bonds. This seems to be a good reason for keeping these Illinois Division Bonds alive.38 President Budd considered the subject raised by Mr. Gavin of such great importance that he furnished Mr. Gavin with a detailed analysis of the financial plan that had been hammered into shape since the Burlington had begun in 1941 its program to make adequate provision for the Illinois maturities. In the debate which Mr. Budd had successfully concluded over the adoption of a large-scale bond purchasing program, it had been the Northern Pacific's Denney who, as the recalcitrant owner, needed to be convinced of the merits of the Burlington's objective. Budd's letter to President Gavin seems to have been designed to set forth concisely and clearly to the executive of the Burlington's other owner all the facts bearing upon the plan it was hoped would solve the company's financial problem. It is, therefore, a significant document in that it presents in unequivocal terms the policy

INITIAL APPLICATION OF DEVELOPED POLICY w h i c h M r . B u d d s o u g h t to h a v e a d o p t e d . P e r t i n e n t p o r t i o n s of

73 the

letter follow: . . . Y o u will recall a report you and M r . D e n n e y and I made to the Board in 1941, to the effect that the Illinois Division Mortgage Bonds can be extended at maturity b y agreement with the holders and with approval of the I.C.C., without conflicting with any rights of junior bondholders, provided there is no increase in the amount of debt or rate of interest. T h u s far all our plans for meeting the maturity have been on the basis of retiring a sufficient amount of the bonds to build up our credit and make extension of the balance acceptable to the holders. T h e bonds are at the rate of $52,483 a mile and interest requirements are $1,934 a mile. T h e total of $85,000,000 is 3 4 % of our bonded debt, and the bonds are a first lien on 1 9 % of our mileage, on 3 0 % of our physical value, and on 34% of our earning value. W e have always considered the security ample. Prior to 1938 all Burlington bonds sold above par, on a yield basis, but in 1938 apparently primary emphasis was placed on security, and in 1939 all our bonds except the Illinois Division 4s went below par. In 1940 the 4s also went down — to 97 — and none of our bonds have come back to par since that time. Y o u will recall the numerous brokers' letters and comments which have criticized our fiscal policy in recent years and advised selling our bonds. Our investment in road and equipment has increased only 1 9 % in the period from 1921 to 1941, inclusive, while our funded debt, including equipments, has increased 45% during that time. Compared with the other western roads this is a very poor showing. In these circumstances, it was obvious that steps would have to be taken to reduce our debt and improve our credit if w e were to extend the Illinois Division Bonds on favorable terms. Of course, a great deal will depend on interest rates and business conditions in 1949, but however such general matters m a y be, purchase and retirement of a substantial amount of our bonds in the next few years will serve the two purposes of improving our credit and facilitating extension of the outstanding bonds at favorable interest rates and without drastic sinking fund. I do not know how many bonds we should buy, but have thought that if we could get the outstanding bonds down to $40,000,000 by 1949, we ought to be able to extend that amount on favorable terms. I t never occurred to me that we could carry out such a plan for meeting the maturity and at the same time use any of the purchased bonds to reissue and sell to secure funds for additions and betterments. I doubt if either the bondholders or the I . C . C . would agree to an extension which involved use of bonds we have purchased for independent financing. Ever since we borrowed money to p a y dividends, there has been doubt of the soundness of our fiscal policy. I think that if we are to obtain extension of part of the bonds on favorable terms we will have to convince the bondholders and the Commission that the owners of the property have made sincere efforts to p a y

74

POLICY FORMATION IN RAILROAD F I N A N C E

part of the debt before it is due. I think retiring the purchased bonds will improve our credit and our standing with the Commission and the bondholders. Another thing which makes it important to extend no more than necessary of the Illinois Division Bonds is the maturity of the $65,000,000 General Mortgage Bonds in 1958. While this is a long way ahead, it is only nine years later than the first maturity, and if the extension in 1949 should leave the Company with heavy fixed charges and large sinking fund payments, the maturity of the Generals might be a very serious problem. On the other hand, if we make a favorable reduction in the Illinois Division Bonds before they mature, we will be in a position to urge the I.C.C. not to impose onerous requirements for debt retirement or restrictions on dividends. As you point out, the First and Refunding Bonds at present would not provide a favorable medium for financing, but as late as 1937 the F. and R. 4^2S sold at an average of 109 and the 5s at an average of 114. If we can restore our credit and make adequate provision for meeting the 1949 maturity on a basis favorable to the Company, I think we may expect the First and Refunding Bonds to sell at a satisfactory price, subject to general market conditions. That mortgage is open, and we can issue a new series of bonds at any time and at any rate of interest. Both the General Mortgage and the First and Refunding Mortgage provide several alternative methods for the issuance of bonds to reimburse the Company in cases of purchase or retirement of Illinois Division Mortgage Bonds from the general funds of the Company . . .37 T h e most significant point distinguishing the foregoing recital from the memoranda previously prepared by President Budd on the subject is the emphasis placed upon the possibility of extending the Illinois Division bonds. " T h u s far," he wrote, "all our plans for meeting the maturity have been on the basis of retiring a sufficient amount of the bonds to build up our credit and make extension of the balance acceptable to the holders." Y e t , as was noted in Chapter I I I , in 1945 President Budd stated that he was never greatly interested in the extension of these bonds. However, as Mr. Budd developed his reasons in this statement of policy in December, 1942, for reducing the debt burden of the Burlington, it is evident that the uppermost objective was purchase and cancellation of as large a portion of the Illinois bonds as possible. For the first time, moreover, attention was called to the possible financial ill effects which might result from extension because of the maturity of the General Mortgage bonds in 1958. One further point distinguished this December recital of objectives from those incorporated in the memoranda President Budd had prepared in response to the questions raised by the Northern Pacific's Denney in the preceding June. A t that time, the suggested magnitude

INITIAL APPLICATION OF DEVELOPED POLICY

75

of bond purchases had been set at $5,000,000 annually, designed to reduce the principal amount of bonds outstanding to $60,000,000. Upon maturity, moreover, a 2 5 per cent payment was contemplated, so that there would remain $45,000,000 of debt to be refunded. B y December, however, as indicated in the foregoing letter, President Budd . . thought that if we could get the outstanding bonds down to $40,000,000 by 1949, we ought to be able to extend that amount on favorable terms." Great Northern's President Gavin was not, nevertheless, completely persuaded that cancellation of the bonds already purchased was the best procedure. Yet he gave his approval to the immediate application of the policy, writing, " . . . I am agreeable to retiring the bonds purchased up to date. Believe this matter should be thoroughly considered from all angles in 1943, before deciding to cancel any bonds that may be purchased hereafter." 38 With the receipt of this agreement, a favorable signal was given to the Burlington's officers to retire the securities purchased in 1942, and on January 20, 1943, the Securities and Exchange Commission was formally notified that $10,993,000 of the Illinois Division bonds had been canceled as of December 31, 1942.39 The foregoing developments indicate that at the beginning of 1943 the financial policy of the Burlington was reasonably well formulated. The procedure that had been agreed upon did not, however, indicate any precise plan for refinancing the bonds that would mature in 1949. Instead, the policy adopted was one of putting the credit of the Burlington into such shape that any desirable expedient could be followed by the company upon the maturity of the Illinois Division bonds. In particular, the Burlington's president proposed that surplus cash be used in the intervening years to purchase outstanding Illinois Division securities, with the idea of reducing the amount which would need to be refunded in 1949. This practice, it was believed, would not only diminish the magnitude of the refinancing necessary, but would improve the terms upon which the refunding would ultimately be made through bolstering the Burlington's credit position. Accordingly, during January, the company continued its purchases of Illinois Division bonds, with the immediate goal the full use of the $15,000,000 appropriations that J. P. Morgan had partially expended. B y February 11 purchases totaled $14,443,000 principal amount of bonds,40 and less than a week later the principal amount was $15,769,000, bought at a cost of $14,999,480.0c.41 Treasurer Vickery summarized the purchases for President Budd and advised him of the exhaustion of the appropriations as follows:

76

POLICY FORMATION I N RAILROAD FINANCE

Chicago, February 27, 1943 Mr. Ralph Budd: The purchase of Illinois Division Mortgage Bonds by J . P. Morgan & Co. under the $15,000,000 appropriated for this purpose has been completed, and herewith is a detailed report as follows : Amount of appropriation Cost of bonds purchased

$15,000,000 14,999,480

Unexpended balance

520

Par value of bonds purchased 3 ^ s 4s

$ 9,850,000 5,919,000

Total

15,769,000

Average price paid

95.12

Total amount 111. Divn. Bonds Issued Bonds purchased under appropriation $15,769,000 Bonds held in Treasury 850,000 In Hands of Public Reduction in yearly interest

85,000,000 16,619,000 $68,381,000 $581,510

Bert Vickery Upon earlier occasions, the exhaustion of the funds appropriated for the purchase of bonds had been the signal for President Budd to take immediate action to obtain authorization from the directors for a larger amount. This time, however, Mr. Budd wrote the presidents of the Burlington's parent lines, " . . . For the time being, it is our thought that no more of these bonds should be purchased unless a block comes in at a very attractive price, in which case we will advise you with recommendation." 42 This apparent reversal of the policy that had been developed during 1942 is startling if only because of its chronological proximity to President Budd's intentions as expressed in his letter to President Gavin only two months earlier. The reason for this abrupt change in plan, however, lay in advice received by the Burlington from its bankers — J . P. Morgan and Company. If one omits for the moment any evaluation of the soundness of Morgan's views, the immediate action taken by the Burlington's officers to conform to their bankers' advice illustrates with simple forcefulness the confidence with which President Budd accepted the opinions of the financial experts he had engaged.

Chapter Five

MODIFICATION OF POLICY AND CLARIFICATION OF OBJECTIVES During the latter part of January, 1943, Mr. S. B. Payne of J. P. Morgan and Company's bond department had prepared a memorandum on the subject of "the most advantageous procedure [for the Burlington] to follow in the use of available cash to purchase outstanding issues." 1 Whereas J. P. Morgan's earlier memorandum on the problem, dated June 25, 1942, recommended the purchase of some Illinois Division bonds every month, and the monthly accumulation, after substantial purchases were made, of cash over and above such purchases, Mr. Payne now saw advantage in following a different course of action. Reviewing the prospective refunding necessary "at or before maturity," Mr. Payne noted two alternatives: "a) to extend the maturity of the bonds under the same mortgage, and b) to use the Company's normal financing medium, which is the First and Refunding Mortgage." Previously the consensus had been that the use of the First and Refunding Mortgage might prove financially impossible, even though President Budd on December 22 had warned against the superficial conclusion that currently depressed prices were a valid index of the subsequent worth of these securities.2 Mr. Payne proposed a positive course of action to improve the credit standing of the F & R Bonds, and thus assure insofar as possible, their investment merit prior to the time the Burlington would have need of this refunding medium to take care of the maturing Illinois Division Bonds. Specifically, he recommended that the Burlington should " . . . divide cash available for bond purchases between the Illinois Division Bonds and First & Refunding Bonds in approximately the same proportions as they are now outstanding." The program, he said, might work out as shown in Table 18. Mr. Payne continued: If $28,600,000 of Illinois Division Bonds were purchased the cost probably would average at least par and the annual interest reduction would

78

POLICY FORMATION IN RAILROAD FINANCE

Table 18. Bond-purchasing

program suggested by S. B. Payne, January 20, IQ43.a Estimated

Bonds

Presently outstanding {thousands of dollars)

Proportion {per cent)

Price (dollars)

Cost {thousands of dollars)

Interest saving {thousands of dollars)

8,294

99

8,211

290

5,720

100

S,72o

229

8,294

90"

7,465

41S

6,292

85 b

5,348

283

26,744

1,217

T o be purchased (thousands of dollars)

Illinois Division

3^'s

40,800

29

Illinois Division 28,200

4's

First and Refunding S's First and Refunding

4^'s Total

40,000

29

29,800 138,800

100

28,600

» Memorandum prepared by S. B. Payne, attached to letter from John Meyer to J. C. James, dated February 2,

1943b

Allows for substantial appreciation from current levels.

amount to about $i,060,000; if a proportionate amount of available cash, as indicated above, were invested in First & Refunding Bonds, the cost of purchasing $28,600,000 bonds would probably be nearly $2,000,000 less, and the saving might run considerably higher . . . In addition the annual interest saving would be $157,000 greater . . . Of course, it would be best for the Burlington to finance the Illinois maturity through their regular financing medium, the First and Refunding Mortgage, and in the meantime to take such steps as seem advisable to make that Mortgage as strong as possible. With the level of fixed charges that would result if the suggested program is carried out, maturities and sinking funds could more possibly be adjusted to provide a salable issue or issues in 1949 or prior thereto. On February 2, 1943, J. P. Morgan's Vice President Meyer forwarded Mr. Payne's memorandum to Mr. J. C. James to inform the Burlington's officer of the opinions being developed by the company's bankers. Mr. Meyer was critical of the new plan, however, and his reservations were such as to nullify the proposals made by Mr. Payne. Specifically Mr. Meyer considered that " . . . Sam's memorandum presents too much of a gamble, particularly so unless the Illinois

CLARIFICATION OF OBJECTIVES

79

Division bonds are further reduced or sell at substantially higher prices. I wouldn't bet nearly so heavily on being able to use the First and Refunding Mortgage in 1949. If the market did work out it would be fine; if it didn't you would have spent a lot of money, and retired debt it is true, but not with an overwhelming saving, and you would still have to extend in whole or in part." 3 Despite the positive steps recommended in J. P. Morgan and Company's bond department, the financial advice that reached the Burlington thus took a dim view of the desirability of adopting such a formal program to provide for the 1949 maturities. It was considered too risky. Nor did the advice apparently contemplate refunding prior to maturity, which was a possibility distinctly recognized by Mr. Payne's memorandum. In effect, J. P. Morgan finally advised that the best plan for the present would be to mark time, and strive for a flexible policy. . . Perhaps it would be better to buy short Governments . . . rather than Illinois Division bonds and First and Refunding Mortgage bonds. The Governments could be used (a) upon maturity of the Illinois Division bonds, or (b) sold prior to maturity to purchase Illinois Division bonds if they went down in price, or (c) sold prior to maturity to purchase Illinois Division bonds if a really substantial block were offered for sale . . ." After amplifying the idea of holding off the market for the present for technical reasons (". . . The market on the Illinois Divisions has gotten pretty much out of our hands. . . ."), Mr. Meyer concluded, "So in summary my suggestion would be that for the time being you consider (x) no more purchases of Illinois Division bonds; (2) the purchase of some Government 1 ¿4s of 1948." Among other points raised in Mr. Meyer's letter in support of the advice to stop purchasing bonds was the implied fact that current prices of the Illinois Divisions were too high. It did not appear sound financial action to Mr. Meyer to buy those securities if ". . . the price of the 4s goes above par and the price of the 3 ^ s goes above 99 . . ." B y suggesting the unwisdom of purchasing additional bonds at prices higher than those named, Mr. Meyer had evidently no thought of the possibility of calling at a price as high as 105. Nor, evidently, did the Burlington's financial adviser appear optimistic over the credit recovery of its client. As was pointed out in Chapter II, during the years 193 5-193 7 inclusive, the 3^2's had sold consistently above par. And in 1943, at the time Mr. Meyer was writing, firstquality rail bonds generally sold on a basis to yield less than the 3.6 to 4.0 per cent implied in the stop-purchase prices he named. Furthermore, Mr. Meyer had condemned the ineffectiveness of a policy of purchasing F & R Bonds because it might result in spending "a lot

80

POLICY FORMATION I N RAILROAD FINANCE

of m o n e y " and not eliminate the necessity of extending "in whole or in p a r t " the Illinois Division bonds. Y e t from the conservative outlook M r . M e y e r adopted with reference to the credit prospects of the Burlington, it was apparently expected that the Illinois bonds were worth no less than a 4 per cent yield risk. If that were the case, one might well ask " W h y not follow a policy which will reduce debt as much as possible, and plan for extension at maturity at the existing interest rates on the Illinois Division b o n d s ? " T h e answer to this question, however, was not contemplated in M r . M e y e r ' s letter to M r . James, although if the unwritten record were available, it might be revealed that this point did receive ample consideration. Nevertheless, when the letter and accompanying memorandum were received b y the Burlington's vice president, he concurred fully in the recommendations of M r . M e y e r as opposed to those of J. P . Morgan's Payne. On February 6, M r . James passed along to President B u d d the conclusions reached b y M r . M e y e r , and added a further reason of his own for discontinuing the buying of Illinois Division bonds, namely, " . . . that purchase of any of our bonds will reduce our excess profits base." 4 In the face of the recommendations of J. P . Morgan and Company and Vice President James, President B u d d advised M r . James on February 14 that he agreed with the new position that had been developed. 5 A p a r t from observing that "Purchasing of First and Refunding Bonds has been tempting all along because of the high rate of return, but I have felt it too risky to purchase any of our own bonds except those which mature first; viz., the Illinois Division Bonds of 1949," President B u d d shed no light upon what critical evaluation the Burlington's policy makers had made of the volte-face financial plan. And, as noted above, on F e b r u a r y 27 B u d d wrote the presidents of the Northern lines of the Burlington's decision to stop " f o r the time being" purchase of Illinois Division securities. Furthermore, the company put into practice the second recommendation of M r . M e y e r , and began buying Governments, presumably in acquiescence to the new procedure suggested b y its financial advisers. 6 Shortly after the adoption of the "flexible program" outlined b y J. P . M o r g a n and Company, however, the policy came under close scrutiny with respect to whether it was in line with the "profit motive" of business activity. M r . M e y e r ' s plan had paid no attention to the relative profitableness of buying Governments as opposed to buying Illinois Division bonds. In fact, J. P . M o r g a n and Company apparently counseled against buying Illinois Divisions on the simple ground that the Burlington should p a y no more than 99 for the 3^2's and 100 for the 4's. Vice President James, in forwarding the proposed plan to Presi-

CLARIFICATION OF OBJECTIVES

81

dent Budd, had added as a reason that if Illinois Division bonds were bought, it would reduce the Burlington's invested capital base, and therefore diminish the base upon which allowances could be claimed for excess-profits deductions. While this real feature of the 1943 Revenue Act would tend to increase income taxes if Illinois bonds were purchased, Mr. James failed to contrast the effect of this course of action with the alternative use that would be made of surplus cash under the recommended plan. In a subsequent interview, Mr. James stated that choice between a policy of purchasing Governments or Illinois Division bonds was not emphasized as a dollars-and-cents proposition. It was "never fundamentally a question of relative cost," for President Budd always wanted to use all cash possibly available in the retirement of Illinois Division bonds.7 This failure to evaluate the profitableness of the alternative plans was quickly noted at one of the Burlington's parent companies — the Great Northern. Mr. George H. Hess, comptroller of that company, wrote the Burlington's Comptroller Johnson on March 8, raising the question of whether it would be more advantageous to invest surplus funds in Governments or in the retirement of the Burlington's mortgage obligations. Accordingly, for the first time, an analysis was made of the effect, from the tax viewpoint, of following either of the two courses of action. The investigation was finished on April 10, 1943, and upset completely the logic of the policy so recently recommended and adopted. For it was shown that while taxes would be increased as alleged if the company's Illinois Division bonds were purchased, the saving in annual interest would be such as to leave a net gain on funds so invested slightly in excess of 0.5 per cent. On the other hand, after taxes were paid on the interest received from Government bonds purchased, the net gain from that alternative would be approximately 0.4 per cent. Although the difference was small, it nevertheless would be more advantageous to continue purchasing Illinois Division bonds.8 It cannot be said to what extent the advice from J. P. Morgan and Company affected the confidence of the Burlington's managers in their financial expert. At all events, the new policy that had been adopted upon Mr. Meyer's recommendation was rejected at once. On May 7, President Budd instructed J. P. Morgan and Company to go ahead with the earlier procedure that had been agreed upon, and authorized the expenditure of an additional $5,000,000 to buy Illinois Division bonds. However, the bankers were requested not to pay above par, "Which," Mr. Budd wrote, " I presume means you will have to confine yourself to the 3^2s unless the market eases off." 9 And so the Burlington returned to the course that had been plotted the preceding year. The authority to purchase additional bonds had been agreed upon

82

POLICY FORMATION I N RAILROAD F I N A N C E

in the Burlington's board meeting of May 5, 1943.10 President Budd recommended the use of $10,000,000 instead of $5,000,000, "and Mr. Gavin was agreeable to the $10,000,000, but Mr. Denney thought that $5,000,000 would be enough at a time . . ." 11 Subsequently Mr. Denney consented to the authorization of an additional $500,000, thus bringing the total up to $5,5oo,ooo.12 The Burlington's bankers acted quickly to expend these funds, the full amount of bonds being purchased by May 12. 13 Almost immediately President Budd sought and obtained authority for another $1,000,000,14 but J. P. Morgan was not as prompt in expending the enlarged appropriations. It was still the Burlington's intent to pay no more than par for securities purchased, and apparently all sizable blocks of Illinois Division bonds had been drawn from the markets at such prices. 15 Although J. P. Morgan had yielded to the decision of the Burlington's officers to revert to their original policy of purchasing the company's own securities rather than the government's, the bankers had not abandoned hope for the alternative plan Mr. Meyer had recommended on February 2. In mid-June, the bankers brought up again the suggestion of buying Governments of about the same maturity as the Illinois Division bonds.16 This time, the recommendation was stated with greater directness as being a kind of insurance medium to provide for adverse market conditions which in 1949 might "render a refunding operation unduly expensive." Thus, it was pointed out that "any offer of extension to the holders of the Illinois Division bonds would be facilitated by the ownership at that time of an amount of cash or its equivalent in government bonds which could be used either as a partial payment on account or as a means of dealing with a minority unwilling to accept an offer of extension." Previously Mr. Meyer had pointed out in support of the recommendation to purchase Governments that technical market factors had led to prices on Illinois Division bonds in excess of the level at which openmarket purchases were prudent. The position now taken by J. P. Morgan and Company emphasized as a consideration of prime importance that if the financial policy being created by President Budd was directed toward extension of the Illinois bonds at maturity, an essential component of such a plan would be the creation of a suitable liquid reserve which might be relied upon to "buy off" bondholders who might reject a program whose goal was a simple postponement of the maturity of their securities. In order to make such an extension acceptable to the Illinois Division bondholders, it was properly foreseen by J. P. Morgan and Company's Anderson that the Burlington should earmark cash or Governments17 which might be called upon as a

CLARIFICATION OF OBJECTIVES

83

method of, say, paying 200 dollars of the principal amount of a bondholder's iooo-dollar bond in cash, and thereby obtaining his agreement to a postponement of the maturity date of the remainder. Yet there was some merit in pressing for continued purchases of Illinois Division bonds which was not stated in Mr. Anderson's letter of June 14, 1943. While it might be held improbable that all holders of the outstanding Illinois Division bonds would agree to an extension proposal (hence some might demand payment in cash), nevertheless consent of only 75 per cent of the bondholders was necessary to bind such a proposition.18 Thus, minority dissenters owning bonds of no more than a quarter of the $62,000,000 outstanding19 would demand cash settlement. Clearly the purchase of additional amounts of these securities would diminish the magnitude of the "insurance fund" to be built up. Thus there would appear to be available to the Burlington's managers considerable latitude in purchasing more Illinois Division bonds. Mr. Anderson concluded his letter as follows: T h e progress which has already been made in the retirement of the Illinois Division bonds has had the natural result of altering the public's appraisal of the investment status of the entire issue, and to a certain extent I imagine the bonds are being bought on the basis of six year money with the expectation of having it collectible at the end of that time . . . I think you might want to consider having a backlog of governments segregated specifically for the retirement of the Illinois Division bonds.

Despite the logic of these arguments, the Burlington's management was not deterred from its objective of open market purchase of the Illinois Division bonds. President Budd's reaction to the points raised by J. P. Morgan and Company was made evident at once through his request to the presidents of the Northern lines for authority to use still another $5,000,000 in the purchase of the Burlington's Illinois issue.20 In line with the previous policy, Mr. Budd stated in his letter, "It is not my thought to pay more than par, and any authorization would be so handled." Although President Budd requested "prompt approval" for the increased authorization, Northern Pacific's Denney demurred. "It would be helpful," he wrote, "before finally passing on your recommendation, to know to what extent you now propose to retire these bonds prior to maturity, abbut six years remaining within which to make such contemplated reduction." 21 Also, he continued, it would aid him in reach-

84

POLICY FORMATION IN RAILROAD FINANCE

ing a decision if President Budd could " . . . forward an estimate of Burlington cash at the end of the year." Before Mr. Budd could answer Mr. Denney's request for additional information, an article 22 appeared in the Wall Street Journal which focused public attention upon the effect of the revised financial structure of reorganized railroads upon their earnings in contrast to those which had not been through the so-called "wringer of 77b." This analysis made public the motive which since 1936 had guided President Budd in his efforts to moderate the proportion of the Burlington's earnings going for fixed charges on the company's debt. Mr. Kelly, the author of the Wall Street Journal's article, observed in particular: Railroads forced into reorganization during the depression years will emerge among the strongest of the carriers in the post-war period . . . A compilation which includes seven railroads which met all fixed charges during the depression years, seven which covered them a sufficient number of times to avoid default, and ten railroads which have recently emerged from bankruptcy, or are going through it, reveals a comparatively favorable future for the reorganized railroads. I t indicates that most railroads which avoided bankruptcy in the depression years will have to make further substantial reductions in their debt structure in order to get on an equal footing with the reorganized carriers.

The compilation prepared for the Wall Street Journal is shown in Table 19, except that data are shown in millions of dollars. The data shown came at once to the attention of the Burlington's officers, and Vice President James prepared a memorandum on "Debt Reduction of Reorganized Roads," in which he examined critically the relationship between the Burlington's situation and that of the other roads mentioned in Mr. Kelly's analysis. 23 Specifically, Mr. James pointed out that "during 1942 and thus far this year, we have purchased $22,269,000 principal amount of [Illinois Division] bonds on which the annual interest is $809,685." In addition, reduction of principal on equipment obligations would make " . . . interest requirements . . . approximately $70,000 less in 1943 than they were in 1942." Thus, interest reductions as of the date of Mr. Kelly's article and not included therein totaled approximately $800,000, and would diminish the charges shown in the Wall Street Journal to " a round figure . . . for 1943 of $8,920,000 . . ." This, it was pointed out, would represent per cent fixed charges to average 1 9 3 6 - 1 9 3 9 revenues of 9.21 per cent, in contrast to the 1 0 . 1 1 per cent shown in that compilation. Mr. James concluded his memorandum:

CLARIFICATION OF OBJECTIVES

85

Even this reduction from 10.11% to 9.21 % . . . does not compare favorably with the [Burlington's chief competitors], the Rock Island 2.78%, Milwaukee 3.54% and N o r t h Western 3.30%. Interest on the remaining $61,881,000 Illinois Division Bonds amounts to $2,305,445 a year. If we retired the entire $61,881,000, our fixed charges would be reduced to $6,614,455, which is 6.83% . . . [or] approximately twice the percentage of the Rock Island, Milwaukee, and N o r t h Western. Table ig. Operating revenues, fixed and contingent charges selected Class I 1942 charges compared with average 1937-1939 revenues.a

Average operating revenues 1937739

Railroad Top grade roads A.T.&S.F • C.&O C.B.&Q N.&W Pa.R.R U.P • Virginian Borderline roads 0 G.N I.C N.Y.C • N.Y.C.&St.L, Pere Marquette. . . S.P • Southern Reorganized roads Erie C.&E.I G.W Wabash Roads under reorganization C.R.I.&P Mo.Pac C.M.&St.P . C.&N.W San Francisco • W.P

(millions of dollars)

Fixed charges i942 b (millions of dollars)

Fixed Ratio of charges including fixed charges to contingent interest average (millions revenues (per cent)

of dollars)

railroads;

Ratio of all charges to revenues (per cent)

7.28 6.60 IO.II 2.40 18.68

7.28 6.60 IO.II 2.40 18.68

19.64

11.70 8.06 9.80 2.16 78.85 14.74 2.32

11.82

—

88.89 111.44

13-71 17-5°

15-43 15-70

—

15-43 i5-7o

34I-76 40.72 30.09

48.51

14.19

—

14.19

5-83 3-57

14-32

—

14-32

11.86

—

11.86

211.75 95-99

28.68 16.06

13-54

—

13-54

160.57 122.00 96.86 90.00 422.17

157-94

79.91

15-53

18.20 44.42

78.99 86.66 105.78 87.52 48.56 15-64

5-9°

0.67 0.84

9-33

16.72

7-37

— — — —

— —

—

—

16.72

i-37 1.11

10.22 8.85 6.12

4-35

9-79 6.20 14.41 8.48 10.14 9.99

8.17

2-57

4.29 4.64 5.80

2.20 7.17

2.78 8.2

3-75 2.89

3-54 3-30

4.90 12.49 8.97 8.88

3-03

6.24 3.20

4-85 i-45

0.50

9-33

11.82

» Source: adapted from Wall Street Journal, June 22, 1943. >> Does not give full effect to many substantial debt reductions which took place in 1942. • These did not cover fixed charges in all depression years.

9-30

86

POLICY FORMATION IN RAILROAD FINANCE

Although Mr. James' evaluation of the facts presented by Mr. Kelly's newspaper account was honestly conceived, it appears that the objective of reducing the Burlington's fixed charges to a percentage comparable to those cited for its competitive roads was based upon a misconception. If, for example, the median ratio of the North Western's fixed charges to average revenues of 3.30 per cent was the goal, this would mean for the Burlington fixed charges of only $3,196,343 on average 1936-1939 operating revenue of $96,838,888. Capitalizing these charges at a conservative 5 per cent would mean slightly less than $65,000,000 of debt on a property whose 1942 stated asset value net of current liabilities and unadjusted credits (depreciation, etc.) was in excess of $6oo,ooo,ooo.24 Even taking 3 per cent as the capitalizing ratio would mean debt of $106,500,000, a proportion still ridiculously low. It might have been more appropriate for Mr. James to compare the percentages of fixed charges and contingent interest to average operating revenues of the company's competitors, if one recalls the original purpose which motivated President Budd to adopt a debt-reduction program for the Burlington. The thought then had been that if the Interstate Commerce Commission were to set rates in such a way that the factor of paramount importance became the necessity of a given road's earnings being sufficient to cover "interest charges," the Burlington should modify its capital structure to be on a comparable basis with its competitors.25 Should such a policy be established by the ICC, however, the Commission would hardly overlook the long-run necessity for a given reorganized railroad of covering the contingent interest charges authorized in its plan of reorganization. If Mr. James had made the comparison on that basis, the Burlington would have appeared in a much more favorable position, for the over-all percentage comparison would then have been as follows: Ratio of all charges to revenues (per cent) Burlington (giving effect to 1942-43 debt reduction) Rock Island C.M.&St.P. North Western

9.21 6.20 8.48 10.14

Even though Mr. James may have considered and discarded the foregoing comparision, he referred to President Budd only the conclusions and interpretive comments based upon the unfavorable showing of the Wall Street Journal article. This information presented Mr.

CLARIFICATION OF OBJECTIVES

87 Budd with additional arguments to be used in pressing the Burlington's owners for authority to pursue vigorously the attack upon the volume of debt outstanding. There still remained President Denney's letter to be answered, and Mr. Budd seized upon this opportunity to outline not only the extent of debt reduction he proposed, but to record once again, with "documentary material," urgent reasons in support of the policy he intended the Burlington to follow.

Chapter Six

THE DEVELOPING FEASIBILITY OF CALLING THE ILLINOIS DIVISION BONDS A.

ADDITIONAL PURCHASES OF BONDS ABE AUTHORIZED

Armed with the analysis published in the Wall Street Journal, President Budd composed his answer to Northern Pacific's Denney on July i. There were two points to be covered: first, a statement of the extent to which President Budd felt that Illinois Division bonds should be retired prior to maturity; and second, an estimate of the year-end cash position of the Burlington. Slightly more than six months earlier, on December 22, 1942, President Budd had written President Gavin of the Great Northern, discussing the former point in detail, and a copy of this letter had been sent at the same time to President Denney. In December President Budd had thought that the Illinois Division bonds would be reduced to $40,000,000 prior to their 1949 maturity. Was there any reason to revise this goal? Apparently President Budd decided that the objective announced earlier was still satisfactory, for he wrote to Mr. Denney: The uncertainty of earnings and cash available for purchasing Illinois Division Bonds over a period of years precludes the setting up of a definite goal, but so long as there are available bonds at par or less I would favor a program of continuing to buy them, with two limitations: First, retaining in our treasury ample free cash and United States bonds (at present this would be not less than $32,000,000); Second, until the outstanding bonds have been reduced to $40,000,000.*

Next, turning his attention to an estimate of the Burlington's cash at the end of the year, President Budd forecast cash assets, exclusive of 1943 federal income tax accruals and before dividends, of $89,000,000. "However," he wrote, "it is estimated that federal normal and

FEASIBILITY OF CALLING T H E ILLINOIS BONDS

89

excess profits taxes, payable in 1944, will amount to $50,000,000 for which provision must be made, leaving approximately $39,000,000 free cash before dividends and debt retirement." Thus " . . . I do not see how we can possibly make a mistake by using $5,000,000 of the present cash to buy Illinois Division Bonds at par or less." And then President Budd concluded his answer to Denney: If you have not seen it, I think you will be interested in the enclosed analysis from the Wall Street Journal

of June 22 [referred to above, p. 8 4 ]

indicating the changed position of the Burlington as regards neighboring roads by reorganization of the latter. Since 1 9 3 1 the fixed charges of the Burlington in relation to its revenue have been such that with the many forms of competition in its territory the credit of the road was not maintained. T h e improvement in the position of competing railroads through reorganization, and the fact that the maturity of $65,000,000 Burlington General Mortgage bonds falls due in 1 9 5 8 , seem to make it imperative that fixed charges be reduced substantially. It also seems clear that we should take advantage of the present opportunity when earnings make the necessary cash available.

The arguments marshaled by President Budd proved convincing to Denney, and on July 3, 1943, he wrote President Budd, " . . . Mr. Gavin and I have discussed your recommendation [to purchase $5,000,000 bonds at par or less] today and approve it." 2 And so, once again, the Burlington resumed its policy of buying in its Illinois Division bonds before their maturity. Added to the $21,500,000 purchases previously approved, this would bring authorized expenditures to $26,500,000 in the fourteen months, since the policy was inaugurated in May, 1942. Surely this represented a creditable attack upon the $85,000,000 maturity in that short period of time. Authorizing the additional $5,000,000 was not, however, the same thing as buying the bonds, as the Burlington's officers were soon to discover. On July 26, J . P. Morgan and Company advised the company, "We are not having much luck on the purchase of Illinois Division Bonds in spite of the reactionary tendency noticeable today in the general railroad bond market. The facts are that the Burlington Illinois Division bonds just have not come out and we shall have to wait until some further selling orders appear." 3 Perhaps the difficulty encountered was due to the Burlington's efforts to buy the bonds "at par or less." No reason had ever been suggested by those shaping the company's financial plan for the consistent endeavor to pay no more than par for Illinois Division bonds, but the policy had been constantly reaffirmed. When the company was faced with the tight market for the bonds in the summer of 1943, it became apparent that it

90

POLICY FORMATION IN RAILROAD FINANCE

would be necessary to devise some other method besides open-market purchases if securities were to be acquired at the prescribed prices. Accordingly, on August 3, President Budd informed the parent lines of his decision to approach holders of the Illinois Division bonds directly. " W e have not been able to buy any of our Illinois Division bonds for par or less recently during the weak security market which has prevailed," he wrote Messrs. Denney and Gavin. 4 He continued, outlining his plan: In talking with Mr. A. M. Anderson today I told him that our success in purchasing Colorado and Southern [one of the Burlington's subsidiaries] General Mortgage bonds encouraged us to feel that we might secure some Illinois Division bonds at favorable prices by public request for tenders. He said that might well be true, and that in his opinion it would not be detrimental to the efforts of J. P. Morgan and Company if we were to request tenders. We are accordingly proceeding to ask Illinois Division bondholders to tender them up to August 25 . . . The outcome of this direct approach, however, only served to confirm the fact that the market for the Burlington's senior securities had strengthened to such an extent that few owners were willing to sell at less than par. In fact, only $453,000 principal amount of the Illinois Division bonds were secured pursuant to the published invitation for tenders up to the end of August. 5 Moreover, through August 26, J. P. Morgan and Company had found it expedient to spend only $80,000 of the $5,000,000 authorization placed in its hands following the approval granted on July 3 by the presidents of the Northern lines. 6 Shall Purchases

Be Made at Prices over Par?

In a real sense, with public appraisal of the Illinois Division bonds above par, a significant milestone was passed in the progress of the Burlington's investment credit. Previous emphasis in the purchase of these securities had been placed upon one main point — the effort to reduce the amount of debt outstanding so as to whittle an $85,000,000 maturity down to a more manageable size. It had been anticipated that a conscientious application of this policy would serve to improve the credit of the company, so that refunding of the remaining debt could be accomplished upon favorable terms. With the senior securities reaching prices at premium levels, one element of the goal, the improvement of the credit position of the company, had been attained. This increase in the price of the Burlington's Illinois Division bonds necessitated réévaluation of the policy to which the company had been committed. If it were no longer a question simply of "buying under

FEASIBILITY OF CALLING THE ILLINOIS BONDS

91

par," some new basis of purchase had to be developed. The obvious upper limit was a price of 105, for if prices proceeded above this point, the company would undoubtedly entertain serious thought of the possibility of exercising its call privilege. Prior to this time, there is no evidence that this possibility had been considered feasible due to the Burlington's credit position. On the other hand, any purchases above par would inevitably call attention to the yield of the funds so invested. As early as July 7, 1943, President Budd had sought financial counsel from Mr. Wallace Winter, one of the Burlington's directors, about establishing some criterion for the prices that should be paid for Illinois Division bonds. Three days later Mr. Winter suggested a policy that might be followed with some logic. Recalling that approximately 62 million dollars' worth of 3 ^ ' s and 4's were publicly owned, Mr. Winter calculated that "the average per annum coupon rate . . . is 3.725 per cent . . . That is what bonds at par will yield . . . " 7 He continued, "It seems to me that it would be reasonable to pay, if necessary, even more than par — that is to say, up to the point where the yield would not be less than what ear-marked money (in government obligations) would provide." Mr. Winter concluded his recommendation with an amusing observation which, nevertheless, is quite interesting. For by implication, it represented a complete reversal of the policy which J. P. Morgan and Company had been urging with respect to the purchase of Governments. "The foregoing is predicated of course," Mr. Winter wrote, "on the idea that cash is not diminished by, say, super-dividends, and that ear-marked money, if it hasn't lost its ears, will do as well, on refunding day, as bonds at par." 8 Disregarding the exact yield available in earmarked government obligations, Mr. Winter's advice undoubtedly focused the attention of Mr. Budd upon the question of alternative uses that could possibly be made of the Burlington's surplus cash. If the company were not to hold its cash idle, some suitable investment must be found. J. P. Morgan and Company had been insistent upon the purchase of Governments, but Mr. Winter felt that whatever investment were made, attention should be paid to the return available. And while the Morgan firm felt that a backlog of Governments would make ultimate refunding easier, Mr. Winter wondered if such earmarked money might not "lose its ears." Evidently, then, here was a serious question of policy that needed to be decided before any further purchases of Illinois Division bonds were made. At the end of August, J. P. Morgan and Company brought the issue to a head. On the twenty-seventh, Mr. Arthur Anderson wrote Vice President James:

92

P O L I C Y FORMATION I N RAILROAD

FINANCE

Since our conversation here in the office a day or two ago, we have been giving some further thought to the question of your trying to accumulate additional C B & Q Illinois Division Bonds along the lines of buying 4's at a premium, where the net yield to the company is at least as good as buying the 3 / 4 ' s at par and where, if the bonds are retired, the premium might represent a deduction from taxable income . . . 9

Thus on August 25 or 26 the company's New York banker had been exploring the possibility of inducing the Burlington to consider purchases on a yield basis. But the evidence does not indicate whether or not it was Mr. James or Mr. Anderson who had first brought the matter up for discussion. The conclusions reached at Mr. James' conference in New York, however, provided President Budd with his cue. He immediately wrote 10 both the Northern lines' presidents for authority to pay above par for securities bought. President Budd called to the attention of Messrs. Denney and Gavin that Mr. Anderson had suggested the premium paid for bonds would be a deduction for income tax purposes, and that the Burlington's comptroller said "that could be done." Precisely, Mr. Budd requested approval of a modification of the policy which would permit purchases at the premiums existing "at, or slightly under, current market quotations." It is somewhat of an anticlimax that the important decision to pay more than par for the Burlington's bonds was based simply upon the tax deduction involved if a premium were paid for the securities. Yet the request for approval of the new policy was made on this ground alone, and, as an argument, must have been fully convincing, for authorization of the procedure suggested by President Budd was immediately granted by the Northern lines. 11 B . EMERGENCE OF THE POSSIBILITY OF REDEEMING BONDS BEFORE MATURITY

Once the Burlington's managers found that their company's senior securities were not only selling above par, but that it was even prudent to use surplus cash to purchase them at the diminished yield, it was natural that serious thought be given to the possibility of calling the 3 per cent and 4 per cent Illinois Division bonds and replacing them with equivalent or lower coupon issues. And, too, the fact that these securities were maturing in only six years gave additional reason for urgent analysis of the implications of paying a premium for the acquisition of the Illinois Division bonds. That the possibility of redeeming the Illinois Division bonds was being seriously considered at this time is evident from a memorandum

FEASIBILITY OF CALLING THE ILLINOIS BONDS

93

prepared by the Burlington's R. W. Coglan on August 30, 1943. 12 Available records do not indicate the circumstances which preceded the preparation of this analysis, but it was undoubtedly written at the request of those responsible for shaping the Burlington's financial policy. The memorandum considered a practical solution to the financial problem arising out of the purchase of part of the $61,348,000 of Illinois Division bonds outstanding at that time, and the call and refunding of the balance. The significant point to be noticed in this new development in the Burlington's policy is that no sooner had the decision been reached to pay above par in the purchase of bonds than the company's financial officers saw fit to have a study made of the manner in which a definitive plan for handling the maturing issue might work out in practice. Although precise details of this first attempt to sketch a specific course of action for the refunding of the Illinois Division bonds were rather vague, the principal outline can be briefly summarized as follows. It was proposed to reduce the debt of $61,348,000 then outstanding by $21,348,000 through continued open-market purchases of bonds. The balance of $40,000,000 would be called at 105, and refunded by the issuance of either ten- or fifteen-year 1 y 2 per cent Serial Notes. The memorandum did not consider what security would underlie this large issue of notes, if any; nor did it suggest how they might be placed. It did, however, suggest that these notes could be sold at an average price of 98, a figure which implies a yield ranging from approximately 1.65 per cent to 3.50 per cent depending upon a maturity of one or fifteen years if all bonds were sold at the average price, and an average yield little more than 2 per cent. Mr. Coglan's memorandum of August 30 provides an interesting index to the thinking of the Burlington's financial officers at the end of the summer of 1943. However, the immediate objective was to complete the purchase of nearly $5,000,000 of bonds which had been authorized at the beginning of July. Approval had been received from Messrs. Denney and Gavin on August 31 to pay premiums if necessary in the authorized expenditures, and on September 4 President Budd informed J. P. Morgan and Company of the decision to buy "at approximately the present market." 13 Willingness to pay above par expedited purchases, and by September 17, the final $5,000,000 authority had been exhausted.14 Approximately $4,147,000 of this amount represented the purchase of a $4,000,000 block of 4 per cent bonds purchased from the Equitable Life Assurance Society on a 3.50 per cent yield basis, 15 the first sizable acquisition above par. With the expenditure of this appropriation, President Budd advised J. P. Morgan that no more purchases should be

94

POLICY FORMATION IN RAILROAD FINANCE 16

made. With a few minor exceptions, this action brought to its termination the bond-buying program, which in just over two years had authorized the purchase of $26,500,000 of the $85,000,000 Illinois Division bonds. The average price of the bonds purchased during the entire program was summarized well after the end of the period as follows: Some time ago you [i.e., President Budd] asked what average prices J. P. Morgan & Co. had paid for our Illinois Division Mortgage Bonds and Mr. Arthur Anderson has supplied the following figures: Total of $26,530,000 principal amount of Bonds purchased at an average cost of 97-359 The break down of this figure is as follows: $y2s, " , 4s , " ,

coupon, average price Registered " " coupon, " " Registered " "

96.968 94-574 98.396 100.30417

C . THE INITIAL DEVELOPMENT OF REFUNDING PLANS

In May, 1942, the Burlington had been faced with an $85,000,000 debt maturing in seven years. These securities, the company's senior obligations, were then selling on a yield basis of more than 5 per cent, and within a month Moody's had given them a rating of Baa, indicating uncertain investment merit. The adoption of the bond-buying program at that time had been decided with two points in mind — to reduce the magnitude of the debt to a manageable size, and to support the prices of Illinois Division bonds and improve the company's credit so that favorable interest rates could be obtained whatever refunding plan were ultimately decided upon. From the point of view of these objectives, the purchasing program had met with resounding success. In the words of J. P. Morgan and Company's Arthur Anderson, "The last two years have given you [Mr. Budd] a great opportunity to attack your maturity problem, and your progress is reflected in a higher level for all Burlington securities, which should simplify such refunding problems as you may have." 18 President Budd's attack upon the Illinois Division debt had not been free of temporary setbacks. Although the initial development of the company's policy of bond purchases had been uneventful and quite straightforward, efforts to put the policy into action had been beset with numerous vicissitudes. The foregoing pages have traced the various objections to the application of the policy, and the steps that President Budd took to overcome these problems and to maintain the Burlington's policy on the course originally charted. There was the

FEASIBILITY OB* CALLING THE ILLINOIS BONDS

9$

ever-present question of the amount of bonds that should be bought and the speed with which they should be acquired. There had been questions of tax liability as it affected the bond-buying program, and there had even been doubts raised that purchase of Illinois Division bonds was as prudent as the alternative investment of funds in Government securities. B y expert guidance, however, the company had been consistently kept to the financial policy which President Budd believed would enable the Burlington to make the most effective provision for its maturing obligations. With the practical termination of the bond-purchasing program, it was only to be expected that those responsible for shaping the Burlington's financial policy would begin careful examination of plans for refunding the Illinois Division debt. At the end of August, as noted above, and even before the final $5,000,000 appropriation had been expended, the company's officers were considering the savings that might be made if the then outstanding $61,348,000 of Illinois bonds were refinanced by purchasing part and issuing 1 y 2 per cent Serial Notes for the balance. While this memorandum presented such cost details as estimates of attorney's fees, printing costs, original tax, and so on, connected with the issue of the suggested 1^2 per cent notes, the analysis can hardly be said to have rested upon sound financial counsel. For the great imponderable was how a $40,000,000 issue of i y 2 per cent coupon serial notes could be marketed at the average price of 98 as suggested. Nevertheless, the memorandum is an important milepost in the development of the Burlington's financial policy. With the end of planned bond acquisitions, the company had made its first definite effort to outline a procedure for refunding its senior securities. Thoughts of refunding were uppermost in the mind of the Burlington's chief policy-maker. In mid-September, J . P. Morgan's Arthur Anderson referred to President Budd's recent discussion with the banking firm on the manner in which the Burlington had worked out its first tentative solution to its refunding problems. "As to those plans," Mr. Anderson wrote, " I was interested in the comment you and Mr. James made yesterday as to what you may want to do and we should like to have an opportunity to offer one or two suggestions on it the next time you happen to be [in New York], . . . " 1 9 Accordingly, President Budd arranged for consultation with the firm's New York banker, and on September 20, 1943, a luncheon meeting was held with officers of J . P. Morgan and Company.20 At this conference, President Budd discussed in general outline the refunding plans that the Burlington's officers had tentatively developed. The unfinished scheme for Serial Notes described in Coglan's

g6

POLICY FORMATION IN RAILROAD FINANCE

August 30 memorandum was one idea, but a plan developed by the Louisville and Nashville Railroad in 1939 for a Collateral Trust Bond issue provided another basis for developing a refunding medium. It will be remembered that the L. & N. plan had been called to the attention of the Burlington's officers in 1942. Superficially that program, developed under the guidance of Morgan Stanley and Company, solved problems comparable to those presented to the Burlington by the maturing Illinois Division bonds. The L. & N. had found itself with $69,243,000 of Unified Mortgage Bonds, the railroad's senior mortgage lien, maturing on July 1, 1940. The plan developed contemplated payment of part of this outstanding debt, and arranging for the sale of a $60,000,000 Collateral Trust issue to provide funds to meet the balance. Collateral to be pledged as security behind the proposed Collateral Trust bonds consisted of the maturing Unified Mortgage bonds, extended for the life of the new issue.21 The analogy between the L. & N. refinancing and the Burlington's problem is evident. Why should not the Burlington also call its Illinois Division bonds and extend them, depositing these securities as collateral under a new Burlington Collateral Trust issue? While at first glance it might appear that the plan developed by the L. & N. would be applicable to the Burlington, J. P. Morgan and Company questioned if the terms of the various C. B. & Q. mortgage indentures would permit extension and pledge of the Illinois Division bonds in the way the Unified Mortgage bonds had been handled. In fact, Mr. Budd's New York discussion seems to have reached an impasse on this point and also in consideration of alternative procedures which, in President Budd's opinion, were legally available. The entire problem was left undecided as a result of the September conference, but President Budd agreed to furnish the bankers with the views of the Burlington's general counsel about the legal points involved in connection with the Illinois Division lien. Upon his return to Chicago, President Budd discussed these issues again with the Burlington's vice president and general counsel, Mr. J. C. James. On October 1, 1943, he wrote J. P. Morgan's Anderson as follows: M r . James is certain of his opinion that there is a right to extend the [Illinois Division] bonds at maturity. If they are called for payment, he thinks the company could extend them for use as collateral under some such plan as that of the L & N in 1940. Of course, this is a problem about which the attorneys for the underwriters would have to be satisfied. 22

Apparently there had been talk in the New York conference about the difference presented in the Burlington's adaptation of the L. & N. plan

FEASIBILITY OF CALLING THE ILLINOIS BONDS

97

with respect to the possibility of extending the bonds at maturity, in contrast to the legality of calling them before maturity, and subsequently extending rather than retiring the issue. T o press the view that calling the bonds and canceling them would be the more advantageous procedure as far as the Burlington's best interests were concerned, President Budd continued: If the Illinois Division bonds were called and retired while our earnings are so high, we could take substantial tax reductions on account of the premium paid and the unamortized discount. It is not clear that this tax saving could be made if the bonds were extended.23 In conclusion, President Budd pointed out to his bankers an entirely different method that might be considered as a solution to the company's financial problem: An alternative method would be to issue First and Refunding Mortgage bonds in exchange for the Illinois Division bonds, without impairment of the lien of the latter, as provided in the First and Refunding Mortgage, and then use the First and Refunding bonds as security for a collateral trust issue for the amount necessary to call the Illinois Division bonds.24 F r o m the foregoing letter, it is at once apparent that the Burlington's officers were probing the possibility of redeeming their company's senior securities prior to maturity — a plan favored because of the large tax saving that might be realized so long as the railroad remained in the excess-profits tax bracket. A n d it appears equally evident that the Burlington's bankers were reluctant to concede the practicability of the extension procedures which had been discussed in the September meeting. President Budd's letter, however, proved scarcely more persuasive to J. P . M o r g a n and Company than the views he had expressed orally in the recent conference, for M r . Anderson's immediate response merely agreed to the obvious — that extension of the Illinois debt would be possible upon maturity. H e conceded that "the tax angle is an important one," but restated his opinion that a call coupled with extension might not be a tenable position. 25 President Budd, however, was not at all satisfied with this more or less offhand answer to the problems of such paramount importance to the Burlington, and asked for a complete analysis of the company's outlook from the viewpoint of financial experts. In response to this renewed effort on the part of the Burlington to obtain advice, J. P . Morgan and Company submitted on October 8, 1943, an extensive memorandum prepared in its bond department on "Various Alternative

98

POLICY FORMATION I N RAILROAD F I N A N C E

Steps Which Might Be Taken to Refinance, Extend or Reduce Issue Before 1949" of the Illinois Division bonds. This memorandum of October 8 was the first considered attempt to develop plans which, by specifically suggested financial instruments, would provide suitable media for solving the Burlington's refunding problem. Proceeding on certain assumptions, the J . P. Morgan analysis canvassed the types of securities which might be marketed successfully, the amount of collateral deemed necessary, and the probable interest rates that would be obtained. The tenor of the J . P. Morgan memorandum was, on the whole, quite pessimistic. Rather than suggesting an aggressive attack upon the problems presented by the Illinois Division maturities, the various alternatives proposed were surrounded by a quagmire of contingencies. These uncertainties cast imponderable doubts upon the feasibility of the plans developed in the memorandum. The J . P. Morgan report discussed four courses of action which could be considered. Under the assumption that it would be practical to call the Illinois Division bonds before maturity, two possibilities were analyzed. The first plan depended upon preserving the lien of the called bonds and issuing collateral trust bonds with the extended bonds as security. This procedure, of course, was roughly the same as that followed by the Louisville and Nashville Railroad in 1940. However, this was viewed as being purely hypothetical, since J . P. Morgan and Company still held that the legality of extending the called bonds was too uncertain. In fact, the report did not even bother to examine the terms under which such a collateral issue might be sold. On the other hand, it was suggested that if the lien of the called bonds could not be held alive, it was permissible under the terms of the respective mortgages to follow a different procedure. The called Illinois Division bonds, plus those previously purchased, could be surrendered in full against the issue of 85 millions of dollars' worth of new General Mortgage bonds; the latter securities deposited in turn under the First and Refunding Mortgage would permit the issuance of a like amount of F & R bonds which could be used either as the primary financing medium, or as security behind a new collateral trust instrument to be sold to provide the necessary funds. Since this last procedure was that actually followed in the final refunding plan, J . P. Morgan and Company's evaluation of this possibility highlights the pessimism running through their entire memorandum of October 8. Noting that it would cost the Burlington approximately $60,000,000 to call the Illinois Division bonds outstanding, the report stated "it

FEASIBILITY OF CALLING THE ILLINOIS BONDS

QQ

seems doubtful if as many as $50,000,000 . . . serial collateral notes secured [by First and Refunding bonds] could at present be sold on favorable enough terms." However, the Burlington's advisers felt that the company's credit was such that " . . . $25,000,000 10-year serial notes . . . could possibly be sold successfully . . ." provided the new debt was secured 100 per cent b y a first lien upon the railroad property. Surely the "possibility" of borrowing no more than this amount of short-term funds was a stringent evaluation of the credit risk of a company that had retired more than that amount of debt in the preceding two years! B u t the bankers were not even satisfied that compliance with this recommendation was more than a step in the direction of a practicable financial plan, for it was pointed out that this procedure would require the use of $35,000,000 in cash, " w h i c h , " they said, "is undoubtedly more than could be spent now." T w o other plans were briefly discussed in the memorandum of October 8. Assuming that it was not practical to call the Illinois Division bonds, the analysis explored the possibility of offering an extension to the existing holders of the 3 ^ ' s and 4's. However, in line with the pessimistic credit appraisal running through the report, it was assumed that " a 25-year Illinois Division bond is worth about a 4 % yield basis in the current market," and so it would be necessary to offer holders "extended bonds worth about 92 in the case of 3J/2S and 100 in the case of 4s." T h u s , to extend the 3>4's would require an eight-point cash payment, an operation which might prove too expensive. If the bonds were not to be called and extension were not decided upon, a final alternative was suggested — namely, to b u y Governments and Illinois Division bonds as excess cash permitted, "on the theory that present earnings m a y last long enough to permit building up a reserve b y 1949 sufficient to cover or almost cover $57,000,000 maturity." I t appears obvious that in October, 1943, J. P . M o r g a n and Company did not entertain a sanguine outlook toward the immediate adoption of an economical and aggressive policy for the solution of the Burlington's refunding problem. T h e greatest service performed b y the October analysis, however, in the light of subsequent developments, was to indicate the element of uncertainty characteristic of each of the alternative plans proposed. T h e memorandum concluded as follows: Some technical questions which come up in connection with various of the above alternatives are: (a) Can the Illinois Division lien be preserved if the bonds are called prior to maturity? (b) Can the Illinois Division be extended at a higher coupon rate?

100

POLICY FORMATION IN RAILROAD F I N A N C E

(c) Can bonds not accepting an extension offer be called without calling the extended bonds? (d) How much cash does the company think it can devote to retiring debt now? (e) Assuming continuance of present operating earnings, what growth in cash is it reasonable to expect from month to month? (Answer depends partly on dividend policy and need for additions and betterments not financeable through equipment trust certificates.) (f) Would tax savings result from a call at 105? Probably yes. How much? (g) Would tax savings result from an extension or exchange offer where a cash bonus is offered? Probably no. These seven questions were searching and pertinent queries which needed definite answers before the Burlington could be said to have a precisely formulated financial policy. Since the J. P . Morgan memorandum called specific attention to these issues, it is probable that the Burlington's policy-makers had not furnished their financial advisers with a clear-cut exposition of the legally available means for the attainment of those aims. If J. P . Morgan's October memorandum did nothing else, it served to notify the railroad company that financial advice with respect to its refunding problems would necessarily have to be based upon a careful statement of the facts surrounding the Burlington's own previously developed financial structure, as well as its current financial prospects and motives. President Budd received J. P. Morgan's analysis as coolly as the generally pessimistic tone of the report warranted. " T h e suggestions contained in the memorandum," he wrote, "are worthy of careful consideration, but I am not sure that any amount of consideration will enable us to reach a definite conclusion as to some of the possibilities." 26 T h e significance of the many questions raised was not, however, lost upon President Budd. H e resolved to have another thorough study made of the problems which the maturity of the Illinois Division bonds presented. For over two years the policy followed b y the Burlington had been the outgrowth of the special committee report of June, 1941. T h e conclusions then reached with respect to extending the Illinois Division bonds upon maturity or refunding them directly through the First and Refunding bonds still colored the opinions of the company's executives. Doubt had been cast upon the feasibility of both these plans b y the Burlington's traditional financial advisers, and without question the time had arrived for a comprehensive reexamination of the company's financial policy. T h e result of this study took the form of a new memorandum, which Vice President James submitted on November 16, 1943, to President

FEASIBILITY OF CALLING THE ILLINOIS BONDS

101

Budd. T h e new analysis presented in thorough and in unusually wellbalanced perspective the alternative courses of action open to the Burlington. 27 Whereas the 1941 special committee report was characterized by an almost mechanically legalistic analysis of the various procedures considered feasible, the 1943 report considered not only the legal problems involved, but presented alternatives in the light of a realistic evaluation of the Burlington's financial prospects and the probable effect of these alternatives as they might influence or be influenced by the investment market. In many ways this memorandum is the most significant single document available to illustrate the development of the Burlington's financial policy. Successive managerial decisions had modified the crude policy formulated in 1941, but the course of action followed was defective because of its failure to tie current decisions in with the projected ultimate effect of these plans upon the refunding problem that would inevitably be encountered. T h e J. P. Morgan memorandum focused attention upon these shortcomings, and Vice President James was able to cast his revised formulation of policy in the shape of an answer to the questions raised on October 8. Appendix I of this study presents Mr. James' memorandum in full. In his covering letter, Mr. James summarized his analysis, conceding that some previous views had been revised. Particularly, the Burlington's general counsel had now concluded, " T h e only clear and unquestioned method of refunding is through both the General Mortgage and the First and Refunding Mortgage." This decision was reached in the memorandum as Mr. James developed his answer to the question, " C a n the Company rely upon extension of Illinois Division Mortgage bonds to meet the 1949 maturity?" 28 Although Mr. James had not been swayed from his opinion that the Burlington did have the technical right to extend, "it would not be good business judgment to rely upon it unless we could have it vindicated by a Declaratory Judgment well in advance of maturity." Considering further whether the bonds might be extended if redeemed before maturity, reliance upon a Declaratory Judgment was again believed the only sure course to follow. But, "While I do not recommend such procedure under present circumstances," said Mr. James, "and of course pioneering in a matter of this [latter] kind is not desirable, the possibilities should not be lost sight of . . ." Thus, Mr. James concluded that refunding through the General and First and Refunding mortgages " . . . may be regarded as the orthodox method which could be followed without criticism or objection . . ." T w o other points were discussed in Mr. James' memorandum of November 16 bearing upon the preference he now felt for the "ortho-

102

POLICY FORMATION IN RAILROAD FINANCE

dox method" of refunding. The first of these partially clarified the attitude the company would take if asked for an interpretation of the call provision of the Illinois Division Mortgage. Mr. James considered the possibility that following the adoption of a plan involving extension of the bonds, some bondholders might disagree with the proposal. The question might then arise as to whether the bonds of the dissenting bondholders could be called under the terms of the mortgage, and the remainder extended as planned. The query was an important one, and, as discussed in Chapter III, was of utmost significance in the development of a policy to refund the Illinois Division bonds. Mr. James' full and complete response to this question was " T h e answer is no. The mortgage provides that the company may redeem all of the bonds secured by this indenture and then outstanding." This interpretation of the call provision clearly implies that those bondholders not agreeing to extension would have to be paid in full at maturity. The second factor pointing toward the desirability of the "orthodox method" was based upon consideration of the effect of refunding directly through First and Refunding bonds. It was reaffirmed that the language of the F & R Mortgage permitted direct pledging of the Illinois Division bonds and contra issue of F & R's "at, after, or within twelve months before maturity of the Illinois Division bonds." This possibility had been clearly stated in the 1941 special committee report. In addition, Mr. James noted another provision which would permit the issuance of F & R's against prior debt bonds at any time. From the legal side, then, the availability of this method was held to be clear. However, the effect of carrying the lien of the Illinois Division Mortgage around the General Mortgage in this fashion was evaluated in the light of the refunding problems which would be faced in 1958 with the maturity of the General Mortgage bonds. "Certainly, if we can avoid it," Mr. James concluded, "we ought not to complicate the financial structure of the Burlington, or jeopardize extension of the General Mortgage bonds in 1958, by putting the lien of the Illinois Division Mortgage under the First and Refunding Mortgage." The remainder of the November statement of policy discussed how the recommended "orthodox method" of refinancing might be used — either by call and redemption of the Illinois Division bonds before maturity, or by waiting until maturity for refunding. Careful attention was paid to favorable and unfavorable 29 circumstances as they affected "calling all outstanding bonds for redemption and refinancing at the present time." (See Appendix I, Sections V - A and V - B . ) Mr. James' summary of these points was stated in his covering letter to President

FEASIBILITY OF CALLING THE ILLINOIS BONDS

IO3

Budd, in which he recommended the policy that his analysis led him to believe should be adopted: . . . the conservative course would be to do no refinancing at the present time, but to adopt the policy of using excess cash, as available, to buy Illinois Division Bonds or Government Bonds in the hope of acquiring substantial amounts of each by 1949 so that the maturity of the balance could then be provided for without serious strain upon the resources of the Company, or, if necessary, the balance could be refunded through both junior mortgages.80 President Budd signified his approval of the policy recommended by a longhand notation, " I agree we should follow the conservative course, # 2 [Section V — see Appendix I.]. . . ." A hasty reaction to the decision reached might be that the mountain labored and brought forth a mouse. For over one month had elapsed since J. P. Morgan and Company had suggested this as one possible alternative the company might follow, and the entire policy was tantamount to a back-tracking to the course upon which the company had been embarked since 1942. However, the significant difference was that as a result of the analysis in November, 1943, the current policy recommended was well integrated with a refunding plan that could be embraced either at maturity of the Illinois Division bonds or whenever the opportunity might arise prior to that time. Throughout the November memorandum the possibility of either selling First and Refunding bonds issued under the "orthodox method" directly or of pledging them as collateral security was recognized. (See Appendix I, Section II.) The conclusion that Illinois Division bonds should be purchased as available was most assuredly no more than confirmation of the longstanding policy which had been terminated in a nominal sense only on September 17, 1943. Although on that date President Budd advised J. P. Morgan and Company that no more purchases should be made, on October 9 he had written Mr. Anderson, "It will be all right for you to continue buying up small lots of Illinois Division" bonds.31 There is no evidence that there was any official authorization of these acquisitions beyond Mr. Budd's instructions, but continued small purchases were made up through November 16.32 Presumably reflecting the decisions reached in Mr. James' memorandum of November 16, President Budd again confirmed with J. P. Morgan and Company that it would "be all right for you to continue . . . buying odd amounts of Burlington Illinois Division bonds as they are offered at 3^4 % or greater yield." 33

104

POLICY FORMATION IN RAILROAD FINANCE

No sooner had President Budd informed the Burlington's bankers that the bond-buying program had been reaffirmed on a small scale than the policy was summarily abandoned. On November 22 the Burlington's executive committee met to discuss the company's earnings prospects and to set the amount of dividends to be paid for the year. The question of conserving cash "so as to be in a strong position to provide for wages and taxes if there should be a sudden drop in earnings" 34 was the principal consideration, and it was decided that the adoption of a conservative financial program would be the prudent course to follow. It was therefore concluded that the dividend would be kept on the same basis as in the preceding year, and also that no more Illinois Division bonds would be purchased for the present, despite the recommendation of Mr. James' memorandum of November 16. Accordingly, President Budd wrote J . P. Morgan and Company, advising them of the altered plans. Thus, the bond-purchasing program nominally terminated in September was formally ended on November 24, 1943. In the report filed with the SEC covering 1943 acquisitions of Illinois Division bonds, the par value purchased was stated to have been $i6,384,ooo. 35 Since October 15, only $105,000 par value of bonds had been acquired 38 but purchases of the bonds over the two-and-one-half years had reduced the amount outstanding by $28,227,000, or to a total on December 31 of $56,773,000." Although the Burlington's executive committee had decided against continuing the moderate debt-retirement program contemplated in the November 16 memorandum, President Budd did not interpret this action as a restraining gesture directed at his persistent efforts to make final arrangements to dispose of the troublesome Illinois Division maturities. Judging from his answer to the proposals J . P. Morgan and Company had made on October 8, 1943, President Budd had been disappointed in the solutions suggested for the Burlington's refunding problems by the one banker entrusted since 1942 with furnishing financial advice. J . P. Morgan's 1943 memorandum served a highly useful purpose, however, for it prompted the Burlington's officers to make a carefully critical analysis of the company's financial alternatives — from both the legal and practical standpoints. The report prepared by Vice President James undoubtedly gave additional impetus to Mr. Budd's intention to perfect a financial program suitable for the company's needs. The record suggests that the inability of J. P. Morgan and Company to propose suitable refunding plans led President Budd to seek financial advice from other sources. It will be recalled that as early as 1936 Morgan Stanley and Company had been asked to look into the prob-

FEASIBILITY OF CALLING THE ILLINOIS BONDS

I OS

lems of the B u r l i n g t o n w h i c h g r e w out of its 1949 Illinois D i v i s i o n maturities. I t is h i g h l y p r o b a b l e t h a t a f t e r pessimistic opinions h a d been r e c e i v e d f r o m J. P . M o r g a n a n d C o m p a n y , P r e s i d e n t B u d d decided to seek a d v i c e f r o m i n v e s t m e n t b a n k e r s rather than f r o m p r i v a t e b a n k e r s . C o r r e s p o n d e n c e is l a c k i n g to s u p p o r t this h y p o t h e s i s , b u t in a n i n t e r v i e w b e t w e e n M o r g a n S t a n l e y ' s V i c e P r e s i d e n t Jones a n d P r o f e s s o r K . T . H e a l y , certain f a c t s b e a r i n g u p o n this s w i t c h of b a n k e r s w a s later b r o u g h t to light. 3 8 I t w a s a s c e r t a i n e d b y M r . H e a l y that d u r i n g 1943 M o r g a n S t a n l e y ' s files contained no e v i d e n c e of c u r r e n t c o n t a c t w i t h the B u r l i n g t o n ' s d e v e l o p i n g financial p o l i c y . U p o n i n q u i r y directed to M r . Jones, it w a s d e t e r m i n e d that P r e s i d e n t B u d d w a s " a p p a r e n t l y t a l k i n g more to b a n k s t h a n M o r g a n S t a n l e y d u r i n g this p e r i o d . " M r . Jones stated f u r t h e r that in the d e v e l o p m e n t of r e f u n d i n g plans " B u d d w e n t to J. P . M o r g a n & C o . first. [J. P . M o r g a n ' s ] A n d e r s o n h a d collateral idea first, [ b u t I ] t h o u g h t [ w e ] c o u l d i m p r o v e on this. B u d d a s k e d w h a t c o u l d be d o n e . " 3 9 T h u s , it w a s a p p a r e n t l y after P r e s i d e n t B u d d h a d considered the m a n n e r in w h i c h J. P . M o r g a n p r o p o s e d to solve the B u r l i n g t o n ' s financial p r o b l e m s that other b a n k e r s w e r e invited t o e x a m i n e the c o m p a n y ' s situation. A m o n g other financial experts consulted for a d v i c e relative to the m a t u r i n g Illinois D i v i s i o n bonds w a s M r . H e n r y S. Sturgis, vice president of the F i r s t N a t i o n a l B a n k of N e w Y o r k . I n response to President B u d d ' s request " t o t a k e a look a t the financial situation of the C h i c a g o , B u r l i n g t o n & Q u i n c y . . . " 4 0 he w r o t e a n indifferent a n a l y s i s b a s e d u p o n j u d g m e n t not s u p p o r t e d in his letter b y considered f a c t s . P e r t i n e n t p a r a g r a p h s of M r . Sturgis' letter f o l l o w : Since the Illinois Division bonds can be extended, it is our judgment that the best way to deal with them is by extension, rather than by attempting to pay them through the issue of first and refunding bonds or through some sort of serial collateral trust issue. These two questions then arise: In what amount can they be extended, and at what time? We believe that if the total outstanding issue in the hands of the public were reduced to $40,000,000 they could be extended for twenty years or so at a fair rate. Y o u will recall that you stated that there were now $57,000,000 in the hands of the public, and that you could afford to use out of cash somewheres between $15,000,000 and $20,000,000. We believe that if you used $17,000,000, that would be adequate. As to the time, this is a somewhat more difficult problem on which to have a sound judgment. It seems to us, however, that, with all the uncertainties of the future, an attempt should be made to be ready to accept the first favorable opportunity. This might mean, of course, that you would in effect have to call the bonds at 105, but as the premium is deductible for tax pur-

IOÓ

POLICY FORMATION IN RAILROAD FINANCE

poses, the net cost would not be large, and you would be able to get the problem behind you. If the time is well chosen, it is possible that a group of investment bankers could be found who would be willing to buy and extend the bonds, thus in effect underwriting the extension. In the meantime and preparing for this opportunity, you might give consideration to asking for tenders of the bonds, with the goal in mind of reducing the issue outstanding in the hands of the public to the $40,000,000 figure. It is evident from the foregoing that N e w Y o r k ' s First National contributed nothing new in December, 1943, to the financial policy evolved b y the Burlington over the preceding years. E v e n the final suggestion of asking for tenders seems peculiarly uninformed in view of the identical procedure followed b y the Burlington four months previously. T h e only point emerging from M r . Sturgis' letter pertinent in its bearing upon the managerial decisions made is the fact that on December 1, 1943, the Burlington "could afford to use out of cash somewheres between $15,000,000 and $20,000,000." This would mean that at least b y November the Burlington's officers had examined the company's need for cash and concluded that there would be available a considerable surplus for retirement of debt. A s early as the end of August, the company had made its own tentative refunding plans on the assumption that over $21,000,000 could be used for continued private purchases of bonds. Subsequent expenditures had reduced outstanding debt b y less than $5,000,000, so the estimate of available cash furnished the First National of N e w Y o r k was, in general, a reaffirmation of the surplus anticipated four months previously. Meanwhile, Morgan Stanley was giving its own attention to the problem of the Burlington's maturing debt. A n undated memorandum prepared in the firm's offices discussed the redemption of $56,773,000 of Illinois Division bonds — the amount outstanding after November 24, 1943. Since the plan contemplated "January 1, 1945, [as] the earliest possible call date," it must have been written with the understanding that no effective action could be taken b y the Burlington before June 1, 1944, or six months prior to the effective call date under the terms of the Illinois Division Mortgage. Hence M o r g a n Stanley's memorandum was written subsequent to November 24, 1943, and probably after January 1, 1944. This analysis, prepared b y an investment banking firm, was the first submitted to the Burlington's officers which outlined specific steps which might be taken to refund its Illinois Division securities. T h e memorandum considered not only alternative bond issues, but the particular security that should underlie these instruments so that they might be sold at suggested rates of interest. T h u s , M o r g a n Stanley's proposals were tendered in a more concrete form than any received

FEASIBILITY OF CALLING THE ILLINOIS BONDS

107

previously by the Burlington. While this turn of events was a desirable innovation from the railroad's viewpoint, it must be remembered that the Burlington had not formally consulted with an investment banking firm since its extensive debt-reduction program had been adopted nearly two years earlier. The company's financial officers, therefore, must have given a more or less unreserved welcome to this objective analysis of their refunding problems. The tentative plans suggested by Morgan Stanley analyzed two main alternatives. The first consisted of the issue of Collateral Trust Serial Notes of one- to twenty-five-year maturity. The second alternative proposed to separate the earlier and later maturities by issuing one- to five-year Serial Notes for approximately one third of the debt to be refunded, and use a Collateral Trust Bond with sinking-fund payments beginning in the sixth year for the remainder of the debt. With these basic alternatives, Morgan Stanley considered first the security that should be pledged under the Collateral Trust issues, next the drain of either the serial maturities or sinking-fund payments upon the Burlington's income, and finally, the probable interest rates that could be commanded by whatever securities were issued. Morgan Stanley's memorandum was written under the assumption that the retired Illinois Division bonds would be surrendered for the issuance of $85,000,000 General Mortgage bonds, which in turn would be issued to the First and Refunding Mortgage trustee, so that $85,000,000 F & R bonds would be available for pledge behind the Collateral Trust securities. Thus the financial proposals made by Morgan Stanley conformed to the "orthodox method" outlined by Mr. James in his memorandum of November 16, 1943 reproduced in Appendix I. One extremely important idea, which had not previously been given explicit consideration, emerged from Morgan Stanley's proposals — namely, the security which ideally should underlie the new Collateral Trust debt. It was held desirable that the new issue should be backed 100 per cent by a first lien upon the Burlington's property in order to create a marketable security. Of course, after the retirement of the Illinois Division bonds, the Generals would become a first mortgage upon practically the entire railroad.41 Therefore the necessary security could be obtained either by indirect pledge of Generals under the F & R bonds, the latter being pledged directly; or, if this procedure would not produce the required 100 per cent backing, supplement the foregoing with the direct pledge of additional Generals under the Collateral Trust issue. The Morgan Stanley memorandum examined specifically the manner of obtaining the security deemed desirable. As stated above, the "orthodox plan" would result in the issuance of $85,000,000 of both

108

POLICY FORMATION I N RAILROAD FINANCE

General and First and Refunding Mortgage bonds upon the retirement of the Illinois Division debt. This would increase the F & R bonds outstanding to $155,000,000. This amount, however, would be secured by the pledge of $85,000,000 Generals in addition to the $18,294,000 previously deposited thereunder as a result of the 1927 retirement of the Nebraska Extension bonds, giving outstanding F & R bonds $103,294,000 claim on the company's first lien. Expressed differently, the F & R bonds would be secured to the extent of 66.6 per cent of their outstanding amount by direct pledge of General Mortgage bonds. Hence a factor was derived to measure the indirect first-lien security applying to any amount of F & R bonds pledged under the Collateral Trust issue. Thus, if $85,000,000 of F & R bonds were used as collateral for the new bond issue, the new debt would be indirectly secured by $56,610,000 of General Mortgage bonds. The relative security available was thus viewed as a function of the amount of Generals available for pledge, and the amount of Collateral Trust bonds or Notes to be issued. For example, if $60,000,000 Collateral Trust instruments were issued, some $3,400,000 additional Generals would be needed to increase the $56,610,000 indirect pledge of these bonds to the desired 100 per cent. Morgan Stanley's memorandum called attention to the existence of $9,873,000 Generals pledged elsewhere that might be used in whole or part as a direct pledge under the new Collateral Trust bonds to create the 100 per cent first-lien security considered standard. More attention, however, was paid to issuing a smaller number of Collateral Trust bonds so that the necessary security could be obtained with greater flexibility. Following this idea, Morgan Stanley examined the impact of varying amounts of serial maturities upon the Burlington's income account over the preceding seven years. It was concluded that a $60,000,000 Serial Collateral Trust Issue resulted in annual maturities which "may be considered high." Depending upon whether 5, ro, or 15 millions of dollars in cash were used in the refunding plan, progressively smaller amounts of Serial Notes were considered, with no recommendation as to the amount preferred. Recognizing, however, that the pledge of $85,000,000 F & R bonds behind the diminishing initial issues of Serial Notes would mean relatively greater security, Morgan Stanley reaffirmed the idea of using 150 per cent F & R bonds to achieve 100 per cent first-lien security. The alternative plan proposed by Morgan Stanley suggested that the $60,000,000 needed for refunding might be obtained through: the use of $5,000,000 to $10,000,000 cash; sale of $15,000,000 one- to fiveyear Serial Notes, with collateral as above; and sale of $35,000,000 to $40,000,000 twenty-five-year sinking-fund bonds, also with col-

FEASIBILITY OF CALLING T H E ILLINOIS BONDS

IO9

lateral similar to above. The advantage of the alternative program lay in the sinking-fund provisions, which, after the fifth year, would prove a much less inflexible annual drain on the Burlington's cash than would serial maturities. With these alternatives — twenty-five-year serial notes or five-year serials plus twenty-five-year sinking-fund bonds — Morgan Stanley probed the possible cost to the Burlington in the light of probable yields obtainable. It will be remembered that the alternative issues were similarly secured: that is, 150 per cent of F & R bonds with their 66.6 per cent security in the form of Generals were to be pledged as collateral. Hence the analysis of the yield at which the new issue might be sold was based upon debt with 100 per cent security in the form of an indirect first lien on the railroad's property. It was concluded that twenty-five-year Serials would bear a coupon of per cent and could be sold publicly at an average price to make the cost to the Burlington 3.67 per cent; on the other hand, the same security sold privately as recommended, would sell at a yield of 3.58 per cent. For the alternative plan, one- to five-year Serials would bear a 2 per cent coupon, and the twenty-five-year Sinking Fund Issue one of 4 per cent; the overall cost of the company if the securities were also sold privately as recommended would be 3.92 per cent. The foregoing analysis of the Burlington's refunding problem prepared by Morgan Stanley was unquestionably more favorable than the memorandum which had been prepared earlier by J . P. Morgan and Company. Whereas the latter company had concluded that it was doubtful if $50,000,000 serial collateral notes could be sold on favorable terms, it was believed that probably half that amount could be marketed if the maturity were no more than ten years and 100 per cent secured by a first lien. Morgan Stanley, in contrast, proposed $50,000,000 to $55,000,000 Serial Bonds, or Serial Notes plus Sinking Fund bonds, which it believed could be disposed of at an interest cost to the Burlington of between 3.58 per cent and 3.92 per cent. Apparently, then, it was decidedly advantageous for the Burlington's officials to invite other financial advice. For had the company been content to act upon the counsel of J . P. Morgan and Company, its prospect would have been no more than to attempt to build up a reserve of cash and Governments . . by 1949 sufficient to cover or almost cover the $57,000,000 [Illinois Division] maturity." 4 2 With receipt of the tentative refunding proposals suggested by Morgan Stanley, the financial policy of the Burlington reached a turning point. At last President Budd was presented with alternative procedures that placed the company in the position of being able to institute immediate refunding plans, provided only that terms could be

110

POLICY FORMATION I N RAILROAD FINANCE

agreed upon. On the face of it, and granting the practicability of the solutions to the company's refunding problems as outlined, there remained three matters to be settled by bargaining. First, and influencing the other two, was the matter of the best yield the Burlington could obtain. Second, there was the problem of the amount of collateral that would be pledged behind the collateral trust bonds — a consideration that would affect the interest rate obtainable. Related to this point, moreover, was the resulting flexibility of the company's capital structure as more or less of the Burlington's available financial instruments were tied up as collateral. Third, there was the problem of deciding between a serial or sinking-fund issue, or a combination of the two. Significantly, however, the Burlington's policy-makers were now able to turn their attention to the practical problems which would arise out of the refunding operation. The decision to refund depended at last upon the development of a refunding medium whose terms would be agreeable to the company and the underwriters. No longer was it necessary to postpone action because of unfavorable opinion on the part of the company's financial advisers.

Chapter Seven

THE CREATION OF FINAL PLAN FOR REFUNDING ILLINOIS DIVISION MATURITIES A.

A

DECISION

IS

R E A C H E D TO

FOLLOW

UP

MORGAN

STANLEY'S

PROPOSALS

The discouraging prospect developed in J. P. Morgan and Company's memorandum of October 8, 1943 — that there was no practicable procedure available to anticipate the 1949 maturity of the Illinois Division bonds — was dispelled as a result of Morgan Stanley's analysis. During early 1944, moreover, the company's financial outlook was even brighter than it had been in the preceding year. Operating revenues were rising steadily, and the market's improved estimation of the company's credit was reflected in the generally higher level of quotations for its securities. Gross Operating Revenues as reported by months to the Interstate Commerce Commission are compared in Table 20 with those of a year earlier. Since the January figures were Table 20. Gross operating income of the C.B.&Q. compared.*

Month October November December January

for selected months,

IQ42-IQ44,

1943-1944 (:millions of dollars)

1942-1943 (millions of dollars)

Ratio of increase 1943-44 over 1942-43 (per cent)

20.5 19.6 19.5 19.5

17.4 16.5 16.3 15.1

18 19 19 29

» Data from Commercial (r Financial Chronicle, vol. 158, p. 2249; and vol. 159, pp. 4, 547, and 932.

112

POLICY FORMATION I N RAILROAD FINANCE

not published until some time in March, the implications of these results were quite impressive in early 1944 as an argument to be used in bargaining for a favorable refunding plan. As attention was later directed to the proportion of gross carried through to net income, however, the foregoing simple comparison lost considerable weight as a convincing argument.1 Meanwhile, prices for the Burlington's securities were continuing the improvement that had carried the Illinois Division bonds above par in the summer of 1943. Illinois Division 3 ^ ' s sold at 10034 on October 1, 1943, and had advanced to 102 by the end of December. The General Mortgage 4's, moreover, had advanced from 97y & to 101 by January 14, 1944. Prices of the First and Refunding Series A and Series B had also shown substantial gains in line with the improved prospects of the C. B. & Q. based in part on the favorable revenue picture.2 President Budd, therefore, had every reason to hope in early 1944 that agreement might be reached with underwriters so that an attractive refunding issue could be immediately developed which would permit redemption of the Illinois Division debt. The particular nature of the Burlington's financial problem had long since been given the epithet "complicated" by the company's officials. The reason President Budd and others looked upon their task as far from simple was due to a certain inflexibility in the terms of the Illinois Division Mortgage Indenture — to which attention has already been directed.3 It provided that when a decision to call the outstanding Illinois Division bonds was reached, it would be necessary to give bondholders six months' notice. The indenture continues: The notice shall be given in the manner following, viz: Appropriate attested resolutions of the Directors fixing the day of redemption shall be delivered to the Trustee; and an appropriate notice, fixing the day of redemption and stating the terms thereof and the place at which bonds will be redeemed, and declaring that from and after said day of redemption the interest on said bonds shall cease, shall be published daily in a newspaper of each of the cities of Boston and New York for four consecutive weeks, the last publication to be at least six months before the day fixed for redemption.4

Including the four-week requirement for published notices of intention, these terms meant that effective refunding plans involving call before maturity would need to be completed some seven months before the date chosen for redemption of the bonds. Since the released lien of the Illinois Division bonds to be called would provide the security for the refunding medium which appeared most attractive, the

THE CREATION OF FINAL REFUNDING PLAN

113

company's officials believed it necessary to obtain purchase commitments of the new issue prior to announcing publicly its intention to redeem the Illinois Division bonds. These factors were construed by the Burlington's officials to argue in favor of private distribution of the new refunding issue rather than a general offer of the new bonds for public subscription. Available evidence discloses that no formal analysis was made of the absolute desirability of public versus private sale of the proposed refunding issue, although the question was discussed. 5 As early as November, 1943, it was determined that refunding the Illinois Division bonds via competitive bidding would be inimical to the Burlington's interests. 6 T h e record suggests that from the point of view of the Burlington's management private placing of the refunding issue through an investment banker was simply a less complicated method to follow, and the natural outgrowth of the relationships the company had fostered with its financial advisers since 1942. The effect of these company-banker relationships through 1943 had been such as to lead the Burlington to adopt a wait-and-see financial policy. For several years President Budd, aided by his company's officials, had struggled to develop adequate plans to meet the Illinois Division maturity, and their efforts recognized that anticipating the 1949 deadline by prior call and redemption would strengthen the company's position to handle economically its 1958 General Mortgage maturity. 7 Y e t for the most part the company's financial advisers had recommended caution, expressing time and again the opinion that the Burlington's credit would not support the immediate adoption of favorable refunding plans. Whether or not a different group of advisers would have made different proposals for the Burlington must remain problematical. A s described below in Chapter I X , other experts did subsequently criticize the method of refinancing ultimately selected by the Burlington, but during the years 1942 and 1943 the company did not formally consult with bankers other than J. P. Morgan and Company and Morgan Stanley and Company to obtain specific recommendations. President Budd was therefore in the position not only of persuading the Burlington's owners of the desirability of taking steps to anticipate the 1949 maturity, but of selling to the company's chosen advisers the desirability of developing a definitive plan which might be put into operation whenever the occasion should arise. Convinced that the preferred refunding plan would necessarily provide for placing the new financial instrument before the Illinois Division bonds were called, the Burlington's financial officers approached their task by canvassing the possibility of developing that refunding

114

POLICY FORMATION I N RAILROAD FINANCE

medium which would meet three standards. The following arrangement is in order of the precedence in which these standards were considered. (a) It must be an obligation whose terms were deemed appropriate by the company's financial advisers, (b) The interest rate and security underlying the new issue must be acceptable to the private investors expected to purchase it. (c) The developed terms approved by the financial advisers and prospective purchasers must be agreeable to the Burlington's owners. The unversed critic might well question the priority accorded the Burlington's financial advisers in this listing of standards to be satisfied. One word is suggested in answer to this arrangement: conservatism. Throughout the Burlington's development of the policy to handle its 1949 maturities, emphasis had been placed upon conservative action. The initial special committee report of June 3, 1941, recommended a standby policy. The next significant summary of plans, June 20, 1942, proposed no more than continued open-market purchases of bonds. On December 22, 1942, further retirement of Illinois Division debt was argued and then reaffirmed on July 1, 1943. Finally, on November 16, Vice President James analyzed with care available refunding alternatives, but with primary consideration for methods that might be followed "without criticism or objection," and recommended a "conservative course," in which President Budd concurred. Therefore, the evidence suggests that the Burlington, in reaching a decision to refund, would follow the conservative pattern to which it had adhered over the preceding several years. Translated into banking relationships, it seems inevitable that the Burlington would confine its efforts to developing a refunding medium satisfactory to those established advisers previously entrusted with rendering financial counsel. A management with a larger group of financial advisers might have invited many appraisals of the company's prospects, but the conservative course was to remain with the professional counselors initially selected. Before dismissing on the ground of "conservatism" the Burlington's decision to restrict the investment banking opinions it would examine to those of Morgan Stanley and Company, a further factor should be considered. The nature of the Burlington's financial problem was complicated in one respect other than the characteristics of the mortgage indenture to be taken care of. The president of the Burlington was not an independent manager of the railroad system he headed. Nor does the record indicate that he had been delegated authority to make binding financial decisions which he alone might consider advantageous for the Burlington. Despite Mr. Budd's intentions to make the most favorable financial arrangements for his road, the ultimate decisions neces-

THE CREATION OF FINAL REFUNDING PLAN

115

sarily had to be made by the Burlington's owners, the Northern lines. It would, therefore, be far simpler to refer to the owners the bargaining stages reached with one banking group than to bargain with several and then submit the final stage achieved with each for approval. A t all events, the call provisions of the Illinois Division mortgage that suggested the necessity of obtaining advance commitments on the refunding plan to be developed (if the bonds were to be redeemed before maturity) plus the prudent conservatism of the Burlington's management in following the recommendations of the company's historic bankers led to continued discussion of the financial problem with Morgan Stanley and Company. Accordingly, President Budd decided in early 1944 to pursue his effort to develop a practicable refunding plan which would be agreeable to his company's owners, to the prospective purchasers of its securities, and to the company's financial advisers. With the development of the financial policy to the stage where the issue of new securities to replace the Illinois Division bonds was being considered, it is logical that Morgan Stanley and Company, as investment bankers, would replace J. P. Morgan and Company as the financial consultant. The tentative program proposed by Morgan Stanley had provided areas of agreement, but, as noted at the close of the preceding chapter, there remained the task of resolving the question of Serial Notes or Bonds, and of deciding upon what security the Burlington would pledge in return for the best interest rate it could obtain. B.

A CONFERENCE IS ARRANGED TO DISCUSS

DEVELOPMENT

OF REFUNDING PLANS

On March 9, 1944, President Budd advised the Burlington's owners that as a result of the stage that the Burlington's financial policy had reached, it was desirable that further conferences be held with the company's bankers. " I t is possible," he wrote, "that a Collateral Note issue could be put out at 3 % or a little more, and if so, it would seem advisable to consider it very carefully." 8 The thought and study that the Burlington's officers had been devoting to anticipating the 1949 Illinois Division maturities had thus reached the level of decision. With President Budd's mention of a possible interest rate of 3 per cent "or a little more," it had apparently been decided that, once the hurdle of a satisfactory interest charge was overcome, a refunding plan should be adopted which would permit the call and redemption of the Illinois Division bonds. President Budd continued in his letter of March 9:

Il6

POLICY FORMATION IN RAILROAD FINANCE

Mr. James and I plan to be in New York the early part of next week [i.e., before Wednesday, March 15] when we hope to discuss the matter with the Morgan and First National people. We hope to advise you on the possibilities when we have our next Board or Executive Meeting, which is now set for March 22. Thus the date was chosen for the Burlington's officers to canvass the best possible refunding plan that its bankers could propose. Morgan Stanley's earlier memorandum had mentioned yield costs varying between 3.58 per cent and 3.92 per cent, but in this projected conference it was President Budd's intention to develop the possibilities of issuing securities at as little as a 3 per cent interest rate. The purpose of this March discussion was therefore to reach a decision as to the appropriate instrument and the amount of collateral required to obtain an interest rate that would warrant the immediate adoption of plans to replace the Illinois Division bonds before their maturity. The conference was held in New York as scheduled and, upon returning to Chicago, Vice President James prepared a memorandum that set forth the conclusions reached in the discussions with the Burlington's bankers. 9 Apparently the idea of issuing one- to twenty-fiveyear serial notes was never seriously entertained, for the memorandum was concerned solely with the alternative method of using collateral trust bonds. There is reason to believe that the Burlington's officers were primarily interested in a single twenty-five-year bond as a refunding medium designed according to the pattern of the L. & N. 1940 refinancing (see above, p. 96). In a subsequent interview, 10 Morgan Stanley's A. N. Jones confirmed that the possibility was under consideration, but that Morgan Stanley had recommended to the company breaking off the early part of the bond issue in the form of serial notes, in order to obtain a better interest rate. Mr. James' analysis of the decisions reached tacitly assumed that the refunding medium would conform to the outline earlier suggested by Morgan Stanley — that is, part in the form of one- to five-year serial notes, and the balance in the form of collateral trust bonds with a sinking fund to start after the retirement of the serial notes. Some consideration was given in the report to the question of submitting the Burlington's refinancing to competitive bidding. I f , however, it were held desirable to refund the Illinois Division debt by January 1 , 1945, the seven-month "notice" period would commence on June 1, 1944, or only two-and-one-half months after the New York conference. With this short period to perfect plans, there appeared no question in the minds of the Burlington's officers but what there was insufficient time to invite other banking groups to study the situation

THE CREATION OF FINAL REFUNDING PLAN

117

and make independent recommendations. Moreover, it was suggested in the N e w York conference that the Burlington's new issue might be sold to several large insurance companies, thus eliminating the necessity of public distribution. Therefore the Burlington began to recognize its problem as being one of using an investment banking firm largely as an intermediary between the company and the prospective insurance company purchasers. ". . . W e believe," Mr. James wrote, "the Commission [i.e., Interstate Commerce Commission] would approve the payment of a fee to some investment banker for setting up the [refunding] program and disposing of the . . . notes to an institutional group." More particularly, however, the memorandum of March 20 outlined the general terms agreed upon for the proposed new refunding issue. Pointing out that the financial experts did not believe that a new instrument could be sold in the amount of $57,000,000 necessary to replace the Illinois Division bonds at an attractive interest rate, Mr. James reported the company's decision to use $17,000,000 of its cash to effect a partial retirement of debt. Tentative plans of the bankers for refunding the remaining $40,000,000 contemplated the creation of two media. Part of this amount, $10,000,000, would be issued as oneto five-year serial notes with a 2 per cent interest rate, to be sold to banks as short-term paper. The balance of $30,000,000 would take the form of Collateral Trust bonds. N o particular attention was paid in the March memorandum to the amount of security to be used as collateral behind the new issues, although this matter had been previously examined by Morgan Stanley. If, however, the Collateral Trust bond required sinking-fund payments of $1,000,000 annually after the fifth year, and if it were properly collateralized, Morgan Stanley and Company suggested that it might be sold to the institutional investors at a rate of per cent. The question left unsettled in the conference on March 14, however, was what precisely was meant by "properly collateralized." Presumably summarizing the direction of the discussion held in New Y o r k on this point, M r . James' memorandum considered the effect of obtaining $85,000,000 First and Refunding bonds by the "orthodox method" and using it as collateral behind $40,000,000 of the new issues. His analysis examined the proportion of first lien which, via the Generals, would thereby be pledged as security, and found it would be 32 per cent if this plan were followed. T h e earlier memorandum prepared by Morgan Stanley expressed this security differently. Since the F & R bonds would be 66.6 per cent secured by Generals, the $85,000,000 F & R bonds pledged would represent an indirect first lien of $56,600,000, or 142 per cent of the $40,000,000 refunding issues.

Il8

POLICY FORMATION IN RAILROAD FINANCE

I n d i r e c t first-mortgage s e c u r i t y of 142 per cent w a s r e c o g n i z e d as p e r h a p s b e i n g too m u c h for a 324 per cent interest risk on the B u r l i n g ton's credit. B e a r i n g u p o n this p o i n t , M r . J a m e s s t a t e d : In fact, there was some thought that the $85,000,000 First and Refunding bonds might over-collateralize the $40,000,000 note issue, if the notes were to be sold to the public [my italics]. However, the intention is to sell the long-term notes to a group of insurance companies, and they would be influenced to accept a lower rate of interest if well satisfied with the collateral. This feature of course would have to be worked out later. A s a result of the N e w Y o r k c o n f e r e n c e , the required collateral needed to o b t a i n the m o s t f a v o r a b l e interest rate w a s l e f t to b a r g a i n i n g . T h e emphasis u p o n the o v e r c o l l a t e r a l i z i n g effect in the case of p u b l i c distribution raises the question of w h a t w o u l d b e considered too m u c h collateral in p r i v a t e distribution — a question the m e m o r a n d u m did not b r i n g up. H o w e v e r , t h e decision u l t i m a t e l y r e a c h e d on this p r o b l e m w a s later s u b j e c t e d t o o u t s p o k e n criticism. ( S e e b e l o w , C h a p t e r I X . ) M r . J a m e s c o n c l u d e d his m e m o r a n d u m b y r e s t a t i n g the reasons w h y it w a s b e l i e v e d the B u r l i n g t o n should c o m m i t itself t o the d e v e l o p m e n t of a r e f u n d i n g p l a n t h a t c o u l d be i m m e d i a t e l y a d o p t e d : T h e principal advantage to the Company in proceeding at this time would be the meeting of the maturity of the Illinois Division Bonds during the present period when railroad securities have a favorable market and interest rates relatively low, rather than risk having to meet the maturity at an unfavorable time, which might be the case in 1949. An important advantage of the method proposed would be that the General Mortgage would become a first lien on practically the entire railroad and the maturity of the Generals in 1958 ought not to present a very serious problem. B y proceeding now the call premium would be practically absorbed in tax deduction, there would be some interest saving from now until 1949, and the security behind the First and Refunding Mortgage, which is the only open mortgage for future financing, would be greatly improved. In the matter of taxes, any interest reduction, of course, increases taxable income, and retirement of debt reduces invested capital base for excess profits tax. However, reduction of debt and reduction of fixed charges are important, not only to meet the possibility of reduced earnings in the post-war period, but also to meet competition of the western roads which are coming out of reorganization with very low fixed charges. 11 F r o m these c o n c l u d i n g r e m a r k s , it is e v i d e n t t h a t the B u r l i n g t o n w a s e x t r e m e l y anxious t o g e t its r e f u n d i n g p l a n s u n d e r w a y . T h e N e w Y o r k c o n f e r e n c e w i t h the " M o r g a n a n d F i r s t N a t i o n a l p e o p l e " (in

THE

CREATION OF FINAL REFUNDING P L A N

119

Mr. Budd's words) 12 reiterated the feasibility of handling the Illinois Division maturity at that time. Preliminary examination of the means available demonstrated the practicability of issuing collaterally secured short- and long-term notes. No decision was reached as to the amount of collateral required for the refunding issues, but the bankers were agreed that an interest rate of P e r cent should be obtainable. This figure was considerably above the 3 per cent rate President Budd hoped for when the conference was arranged; but was still an improvement over the 3.92 per cent interest cost suggested in Morgan Stanley's earlier analysis. On the day that Mr. James' report on the New York conference was completed, President Budd submitted the memorandum to the presidents of the Northern lines. The 3 % per cent proposed interest rate was disappointing, but President Budd mentioned this alternative anyway, even though the rate was "about the same as the present Illinois Division bonds are costing us." 13 In addition to recommending that the parent companies consider the feasibility of the plan discussed in Mr. James' memorandum, President Budd suggested two other alternatives: (2) Buy up to 17 million Illinois Division bonds at not to exceed 105, and set aside substantial amounts each year for a similar purpose or for use at maturity, 1949, [or, finally] (3) Wait six months in the hope that our credit will continue to improve, and in the meantime consider taking action under (2) above. The third alternative may be best . . . [but] there is of course the risk that conditions may not be as favorable then [i.e., in six months] as they are now, and it would be worth a great deal to have that maturity definitely disposed of. 14 C . MORGAN STANLEY SUBMITS ALTERNATIVE REFUNDING PLANS

Although the decision to go ahead with the refunding plans was not reached in the conference in New York on March 14, those associated with the plan at Morgan Stanley and Company sensed that President Budd would urge immediate adoption of a proposal if suitable refunding media and a satisfactory interest rate could be agreed upon. This attitude on the part of Mr. Budd was also implied in his letter of March 20 to the presidents of the Northern lines. However, the Burlington's executive, who originally hoped for an interest cost as low as 3 per cent, had left the New York discussions with the apparent impression that the credit of his company was considered too poor to enable him to better a 3 % per cent rate. In view of the fact that this cost was about the same as that being incurred on the outstanding

120

POLICY FORMATION I N RAILROAD FINANCE

bonds, President Budd concluded that the best policy to adopt under the circumstances was to wait until improvement in the company's credit would warrant a more advantageous refinancing rate. Meanwhile, Morgan Stanley and Company continued their efforts to perfect a refinancing proposal which would prove acceptable to Mr. Budd. Following the March 14 conference, Mr. A. N. Jones of the investment banking firm worked up a formal plan "to give the best possible collateral for a new issue of collateral trust bonds." 15 This plan, which Mr. Jones labeled "Plan I," was designed "so that collateral bonds could be sold on at least a basis." 16 The inclusion of the phrase "at least" in this context suggests that the investment bankers believed that the Burlington should be encouraged to hope for a better rate in order to avoid the possibility of the company's terminating negotiations on the grounds of the unfavorable, albeit hypothetical, figure of per cent. Subsequently Morgan Stanley's Jones admitted that the 3 % per cent rate was used because of the policy the firm followed of making all their initial analyses of financial problems "conservative." That is, Morgan Stanley made a practice of giving to railroads estimates that were on the high side. "Then if we get a better price, [we] pass it on to railroads . . . Other firms may give [a] lower estimate and hedge it about with conditions." 17 Nevertheless, Plan I suggested that bonds with a coupon rate of 3^2 per cent might "be sold privately . . . at a price somewhere between gyy 2 and 100 to yield between 3.65% and 3.50%." 18 Plan I was prepared on March 16, 1944. Because of certain features of the plan which, it was felt, might make the proposals undesirable, five additional plans were developed which in varying degree provided greater financial flexibility. These proposals, identified as Plans II, III, IV, V, and VI, were airmailed with plan I to the Burlington from New York on March 20, 1944 — the same day on which President Budd had forwarded Mr. James' memorandum to the Northern lines. In the covering letter accompanying Morgan Stanley's March 20 recommendations, Mr. Jones wrote Mr. Budd: If . . . you contact two or bonds] to get drafting some

decide to go ahead on a refunding plan, would be glad to three of the large institutional holders [of the Illinois Division their views and then sit down with Mr. James to assist in of the necessary documents.

While it is again apparent that no decision had been reached by March 20, the receipt of Morgan Stanley's proposals prior to the executive committee meeting on March 22 gave President Budd a considerable number of refunding possibilities to present for the con-

THE CREATION OF FINAL REFUNDING PLAN

121

sideration of the Burlington's owners. Vice President James' memorandum on the subject discussed the necessary collateral in only the most general terms, but the six alternative proposals of Morgan Stanley gave in precise detail how various financial plans might be established. Table 21 compares the essential characteristics of Plans I, II, III, IV, V , and V I , which were referred to President Budd so that the Burlington could make its decision to refund on the basis of financial proposals deemed practicable by the experts consulted. All the plans contemplated the use of the company's cash to retire part of the outstanding Illinois Division bonds, so that only $40,000,000 would need to be refunded. T h e table has been arranged to focus attention upon the varying combinations of collateral, and it can be seen that Plan I, providing for bonds secured by an effective first lien of 135 per cent, was the strongest, while Plan V, with 100 per cent security for the bonds, was the weakest collateral position suggested. Plans IV and V I made allowance for securing the one- to five-year Serial Notes, provisions omitted from the preferred Plan I because Mr. Jones was . . against collateral for bank loans. T h e bank loan rate is not much affected by collateral. On the other hand collateral is all important on bonds, so all collateral should go there." 19 Comparison of the plans formalized by Morgan Stanley's analysis of March 20 with the tentative outline Vice President James prepared on the same date highlights the restrictions placed upon subsequent issuance of First and Refunding bonds, as well as the collateral deemed necessary to warrant a per cent interest cost. Apparently Mr. James' conversations in New Y o r k had left with him the impression that 142 per cent equivalent first-lien collateral coverage would assure no less than a per cent interest rate. But when Morgan Stanley's Jones set down on paper the precise terms and restrictions visualized for various refunding plans, the 142 per cent security was reduced to 135 per cent, and with it the probable interest cost was lowered to 3^2 per cent. D.

SELECTION OF AN APPROPRIATE REFUNDING

PLAN

When the executive committee meeting convened on March 22, 1944, President Budd was well informed about the various alternatives that the company might adopt. Plan I suggested by Morgan Stanley offered assurance that the Burlington could, if it were so decided, proceed at once with the mechanics of a scheme which, at favorable interest rates, would provide for the immediate call and redemption of the Illinois Division bonds. When President Budd had advised the presidents of the Northern lines only two days previously about the refunding prospects of the Burlington, the outlook had not been nearly

5 o* o M "o è S

•21 « e 5 O **

«

•a S

fi »,

fa o «s ^ a jj

tei

i ls rj •Su ga a'" «M Ü »

o

-I s a fe

«OT •S «j I « I -o «J d § e.

1

D « ^ §Ä.S z

rs

O O cd m f^ o S •S S "S M M « tïO-C -O a-ö « ^ E 3 S

o « X) d

h-) "O fe ì£ c Co 8 * C V 2 SS ? c« rt«i 'S .$- 0°' * > g

4, XI S

'

g

q-3

°

g

3 g

I pí u

£•3 s •citt fl ïï« ü S N -s á ï W j

H j J2 Ä

« ^ S s «> a o V > y J) O S u m . u U "H 4> V S b S

¡¡•o N e. s »

C

s 3,,-g u En rt .22 ^ ui te o -o ^ M a o£5

C 3 „ £ 4's of 1969 and the First and Refunding Series of 1974 3^4's had been drawn up with provisions which permitted call on any interest date upon sixty days' notice. The former bonds were callable at 105, and the latter at 1 0 3 ^ if the company should elect to redeem them in 1945. For the Collateral Trust issue, these terms would mean a yield at call of 3.20 per cent, and for the F & R's of 1974, of 3.55 per cent. Subsequent to the sale of the F & R 3^4's the Burlington's credit had continued its upward climb; and so the company's financial managers resolved to replace both the Series of 1974 3 % ' s and the initially issued Collateral Trust 3^2's with a new, lower coupon-rate series of First and Refunding bonds.

L80

POLICY FORMATION IN RAILROAD FINANCE

Accordingly, Step III of the refunding operations growing out of the Burlington's perfected financial policy was undertaken. In contrast to Step II, the new move was intended as further partial reduction of debt, and to that end the company decided to devote approximately $5,000,000 of its own cash toward the retirement of securities. Thus, $65,000,000 of a new First and Refunding Series of 1985 was offered for competitive bidding. For the third time Morgan Stanley and Company was awarded disposition of the issue, the firm upon this occasion heading a syndicate which tendered a bid of 100.039911 for a coupon rate of per cent. B y this operation the $30,000,000 Collateral Trust 3^2 per cent Bonds and $40,000,000 First and Refunding 324's, Series of 1974, were eliminated from the Burlington's capital structure. Interest savings as a result of this refinancing would amount to over $500,000 annually, but there would again be obtained a tax reduction as a result of the nearly 3.0 millions of dollars in call premiums paid for redemption. Award of the F & R 3 ^ ' s of 1985 was made to Morgan Stanley on October 26, 1945. But the completion of Step I I I in the refunding operations was the signal for yet further application of the company's financial policy. The two remaining issues of the 1940 funded debt structure bore interest rates of 4 and 4 ^ per cent respectively. Neither security contained sinking-fund provisions, and the noncallable 4 per cent General Mortgage bonds, publicly outstanding in the amount of $65,247,000, would mature in fourteen years. Maturity of the First and Refunding 4y 2 per cent Series B was thirty-two years in the future, but its coupon rate was far out of line with the interest cost the Burlington's credit had demonstrated could be obtained. Earliest call date of the latter issue, moreover, was seven years away. Reconsidering the condition of the bond market and "because of the want of desirable provisions in these bonds, and in order to have its bonded debt in more manageable form," 12 the Burlington's managers decided once again to undertake refinancing of its outstanding securities. Step IV was therefore instituted, asking holders of General Mortgage 4's to submit their bonds on tender of a price of 120, and holders of the F & R 4^2's to submit at 123. Generals in a principal amount of $32,568,000 were so purchased and $17,339,900 F & R 4>4'S.13 TO refund $49,765,000 of this amount, the Burlington invited bids from "approximately 450 persons, firms, and corporations." 14 The highest bid received was 100.13999 f ° r a Series of 1970 First and Refunding Mortgage bond bearing a coupon rate of 2 % per cent. The interest cost to the Burlington for this (final) operation was 2.87 per cent. It is significant to note, as revealed in Table 25, that Halsey

[i8i]

182

POLICY

FORMATION

IN

RAILROAD

FINANCE

Stuart and Company headed the group that submitted the successful bid in this last refinancing step. The yield cost or effective interest saving based upon the prices paid for the Generals and F & R's purchased was approximately 2.74 per cent. Since this "saving" is less than the 2.87 per cent interest cost of the bonds sold in Step IV to provide the funds for the refinancing, it may at first appear that Step IV was an uneconomical refunding operation. However, over 10 millions of dollars in call premiums was paid, which, as in the previous instances, was partially offset by diminished excess-profits taxes. More important was the fact that the 1958 maturity of the General Mortgage bonds was approximately 50 per cent anticipated, and by means of sinking-fund securities which had the flexible feature of being callable in whole or part. And also, the refunding operation did result in a considerable gross reduction in annual interest charges. Table 25 summarizes the successive steps in the Burlington's 194445 refinancing operations. As stated earlier, the purpose of this book has been to trace the development of the financial policy that made possible these remarkable refinancing operations. Success of the policy can be judged on balance, as it was above, by comparing the magnitude of the finally evolved funded-debt structure with that for 1940, and by measuring the reduction in interest charges that were made possible by this consistent and conscientious application of a brilliantly created financial policy. D.

REDUCTION IN FUNDED DEBT AND INTEREST 1945

COMPARED WITH

CHARGES,

194O

The financial policy painstakingly developed by President Budd between 1940 and 1944 was carefully applied during 1944 and 1945 in the four refunding operations illustrated in Table 25. The effect of these changes as compared with 1940 are summarized in Table 26. Total long-term debt was reduced $45,620,000 by the end of 1945, or 19.4 per cent, while the interest burden on this debt declined $3,550,000, or an astonishing 37.6 per cent. The total of all fixed charges, as shown in Table 26, declined from 9.66 to 6.11 millions of dollars, or nearly 37 per cent, in the same period. The outstanding funded debt of 1945 was actually smaller than at any time since 1922, when the first $30,000,000 issue of First and Refunding bonds had boosted long-term obligations to $203,200,000.15 Fixed charges were at a smaller annual rate than at any time since the Illinois Division bonds were originally sold in 1899.16 Further evidence upon the success of the Burlington's 1944-45 refinancing may be introduced from two sides. In the first place, it will

SUBSEQUENT REFUNDING OPERATIONS

183

be recalled that one of the primary motives that led President Budd to undertake the development of a decisive financial policy was his wish to place the Burlington's debt structure in as strong a position as that of the four Midwestern railroads considered the Burlington's most important competitors. Two of these railroads, by the end of 1945, had had their reorganizations consummated (the Milwaukee and the North Table 26. Chicago, Burlington & Quincy Railroad Company, long-term, debt and fixed charges, IQ40 compared with IQ45 (millions of dollars). Long-term debt Charge Funded debt Illinois Division 3^2's and 4's. . . . General Mortgage 4's First and Refunding bonds S ' s of 1971 4 ^ ' s of 1977 3 ^ ' s of 1985 2 ^ 6 ' s of 1970 Collateral Trust Notes and Bonds 2 j i ' s of 1946

i > i ' s of 1949 Equipment obligations Total long-term obligations . . 'ther fixed charges Other interest Leased line rentals Amortization of discount Total fixed charges

1940"

84.42 65-25

40.00 29.80 —

i945 b

—

32.68 —

12.46 65.00

Fixed charges 1940"

i945 b

3.12 2.61

I-3I

2.00 1-34 —

—

—

0.56 2.03

—

49-77

4.20

O.II

11.16

0.70 8.00 20.60

0.23

o-39

234-83

189.21

9.41

5-86

0.02 0.08

0.02

0.15

0.12

9.66

6.11

—

—

—

1-43 0.02 0.12

O.II

» C B Q Annual Report, 1940, pp. 18, 28. b Based on C B Q Annual Report, 1945. Fixed charges computed from funded debt as shown on p. 26. Other fixed charges as reported on p. 32 except that ''other interest" has been adjusted to eliminate non-recurring charges connected with 1945 refinancing operations.

Western), while a third, the Rock Island, had its reorganized structure approved, though not adopted. Table 13 directed attention to the goal, unknown in 1940, that President Budd's policy committed his railroad company. Meanwhile, the Illinois Central had attacked its own outstanding debt and, like the Burlington, had done so without the aid of bankruptcy proceedings. Table 27 compares the accomplishment of the Burlington with that of its competitors and supplies the answers to the question mark posed in Table 13.

184

POLICY FORMATION I N RAILROAD F I N A N C E

While the absolute record of the Burlington's improved position reveals a remarkable interchange of low interest obligations for high coupon issues, the comparison of Table 27 presents an equivocal answer to the success of the Burlington's refinancing operations. The 19.4 per cent reduction in the Burlington's debt was less than for any of its competitive roads. However, the record shows that the Burlington's fixed charges declined considerably more percentagewise than for its only competitor, which remained free of Section 77 reorganization. Comparison of the extent of debt or fixed-charge reduction is, howTable 27. Reduction of long-term debt, the C.B.&Q. compared with its competitors in 1940 and 1945. Funded debt and fixed charges (millions of dollars)." C.B.&Q. Funded debtb 1940 1945 Per cent reduction Fixed charges 1940 1945 Per cent reduction Fixed charges as percentage of I93t-1Q40 revenue Excluding contingent interest 1940 1945 Including contingent interest 1945

234.83 189.21

C.R.I.&P.

330.36 116.29° 19.4

9.66 6.11

C.M.&St.P.

475-^3 191.26 64.8°

14.02 3.46°

C.&N.W.

362.69

365-08 256.82

173-54

59.8 14.55 4.03

I.C.

52.2 16.45 2.79

29.6 16.40 13.44

36.8

75-4°

72.3

83.0

17.1

10.5 6.7

18.3 4.5°

14.6 4.0

19.5 3-3

15-7 12.9

6.7

9.1«

9.9

8.2

12.9

"Sources: Funded debt d a t a — B u r l i n g t o n , Table 26; Rock Island, 1940, Moody's Steam Railroads, p. 386; 1*945, Standard Corporation Descriptions, vol. 7, no. 35, sect. 1, p. 2817, August 20, 1946; Milwaukee, Moody's S earn Railroads, p. 583; North Western, Hid., p. 1059. Fixed charge d a t a : Rock Island, Milwaukee, North Western, from Table 12; Illinois Central, from Moody's Steam Railroads, p. 793; Burlington from Table 26. Fixed charges as per cent of 1931-1940 revenues: revenue data from T a b l e 12; contingent interest from Table 13 b Includes equipment obligations. See Chap. II, n. 5. 0 Reorganized basis.

ever, significant only in the light of the ability of the railroad to meet the diminished fixed burden. Expressing fixed charges as a per cent of average revenues yields a rough index of this ability. Table 2 7 again presents an equivocal answer to the question of how successful was the Burlington's 1944-45 refinancing. If it were the purpose of the management to reduce fixed charges to a level comparable with that of the reorganized rival railroads' fixed-interest requirements, the policy of debt-reduction had not been carried far enough by the end of 1945The Burlington's charges were a sensibly smaller proportion of its 1931-1940 revenues than for the Illinois Central, however, and on this basis, again, President Budd's policy may be labeled successful. From another point of view, however, the Burlington's refinancing

SUBSEQUENT

REFUNDING

OPERATIONS

185

was an outstanding success. If contingent interest charges on the reorganized railroads' funded debt be considered as an economic expense — for unless it were covered, there would be no incentive for stockholders ever to contribute funds; nor would the railroad find it possible to avoid further reorganization upon maturity of these contingent interest debts — then the Burlington's financial policy must be granted accolades of praise. Table 27 reveals that, including contingent interest, the Burlington's debt burden, even after reorganization of three of its competitors, remained at the end of 1945 the lowest in relation to average revenues. This had been the case during the entire period that President Budd had held his office with the railroad company (see above, Tables 12 and 27). A final comparison based upon the Burlington's 1944-45 refinancing may be made to present further evidence upon the success of the policy evolved by President Budd. Between 1940 and 1945 other railroads were using war-accumulated earnings to reduce their outstanding debt. What was their experience in the aggregate? Table 28 reveals that, although the relative debt reduction of the Burlington fell short of that of railroads in the Western District between 1940 and 1945, the achievement was greater than that for all Class I line-haul railways in the United States. More to the point, however, is the fact that President Budd's policy resulted in a greater relative reduction in fixed charges than experienced by the aggregate for both railroads in the Western District and for the country as a whole. Surely this is a significant accomplishment — and eloquent testimony to the successful application of the policy developed by the Burlington in the years following 1940. Table 28. Long-term debt and fixed charges 1940 and 1945, C.B.&Q. compared with Class I line-haul railways and for the Western District (millions of dollars). All districts

Western district

C.B.&Q.

Long-term debt 1940"

11,290

S,3io

94Sb

9,290

4,090

I

Per cent of r e d u c t i o n . . . . Fixed charges

17.7

608.6

251-4

945b

S22.9

199-3

Per cent of reduction.. . .

14.1

189 23.0

1940 " 1

235 19.4

9-7 6.1 20.8

36.8

a Burlington data from Table 27, above. Other data from Interstate Commerce Commission, Annual Statistics of Railways (Washington, 1940), Table 158, p. 164, entitled "Abstract of Statistics by Districts and Regions, December 31, 1940." b Burlington data from Table 27; other data from Interstate Commerce Commission, Preliminary Abstract of Railway Statistics (Washington, 1945), Summary no. 1, pp. 5, 6; entitled "Recapitulation of Selected Items of Class I Line Haul Steam Railways."

i86 E.

POLICY FORMATION IN RAILROAD F I N A N C E

CONCLUSION

It has been the purpose of this study to trace the development of financial policy in the light of the day-to-day decisions made to provide a solution to a particularly complicated and troublesome financial problem. Two factors unfolded to provide the primary motives for the adoption of a decisive policy. On the one hand was the inescapable fact that the Burlington was faced with the necessity of providing for the refinancing of an $85,000,000 bond issue — the Illinois Division Mortgage bonds — whose 1949 maturity was inexorably approaching. Associated with this problem on the other hand was the question of competitive relationships with rival railroads, several of which were undergoing drastic capital-structure reorganizations. The Burlington's managers were unwilling to ignore the possible threat of these reorganizations, as competitive roads might emerge from bankruptcy proceedings with a small burden of fixed charges which would make the Burlington vulnerable to subsequent potential rate reductions. Although the possibility of refinancing was first considered in 1936, it was dropped because it was concluded that the terms of the company's various mortgages did not at that time warrant refunding operations. In 1940 the problem was reopened, and a special study of the ways and means for refinancing was authorized. This study was completed in 1941, but as it was largely negative in tone, and suggested a watch-and-wait policy, no decisive action was taken. The year 1942, however, marked the beginning of a positive attack upon the company's financial problem. In that year, and despite some opposition from the Burlington's owners, President Budd instituted a program of debt reduction through the open-market purchase of Illinois Division bonds. Concomitant with the application of this policy was the improved financial condition of the railroad company as its revenues and earnings were swelled by wartime traffic. There was, therefore, a coincidental improvement in the market prices of all the Burlington's funded obligations, and it appeared, during the summer of 1943, that there was a growing feasibility for taking immediate steps to develop a suitable refunding plan. Cautious and well-considered groundwork was laid during the fall of 1943 for the creation of the final phase of policy which would permit the refunding of the Illinois Division debt. These steps culminated in the development of alternative financial plans to be used in the call and refinancing of those bonds whose maturity had been responsible for efforts to create a workable financial policy. The considerations involved in the selection of the plan deemed appropriate illustrated the care and well-informed analysis characteristic of the company's entire

SUBSEQUENT REFUNDING

OPERATIONS

187

efforts to reduce its burden of fixed charges and also its funded debt. Application of the ultimately developed financial policy resulted in elimination of the Illinois Division bonds, and provided the basis for subsequent refinancing operations. T h e final steps ended in a reduction of debt of nearly 20 per cent and a 37 per cent reduction in fixed charges. Thus, the financial plan evolved met thoroughly the original motives which had led to its creation. Furthermore, the new capital structure was created with flexible call provisions which would permit the company to apply its financial policy at any subsequent time it wished.

APPENDIX I Memorandum Submitted by Vice President James to President Budd of the Burlington, November 16, 1943.

MATURITY

OF ILLINOIS DIVISION

MORTGAGE

BONDS IN 1949 I. Can the Company rely upon extension of Illinois Division Mortgage Bonds to meet the 1Q4Q maturity? My present thought is that while we have a technical legal right to extend the Illinois Bonds, it would not be good business judgment to rely upon it unless we could have it vindicated by a Declaratory Judgment well in advance of the maturity. It is a general rule of law that if a junior mortgage contains no covenant against the extension of senior bonds, the mortgagor, by agreement with the senior bondholders, can extend the time of payment as against the junior bondholders, providing there is no increase in the amount of debt or the rate of interest. The General Mortgage permits, but does not require, refunding the Illinois Division Bonds through the General Mortgage. Also, there is no covenant in the General Mortgage to pay prior bonds when they come due, and no express provision against the extension of prior bonds. In the First and Refunding Mortgage, the Company reserves the right, at its option, to extend the time of payment of any or all prior debt bonds. Accordingly, from a technical legal standpoint, the Illinois Division Bonds could be extended with the consent of the holders, and without consent of holders of the General Mortgage Bonds or First and Refunding Bonds. However, an examination of the old files and other historical material shows that the Company officers who took part in making some of the mortgages intended or expected that the Illinois Division Bonds would be paid at maturity or refunded through the General Mortgage. A letter dated August 24, 1909, to the Trustees of the General Mortgage, signed by Mr. T. S. Howland, then Secretary, and approved by Mr. George B. Harris, President, "proceeded on the assumption or expressed the purpose of refunding all existing bonds under the General Mortgage, and upon their maturity, of cancelling these bonds and discharging the mortgages." In a letter of August 15, 1922, to Mr. Holden, from which the foregoing passage is quoted, Mr. Shelton said that since there was no covenant in the mortgage to do this, and since there was a legal right to extend the existing

190

POLICY FORMATION IN RAILROAD FINANCE

bonds beyond maturity in the absence of a contract in the mortgage, he did not believe it was fair to infer that Mr. Howland intended to bind the Company about this matter, that it was something not within the purpose of his letter, and should not stand in the way of extending existing bonds. M r . E. T . Nichols, then Fiscal Agent in New Y o r k and a Director of the Company, took the opposite view and there was considerable correspondence in 1922 in which Mr. Nichols vigorously contended that the General Mortgage was intended to be the successor lien on the Illinois Division property and on the Nebraska Extension property; that when these underlying bonds matured and were paid off, either with treasury funds or with the proceeds of bonds issued under the First and Refunding Mortgage for that purpose, the mortgages securing the underlying bonds should be satisfied and their liens extinguished so that the contemplated succession in lien of the General Mortgage might become effective. He said that the General Mortgage was loosely drawn and that the absence of a specific covenant in it that the Company would not extend prior mortgages should be considered in the light of the fact that practically all it covenants is that the Company will pay the General Mortgage Bonds as they mature; that the absence of specific provisions indicated clearly to him that the Company intended that the General Mortgage should succeed in lien as the prior debt bonds matured and were paid. M r . Nichols also relied on M r . Howland's letter and stated that keeping prior debt bonds alive would appear contrary to the understanding with the General Mortgage Trustee. In subsequent correspondence, M r . Shelton insisted on the legal right to extend prior debt bonds. In an early letter M r . Holden expressed the opinion that General Mortgage bondholders would not be hurt by keeping prior liens alive, until there was a default under the prior liens, and that then the General Mortgage Trustee could protect the lien of that mortgage by redeeming from the prior lien debt. Apparently Mr. Holden was considering a situation where prior lien bonds had been paid or purchased with funds derived from the sale of First and Refunding Bonds, so that the Trustee of that mortgage was subrogated to the lien of the prior bonds. It is not clear how redemption by the General Mortgage Trustee would operate if the prior lien bonds had been paid or purchased with treasury cash. B u t the right of redemption of prior liens, in the General Mortgage Trustee, seems to have given some concern. T h e question of the right to extend prior debt bonds arose when the Nebraska Extension Bonds matured in 1927. Those bonds were retired by issue of General Mortgage Bonds which were deposited under the First and Refunding Mortgage and in turn First and Refunding Bonds issued and sold to provide funds for the retirement of the Nebraska Bonds. In a letter dated January 20, 1927, from Mr. C . I. Sturgis to Mr. G. R . Martin, advising about this program, is the statement "perhaps it was not so much M r . Nichols' 'equity' plea which decided us, as it was a desire to get the Nebraska Extension and its underlying mortgages satisfied and liens released." The L a w Department files in the Chicago office up to 1922 were destroyed in the fire at that time. Efforts to locate material in the old files from the Boston office, thus far have not been successful, but there may be corre-

APPENDIX

I

191

spondence in the 69 boxes of material still in storage in the Chicago freight house. No doubt the Central Hanover Bank and Trust Company, Trustee under the General Mortgage, has a large file and The First National Bank of New York, under the First and Refunding Mortgage, may have considerable material relating to the drafting of that mortgage and to the maturity of the Nebraska Extension Bonds in 1927. Mr. Nichols was Fiscal Agent of the Company in 1908 when the General Mortgage was made and continuously thereafter until the time of his death. During the same period he was Fiscal Agent of the Great Northern. From his long experience in railroad financial affairs in New York, his opinion against extension of the Illinois Division Bonds was from the viewpoint of the banker and investor. There is nothing in his letters to indicate that he had discussed the matter with the Trustee of the General Mortgage but on account of the Howland letter to the Trustee, and possibly other material such as bond circulars, which are not available to us, it would not be surprising if the Trustee had the same feeling. If the Company intends to extend the Illinois Division Bonds, the question should be taken up promptly with the Trustees under both junior mortgages. Declaratory Judgment procedure in the Courts would permit an advance adjudication of the right to extend the bonds, if we could make it out, and might be resorted to if necessary to satisfy the Trustees as well as the underwriters handling the extended bonds. There has been so much disaster in railroad bankruptcy reorganizations that the Courts would be inclined to approve methods of refinancing which were not inimical to the interests of junior bondholders, particularly if the refinancing offered favorable interest rates, sinking fund, and other provisions, making the refinancing sound and for the general benefit of the Company and all its security holders. Such Declaratory procedure has been resorted to by other companies in cases where there was doubt as to the right to extend prior debt. I - A . Ij the Illinois Division Bonds could be extended, could Illinois Division 33/2 be extended as 4s, thereby increasing the total claim under the mortgage? The general rule that extension of the time payment of a mortgage debt does not impair its priority or standing as a lien, as against junior encumbrances, is subject to the limitation that there can be no increase in the amount of the senior debt or the rate of interest. Several expedients have been used to circumvent this limitation. One is an agreement by the mortgagor to pay some additional interest, which is valid between the parties and effective until default, although not secured by the mortgage as against junior bondholders. Security for the additional interest has been provided by acquiring a portion of the bonds and pledging them for that purpose. Another method has been to retire such an amount of the outstanding bonds that the total aggregate interest on the extended bonds, at the increased rate, was no greater than the total aggregate interest on all the bonds secured by the mortgage prior to the extension. While these expedients may be within technical legal limits, they might be criticized as a scheme to get around the limitation.

192

POLICY FORMATION IN RAILROAD FINANCE

I - B . If the Illinois Division Bonds could be extended, could the bonds be called for redemption prior to maturity, and extended? N o Court decision has been found which answers this question satisfactorily. T h e difficulty about redeeming bonds and then extending them stems from the old doctrine of the common law that payment of a loan secured by a mortgage, extinguished the debt and effected a merger of the mortgage lien with the fee. This was the state of the law at the time the Illinois Division Mortgage was made. Article I X of the mortgage provides that if the Company shall fully redeem or pay all the bonds and pay all proper expenses and charges of the trust, "then the estate, right, title, and interest of the Trustee shall cease and determine, and all the railroads and other property, and all estate, right, title, or interest therein conveyed by this Indenture, shall revert to and revest in the Company; yet it shall be the duty of the Trustee to discharge and satisfy the lien of this Indenture, and to make such reasonable deeds of release to the Company as by counsel of the Company may be advised." The Burlington Nebraska Extension Mortgage of M a y 2, 1887, which in some respects was used as a model for the Illinois Division Mortgage, provided in substance that upon payment of the bonds all estate, right, title, and interest of the Trustee should cease and determine, and the right and title to the property should revert to and revest in the railroad company, without any acknowledgment of satisfaction, reconveyance, re-entry, or other act. Obviously these old mortgages were drawn on the theory that extinguishment of the debt merged the mortgage lien with the fee, and that was quite generally the rule followed in the equity courts in that period. Also, the Illinois Division Mortgage treats a redemption before maturity the same as payment at maturity, in the above quoted Article I X . Without exception the American Courts now apply the rule that a corporation may purchase its own bonds and re-issue them, where there is no prejudice to the rights of intervening lienors, and there is a manifest intention to keep the mortgage alive; a distinction being made between purchase and payment. Courts of equity, notably in Illinois have disregarded common law merger and preserved the lien of a mortgage in cases where such action was required by justice and the intention of the parties, as where the mortgagor paid the debt with money furnished by another, the mortgage was not satisfied but kept alive by agreement of the parties and assigned to the person furnishing the money. The principle of subrogation has been applied in many recent cases. Also, in a number of cases the Courts have distinguished between redemption before maturity and payment at maturity where the question was whether a negotiable instrument had been acquired before or after maturity. Although no Court yet has held that bonds redeemed before maturity may be extended and the lien of the mortgage preserved in favor of a third person who furnished the money, such a decision would be the next step in the logical development of the law, particularly where meeting maturity of the sen-

APPENDIX I

193

ior bonds is of vital importance to the junior bondholders to avoid sacrifice of their interests in bankruptcy reorganization and where there is nothing in the minor mortgages restricting the right to extend the senior bonds at maturity. Upon a showing that a plan of sound and economical refinancing could be based upon redemption of the bonds before maturity and their extension preserving the lien of the mortgage, a Declaratory Judgment might be obtained authorizing such procedure. T h e junior bondholders and Trustees of the junior mortgages would be parties to the proceeding and bound by the judgment. While I do not recommend such procedure under present circumstances, and of course pioneering in a matter of this kind is not desirable, the possibilities should not be lost sight of if changed circumstances should necessitate resorting to it. I - C . Could the bonds not accepting extension be called, without calling extended bonds also? The answer is no. The mortgage provides that the Company " m a y redeem all of the bonds secured by this indenture and then outstanding." II. Refunding Illinois Division Bonds through the General Mortgage and the First and Refunding Mortgage. What may be regarded as the "orthodox" method which could be followed without criticism or objection, would be to tender Illinois Division Bonds, cancelled or uncancelled, to the Trustee under the General Mortgage in exchange for an equal principal amount of General Mortgage Bonds (pursuant to Section 3 of Article I ) ; then tender the General Mortgage Bonds to the Trustee under the First and Refunding Mortgage (pursuant to Sections 1 and 4 of Article Three) in exchange for an equal principal amount of First and Refunding Bonds which could be sold or pledged to provide funds for the Illinois Division maturity. This was the method followed in meeting the maturity of the Nebraska Extension Bonds. Authorization by the Interstate Commerce Commission would be necessary. This method would be available whether the Illinois Division Bonds were called for redemption prior to maturity, were purchased prior to maturity, or paid at maturity. It would contemplate release of the Illinois Division Mortgage so that the General Mortgage would become a first lien on practically the entire railroad, and the First and Refunding Mortgage would become a second lien, and would be collaterally secured by $85,000,000 plus $18,294,000 General Mortgage Bonds, total $103,294,000 or approximately 58% of the first lien of the then $178,000,000 General Mortgage Bonds. Of course, the difficulty in refinancing through First and Refunding Bonds is that they are presently selling in the 80s. On the other hand, there are now outstanding $56,818,000 Illinois Division Bonds and with further purchases or accumulation of cash for the purpose, the amount of money necessary to pay the outstanding balance at maturity reasonably might be expected to be down to the point where $85,000,000 First and Refunding Bonds would furnish adequate security for a loan or an issue of Serial Collateral Trust Notes salable to provide funds to pay the balance of the Illinois Division Bonds then outstanding.

194

POLICY FORMATION IN RAILROAD FINANCE

I I I . Refunding Mortgage.

Illinois Division

Bonds through the First and

Refunding

I I I - A . " A t , after, or within twelve months before maturity." The First and Refunding Mortgage purports to provide for going around the General Mortgage and issuing First and Refunding Bonds (third, but unnumbered, paragraph of Section 4, pp. 56 and 57), the new bonds to be delivered to the railroad company in exchange for cash equal to their principal amount, which cash shall be paid to the railroad company or upon its order upon delivery to the Trustee the Illinois Division Bonds cancelled or uncancelled. There is a provision (p. 57) that the Illinois Division Bonds and Mortgage would be kept alive so long as the General Mortgage Bonds were outstanding. These provisions obviously are drawn on the theory of subrogation. M r . Nichols took special objection to keeping the lien of the Illinois Division Mortgage alive until the General Mortgage had been released. H e contended that while the railroad company was free to deal with the Illinois Division Bonds which it acquired before their maturity, by pledging them under the First and Refunding Mortgage, the Company could not by agreement with a subsequent Trustee circumvent the rights, as he called them, of the General Mortgage bondholders to have the Illinois Division Bonds paid at maturity; that the purpose of this section was to secure for the First and Refunding Mortgage, liens upon the property superior to the lien of the prior General Mortgage; that he did not think this could be done and that "even though his law might not be good, his equities were all right." A further provision (p. 58) of the First and Refunding Mortgage is to the effect that "if, at the respective maturities of the Illinois Division Mortgage Bonds and the Nebraska Extension Mortgage Bonds it shall be obligatory upon the railroad company, in observance of its covenants in the premises contained in its aforesaid General Mortgage, to deliver to the Trustee under said mortgage any of such matured prior debt bonds which shall have been acquired and shall be held by the corporate Trustee under the provisions of this indenture, then upon the written order of the railroad company the corporate Trustee shall deliver all of such matured prior debt bonds then held by it to the Trustee under said General Mortgage; provided, however, that in exchange therefor, the corporate Trustee shall receive, to be held by it under this indenture as part of the trust estate, General Mortgage Bonds for a principal amount equal to the principal amount of the prior debt bonds delivered to the said General Mortgage Trustee. In case the railroad company should determine so to proceed, it may cause such General Mortgage Bonds to be issued in the first instance to refund maturing prior debt bonds of any of the two issues above specified, provided, that such General Mortgage Bonds so issued forthwith shall be pledged under this indenture; and in any such case, upon such pledge of such General Mortgage Bonds, the corporate Trustee under this indenture shall au-

APPENDIX I

195

thenticate and deliver to the railroad company bonds reserved under this Article Three for a principal amount not exceeding either the principal amount of such General Mortgage Bonds so pledged under this indenture or the principal amount of prior debt bonds refunded thereby." The above quoted provisions obviously indicate doubt, at the time the First and Refunding Mortgage was made, whether or not it was obligatory on the railroad company to deliver matured Illinois Division Bonds to the Trustee under the General Mortgage. All the foregoing refunding provisions are limited to "at, after or within twelve months before maturity of the Illinois Division Bonds." I I I - B . There is another provision (first sentence of Section 4, Article Three) for exchange of First and Refunding Bonds for an equal principal amount of prior debt bonds, cancelled or uncancelled, at any time, whether the prior debt bonds were paid at maturity, purchased prior to maturity, or called for redemption prior to maturity. The sentence contemplated going around the General Mortgage and exchanging Illinois Division Bonds for First and Refunding Bonds, and the next sentence provides that all bonds so delivered shall be held by the Trustee without impairment of the lien. This might be effective to preserve the lien of the Illinois Division Mortgage Bonds up until 1949, but was subjected to the same objection that if it amounts to an agreement between the Company and the first and refunding Trustee to keep the lien of the Illinois Division Mortgage alive beyond 1949, it might be in conflict with rights or equities of the General Mortgage bondholders, particularly if the Illinois Division Bonds were paid or purchased with treasury cash, so that there would be no basis for the doctrine of subrogation. IV. If the lien of the Illinois Division Mortgage were carried around the General Mortgage and brought directly to the security of the First and Refunding Mortgage, serious difficulties would be created for the 1958 maturity of the General Mortgage Bonds. Any divisional mortgage may cause trouble in refinancing other mortgages. In the recent bankruptcy reorganizations there was much controversy and litigation as to the value, earning power, and "contributed traffic" of property subject to divisional liens. The situation is more difficult where the divisional lien securities are pledged under a third mortgage and the second mortgage matures. Some of our most troublesome problems in working out the Colorado and Southern Plan resulted from having segments of the system (South Plains Line and certain terminals) pledged under the General Mortgage which otherwise was the system junior mortgage. Certainly if we can avoid it, we ought not to complicate the financial structure of the Burlington, or jeopardize extension of the General Mortgage Bonds in 1958, by putting the lien of the Illinois Division Mortgage under the First and Refunding Mortgage. The General Mortgage is closed, and the bonds are non-callable, but they could be extended at maturity, by agreement with the holders, because the railroad company has reserved in the First and Refunding Mortgage an op-

196

POLICY FORMATION IN RAILROAD FINANCE

tion to do so. No one has questioned that. While it is impossible to foresee what the situation may be in 1958, experience teaches that extension of the General Mortgage Bonds would be more difficult at that time, if the lien of the Illinois Division Mortgage had been kept alive for security of the First and Refunding Mortgage, than if the Illinois Division Bonds had been refunded through the General Mortgage so that the latter was a first lien on practically the entire railroad. Of course the credit of the Company may have improved to such an extent by 1958 that the General Mortgage Bonds can be satisfactorily refunded through the sale of First and Refunding Bonds, but the conservative course is to keep open the opportunity for extension of the General Mortgage Bonds. V. The clear and unquestioned method of refunding Illinois Division Bonds through both mortgages might be used in either of two ways: ( 1 ) Calling all the outstanding bonds for redemption at 105; funds to be provided in part by treasury cash and the balance through sale of Serial Collateral Trust Notes secured by a new issue of $85,000,000 First and Refunding Mortgage Bonds, issued in exchange for a like amount of General Mortgage Bonds, which would be issued in exchange for the $85,000,000 Illinois Division Bonds. The amount of cash which the Company could use for such a call, the amount of Serial Collateral Trust Notes to mature each year, the final maturity date, and the rate of interest would have to be worked out in conformity with present and future cash requirements of the Company, prospective earnings, and salability of the notes. (2) Do no present financing but use excess cash as it comes in to buy Illinois Division Bonds or Government Bonds in the hope that present earnings may last long enough to acquire substantial amounts of the Illinois Division Bonds and to build up a cash reserve sufficient to cover a large proportion of the outstanding bonds by the time they mature in 1949. Then any amount of Illinois Division Bonds, up to $85,000,000, could be exchanged for General Mortgage Bonds, and the latter exchanged for First and Refunding Bonds, which could be sold or used as collateral for a note issue to raise whatever additional funds were necessary to retire the then outstanding balance of Illinois Division Bonds. V - A . Circumstances favorable to calling all outstanding bonds for redemption and refinancing at the present time: (a) Advantage of current low interest rates and credit due to high earnings. We believe we could sell as large an amount of Serial Collateral Trust Notes as the Company safely could undertake to retire in one to seven years, at 2% interest. Of course, lower interest charges on the Serial Collateral Trust Notes than on the Illinois Division Bonds to 1949, would have the effect of increasing taxable income so that the total saving in interest would not be a net saving to the Company so long as taxes continue on present bases. (b) T a x deductions. If the bonds were redeemed and used as outlined in method ( 1 ) , the call premium of approximately $2,840,000 and the un-

APPENDIX I

197

amortized discount of $405,000 as of July 1, 1944, or a total of $3,245,000 would be deductible from income for tax purposes in the year the bonds were redeemed. With present earnings and excess profits tax, the tax saving on such a deduction would be approximately $2,628,450. On the other hand, reducing indebtedness from the present $56,818,000 Illinois Division Bonds to the principal amount of the Serial Collateral Trust Notes, and the successive annual retirements of the Notes, would reduce invested capital for excess profits tax purposes. Every $1,000,000 reduction in invested capital reduces the excess profits base by $500,000 and increases excess profits tax 4 1 % of 5 % of that amount, or $10,250 a year. (c) Importance of reducing fixed charges, not only to meet possible reduced earnings in the postwar period but also to meet competition of the western roads which are coming out of bankruptcy reorganization with very low fixed charges. For example, a recent bond house circular pointed out the following ratios of annual fixed charges at the end of 1943 related to prewar average gross earnings ( 1 9 3 2 - 1 9 4 1 ) : C. R . I. & P . C. M . St. P. & P, C. & N . W D. & R. G Mo. Pac C. & E . I C . G. W Wabash C. B . & Q

2.5%

4-9% 6.6% 6.8% 4-5%

4-7 % 5-7% 9-5%

(d) Present favorable position of the railroads with the public. The railroads have made a splendid war record and generally are conceded to be the backbone of inland transportation. Railroad securities are receiving more favorable attention in market circles. After the war there will be new highway vehicles and airplanes to catch the popular fancy and the importance of the railroads may soon be forgotten. (e) M r . Budd's reputation would be an asset in financing and the general standing of railroad management is important in public evaluation of securities. After the war Congress might reduce the compulsory retirement age for all railroad officers and employes to 65 years, which would result in more or less unseasoned management of many railroads and might be disturbing to investors. V - B . Circumstances which indicate caution in calling and refinancing the bonds now: (a) A substantial amount of cash would be required. The First and Refunding Mortgage is the only one open for refinancing and the 4J/2 and 5% bonds are selling in the eighties. The $85,000,000 new First and Refunding Bonds to be obtained under method ( 1 ) probably would not be regarded as adequate security for an issue of $56,800,000 Serial Collateral Trust Notes at

198

POLICY FORMATION IN RAILROAD FINANCE

low interest. To be saleable at favorable interest rates, the amount of the note issue would have to be reduced by perhaps $20,000,000 or $25,000,000 cash. The Company would sell $15,000,000 or $17,000,000 low interest Government Bonds and no doubt add another $10,000,000 cash by July 1 , 1944. (b) The Company should not undertake commitments beyond its present or prospective ability to pay, particularly the use of a large amount of treasury cash for calling the bonds or large annual maturities of Serial Collateral Trust Notes. No one knows how long the war will last, how long earnings will remain at present high levels, how much will be left after taxes and wage adjustments, or how much will be needed for improvements and new equipment to meet competition, to improve efficiency and to reduce operating costs. (c) The maturity of the non-callable General Mortgage Bonds in 1958 is a limiting factor in any long range financing by Serial Collateral Trust Notes. (d) Government restrictions. Any refinancing would have to be approved by the I.C.C., under Section 20a; the Commission is strongly committed to sinking funds and might place restrictions on dividends. Also, the Commission now has the Competitive Bidding Investigation under advisement, and a bill is pending in Congress to require competitive Bidding. Calling and refinancing the Illinois Division Bonds would be a complicated transaction, probably requiring underwriting, and compulsory competitive bidding would be a handicap. (e) Of course, purchase of substantial amounts of bonds as funds are available would reduce fixed charges, and it might be possible to reduce the principal of the debt in 1949 to a greater extent by method (2) than under method ( 1 ) . ( f ) Possibility that market prices may fall at some time before 1949. While this is a doubtful prospect for such short-term securities, there might be "bargain prices" in a depression, of which the Company could take advantage if it had available cash. V I . Obviously the conservative course would be to do no refinancing at the present time, but to adopt the policy outlined in method (2) above of using excess cash, as available, to buy Illinois Division Bonds or Government Bonds, in the hope of acquiring substantial amounts of each by 1949 so that the maturity of the balance could then be provided for without serious strain on resources of the Company; if not, then refund the balance through both mortgages. V I I . So much attention has been, and is being given to meeting the maturity of the Illinois Division Bonds and $27,332,000 principal amount have been purchased during 1942 and 1943, that it hardly seems necessary to make any comment on the vital importance of meeting this maturity. However, the decisions of the Supreme Court in the Western Pacific and Milwaukee reorganization cases in March of this year approved the I.C.C. reorganization pattern of basing capitalization in reorganization on estimated earnings, and refused to subject the findings of the Commission to full judi-

APPENDIX I

I99

cial review. These decisions emphasized the disastrous consequences of Burlington being unable to meet the 1949 maturity, and the 1958 maturity of its General Mortgage Bonds. J.

Chicago, Illinois, November 16, 1943.

C.

JAMES

APPENDIX

II

LETTER FROM VICE PRESIDENT

JAMES

TO 0. E. SWEET, MAY 4, 1944 [On May 4, 1944, Vice President James answered Director O. E. Sweet of the Interstate Commerce Commission's Bureau of Finance setting forth reasons underlying the payment of a $75,000 fee to Morgan Stanley and Company for financial advice. Mr. James' letter sketched the historical services performed by the investment counsel in the development of the Burlington's Illinois Division Mortgage refunding program, and gave company testimony to the excellence of these services. In addition, Mr. James' letter stated why the firm of Morgan Stanley was originally chosen as adviser. Reasons given by Mr. James, as excerpts from his letter to Mr. Sweet, are presented below.] Dear Sir: In reply to your letter of May 1, 1944, asking what services Morgan Stanley & Co. has performed in working out our plan and selling our $30,000,000 Collateral Trust Bonds, for which we have agreed to pay that firm a fixed fee of $75,000; . . . We believe that the number of hours spent in services of this kind is not a controlling factor in the amount of compensation, but, somewhat like the services of an architect or a doctor, the compensation is largely based upon qualifications and experience, the quality of the work performed, and the results accomplished. However, a brief summary of the work done by Morgan Stanley in this case will indicate the large amount of time they spent on it. The above reference to services of a doctor may be carried one step farther; the family physician who through years of observation has become familiar with the individual characteristics of a patient is best able to advise how the physical and mental health of the patient may be improved. In this very important transaction, the Railroad Company needed the best expert advice and services obtainable, and it was fortunate in having as its financial counsel a firm not only outstanding in the field but one which has been intimately acquainted with its affairs over a period of years. As early as 1936, Morgan Stanley worked on possible plans for refunding or extending the Illinois Division Mortgage Bonds. At that time, Burlington bonds were selling above par and on a yield basis comparable with high quality railroad bonds. Before plans were developed, Burlington securities, along with railroad bonds in general, began to decline in market price and it was obviously impracticable to proceed further. In the succeeding years, the Railroad Company frequently

APPENDIX

n

201

consulted with Morgan Stanley on its financial problems, including studies of its credit position, always having in mind the $85,000,000 Illinois Division maturity, a large and unwieldy amount of bonds to refund with the market for railroad securities in the condition that it was from 1937 to 1942 . . . Early in 1944, the cash position and credit of the Railroad Company so improved that it again took up with Morgan Stanley the possibility of undertaking a comprehensive financial program, not only to provide for the Illinois Division maturity, but to strengthen the First and Refunding Mortgage, being the only open mortgage, so that the Railroad Company would be in a position to meet the maturity of its General Mortgage Bonds in 1958. It was felt that the Railroad Company could use some of its cash to reduce the Illinois Division debt, and banks in Chicago and N e w Y o r k were consulted about the possibility of a short-term bank loan to provide part of the additional funds to call the Illinois Division Mortgage Bonds; the major portion of the money to be raised by the sale of a long-term issue . . .

APPENDIX

III

TELEGRAM FROM OTIS AND TO PRESIDENT

COMPANY

BUDD, MAY 9, 1944

Otis & Co. and Associates are prepared to purchase an aggregate of $40,000,000 principal amount of Collateral Trust Notes and Bonds of the Chicago Burlington & Quincy Railroad secured by $50,000,000 (or 1 2 5 % ) of First and Refunding Mortgage Bonds. Under the plan for an aggregate of $40,000,000 Notes and Bonds which you have submitted to the Interstate Commerce Commission in Finance Docket 14535, $70,000,000 of First and Refunding Mortgage Bonds are contemplated as collateral. Our proposal would release $20,000,000 of these bonds to the Railroad for other purposes, and would contemplate prices to the Railroad at least as favorable as those proposed in I C C Finance Docket 14535. You will recall that we were joint purchasers last year of $10,000,000 serial notes of the Erie Railroad, secured by 1 2 5 % of that Roads First Mortgage 4 % bonds. At that time Erie First 4's were selling at 96 so that the market value of the collateral was 120% of the principal amount of the notes we purchased. A t present Erie 4's are selling at 105% so that the market value of the collateral has increased to somewhat more than 1 3 1 % of the principal amount of notes outstanding. In our judgment 1 2 5 % collateral is sufficient in your case. And since the Burlington First and Refunding 4/4's of 1977 are currently quoted at 104% the market value of this collateral would be equal to 1 3 1 % of the proposed principal amount of Collateral Trust Notes and Bonds. As an alternative which we believe would be far more advantageous to the Burlington, we are prepared to purchase an issue of one-to-twenty year serial bonds issued under the First and Refunding Mortgage in a principal amount of $40,000,000 maturing $2,000,000 per year. Under this plan there would be released to the railroad for other purposes $30,000,000 of the $70,000,000 First and Refunding Mortgage Bonds contemplated as collateral in your application in I C C Finance Docket 14535. This plan, in principle, is similar to the Chesapeake and Ohio Series G Refunding and Improvement Bonds issued in 1941, and we strongly recommend its adoption by you. We are informing the Interstate Commerce Commission of the contents of this telegram. OTIS &

Co.

APPENDIX

IV

TABLES Table A. Monthly high-low prices on selected C.B.&Q. bonds. Source: Bank and Quotation Record, vols. 1-17,

1928-1944.

111. Div. 3 ^ ' s Low

1928 February March April May June July August September October November December 1929 January February March April May June July August September October November December

... ...

High

General 4's Low

F. & R. 4 ^ ' s

High

Low

High

IOlf^ 101)4 ioiyi 101 98 97 96K 98yi 98 yi 99V\ 97 yi

102yi 102p& 102 98^ 99H 98yi 99yi 99 yi 100yi 99H

90 89 88% 89^ 86 87 85^ 86yi 86^ 87yi 8SK

90yi QO^i 8gy4 91 yi 87% 87^ 85% 86yi 87 yi 88yi 87 yi

88 93 92^ 93 X 91 yi

gSH 97% 97tt 96% 94H 94/^2 94H 95 94% 94^ 93X

... ... ... ... ... ... ... ... ... ... ...

85^ 84yi 83 83 82 82 82 s2yi 81 8itf 82^ 82yi

86 85 H 8SV2 86 84H 8S 84 83H 83 84 84 87

gi% 90% 90yi 89 yi 90 89yi 89 88^ 88yi 88yi 90 91

93^ 92 yi 93 92^ 92 yi 91 90 89^ 90 91 yi 92 yi 93X

97 97 yi 95 95 95 96 93l/i 99H 95^ 94% 94yi 97 H

99yi 98yi 97 97 yi 97 yi 96yi 9SX 95% 96 96 98 99%

... ... ... ... ... ... ... ... ... ... ... ...

8Syi 85yi 86X 86 86y i 87yi 87yi 88X 89^ 89 86^ 8Syi

87 85^ 88X 87% 87% 88 88yi 9°H 91 91 yi 90yi 91

89 91 yi 91K 9 iyi 92 % 94 94% 95% 96 yi 96 95^ giyi

93 93>< 94 937A 95 96yi 95*% 97 97% 98 H 98 97H

96 96^ 97 97rt 98 98yi 99 iooyi loiyi iooyi ioiyi 97H

99 98 100 98^ 99yi 100 iooyi i°2yi 103 #

... ... ... ... ... ... ... ... ...

...

97 96yi 96X 94^ 92$>i

1930 January February March April May June July August September October November December

102^ 102

204

POLICY FORMATION IN RAILROAD FINANCE

Table A. (Continued) 111. Div. 3 ^ ' s 1931 January February March April May June July August September October November December

...

... ... ... ... ... ... ...

Low

High

goX

92 9i X giX gi$i

90 90 89 90^ giyi 91 go}4 90 80yi 82

•••

nX

••• ... ... ... • •• ••• ... ... ... ...

79 x 79 80^ igVi 73 75 78X 81 83yi 87yi

...

84H

g*X

92

gsX

93 y* 93 92 83^ 83^

General 4's

F. & R. 4 ^ ' s

High

Low

High

96J4 96 n

98^

100 loifi

gyH g6X

gsy

103K 103 102^ \oiyi 104yt 104 10tf/i 10¡yi

Low

98 99 g&H 96 9 86X 88 82

100 100

ggX 99X giH g$X 91 yi 8gX

101X 102X 102 102X 100

gyH goy 89 82

101X 97

g4X 89

1932 January February March April May June July August September October November December

...

84^

83^ 82 84 80 83^ 81 82 90 87 X

&gX

84 82X 84X 81 78 74 82 85 8gH 87X 87X 87

88yi 85^ 88fg 87 yi 86K

89^ 87X 87 78 83^ 85 gopi 92 89^ 88X 84X 88X

93X g^X giX 85H

8sX 85 H

93 92 92 8gtt go^i

85 83 84

8lX

81H 81H

84X

74

7SX 81 84

83X 7gX 78

85

88X 82X

76 81 86 88 88 83X 80H

1933 January February March April May June July August September October November December

... ... ... ... ... ... ... ... ... ... ... ...

88 83^ 82^ 80 81 8S 86H 89 87 88 84 86X

91 89 8s 84H 87X 87 X 90

9°X g°X g°X 88

91X

giX gsH gsX 94X g*X

90 92 yi

7gX

80 75 68 72 84^ 89 9i

8sX

87 77 78^

85 85X 82 75 86 8gX 92 92 yi 91 9°X

87 X 88

APPENDIX IV

205

Table A. (Continued) 111. Div. 3 ^ ' s

1934 January February March April May June July August September October November December 1935 January February March April May June July August September October November December 1936 January February March April May June July August September October November December

.... • • •• •••

....

High

Low

High

Low

High

88 92^ 94 97

93 95yi 97 X 99 H 99 H ioo)4 101X 101 101 pi 101 yi ioiyi I02p&

88)4 g6)4 98 yi 100yi 101 102)4 102 102 99 101 yi

95 99 X 100H

96 95 97^ 99 100 yi 102 yi 101 97 98^ 98 yi 101 yi 104

100 99 looyi 102 103 103K 104K 103 101 yi 102 yi 105 ioiyi

103 105^ 106 yi 105^ 105

106 yi 107 yi 107 yi 106 yi iosyi 106 yi 107 106 IO4>6 104 10S \obyi

lo&yi no no iioj^ 10 gyi 108yi

106^ 107)4 106 yi 104yi 104yi 105^ io6yi IOSX 105 103^ 104yi 105

108 109 logyi 106 yi 107 107 y2 108 107 yi 106 yi 105H 106 107 yi

107X log yi

109 yi 112)4

106 yi

109 112

98yi

•••

... ,...

.... — ....

99yi 99 101

10l}4 103 lo$4 io$)4 102)4 I03X 104 yi io2yi 102 )4

.... ... ...

102)4 102 103^

106yi 105 103 103 103 yi 106

— ...

104)4

106 yi

105^ 106 105^ 106 10714 107^ 107H 108 108^ io8yi 109

lo^yi 107% 108^ 108H 108H 108X 109 108 yi • 109 109 yi

.... ,... .... — .... .... .... ,... ....

F. & R. 4 K'S

Low

.... gSH .... ggX . . . . 100 ••• 99 .... ,...

General 4's

107X

l°3lA 104yi

104 I04 105 yi 10\!/i 102 yi 105^ 105 yi 107 yi

108yi 107X 107 yi 105 yi ioiyi

108yi

111H 113X 112H 113H 113H 113H 113H

h i yi h i yi h i yi 112^4 112 yi "3 X 114^

114yi 114yi

11 ¡yi

114H 115H 116K

108yi myi hi noyi 112 III^ h i yi H2yi "3 112 yi 113

113H 112 yi 112 yi 114 112)4 113 J4 114 114 114 114

206

POLICY FORMATION IN RAILROAD FINANCE

Table A. (Continued) 111. Div. 3%'s

1937 January February March April May June July August September October November December

... ... ...

,... ,... ... ...

Low

High

109yi 107% io6>4 104pi 104%

109^ no 108% 106X 107% 108^ 108% iog% 108 107 107 108%

107^ 107X 106^ 104 105

1938 January February March April May June July August September October November December

gg3/i 101% • • • 943A ,... 94H ... 86 ... 8S ... 9A% ••• 95% ... 92 ... 9 5% ... 97 ... 96%

107 103K I02}4 97 96)4 95 97 97

1939 January February March April May June July August September October November December

.... 97^ ... 98 ••• 99% ••• 97H ••• 97% ... 99H ... 100% ... 97 ... 94 • • • 9SH 95% ... 94

100 99/4 100% 100 99% 101 10l}£

...

99 99% 98

IOI

97/4 100 99# 96X

General 4's Low

111^ 107% 107% 107% m m

High

Low

High

117JÎ "5 112^ 109^

III

113% 113% 109% 106% 107 109^ IOÇA 10g 107% 102^

109^ 109%

ioifi

116X ii4# 114H logH 112 111% m% 110% iog% no 106^ 105%

98^

93% 95 88^ 81% 75 68 85 87 85 84^ 8g% 88%

105 98H 95% 88% 85 85 90 89^ 88% go 91% 93

99% 99 100 98^ 97% 99% 99% 99H 94% 96 95 9i%

go 8g% 89% 85% 85% 86% 87% 80 81X 8$% 80 7\%

93% 91 94% 89% 87 88}4 91 9*% 90 88^ 87% 80

113% 112^

IIO>i

II2}4

109^ 108^ 107 107%

IlOfi

99 103 95 93# 85^ 81^ 92^ 93 89^ 93% 96 96^

109 107 104

97 97% 94 95>é 97% 98% 93^ 91K 92^ 90K 85

F. & R. 4%'s

97 92% 98 9V/2 95 98H

APPENDIX IV

Table A.

207

(Continued) 111. D i v . 3 ^ ' s Low

General 4's

High

Low

95 92^ 93^ 9sK 90^ 91 93 93K gi}4 91 91 91^

97^ 95 96^ 97^ 98 93J< 96 95 94K 93^ 92^ 94

89

92 91 91 92X 91^ 92 92K 89 88 87^ 86}4 83

85 86>< 88 87K 85 8s K 86K 87^ 89^ 92^ 92^ 92^

High

F. & R . 4 ^ ' s Low

High

1940 January February March April May June July August September October November December

84^ 84 84^ 82^

92 y i 90 92 93 91^ 88^ 90 88^ 86>g 86 86J4 86

79 } i 77^ 78 81 72^ 71 76^ 73 74^ 73 71K yi}4

82^ 81 83^ 83 84^ 77^ 8o>£ 79M 78 76 74H 74

94^ 94^ 94^ 94^ 94 93^ 93^ 93^ 90 89^ 88 A 88^

83^ 83 83^ 84 81K 8ifg 80H 76^ 75^ 77 76% 71^

88K 85A 86 87K 8sH 83 82)4 81X 78^ 82 79K 78^

7 ^A 74^ 74 7SH 75 73 67^ 66^ 67^ 66 63X

80 77H 78^ 77 A 77 A 75 74^ 70^ 69^ 69 69

89^ 89^ 89^ 89^ 87^ 88 88^ 89^ 93^ 94^ 94}i 94

77^ 79^ 79^ 77 76 73^ 75^ 75^ 77% 79 80 80%

83^ 82^ 81% 8ofi 79^ 78 76^ 79K 79^ 82^ 82^ 82

69 70 70 }i 69 68H 63^ 63^ 63H 66^ 64 62% 62^

72^ 72 72 7iJ< 7 ^ 69 66 67 67^ 67 67^ 65

88 9* 83 8 S >i 86fis

1941 January February March April May June July August September October November December

1942 January February March April May June July August September October November December

208

POLICY FORMATION I N RAILROAD FINANCE

Table A. (Continued) 111. Div. s H ' s 1943 January February March April May June July August September October November December

General 4's

F. & R. 4 ^ ' s

Low

High

Low

High

Low

High

92^ 97 g6yi 96yi gyyi 99}4 99K gg% 99^ 100 101 101

gy^i gSyi 97^ gjyi ioofi 100yi ioo}i looyi ioo}4 101 yi 102 102%

81 88 H Sg^i 89% 92^ 96 g6£4 9&X g6X 96X 96y i 96pi

89 92H giyi 94Ya, 7 97 A 97^ ggyi 99 98 g8H 97 98K

65 69 73 73H 77 H So}4 8o^ 80 80 19jA 81 8i#

70.^ 73 77 78 WA 84^ 82 pi 82^ 82 yi 83K 84X 85

102 102 102 10356 io6}4 106^ 105H iosH 105$$ 105& 105^ 105 A

lotyi 102^2 103 io6)4 iofrj-f 106^4 io6yt

98 102 102 y i 104yé 107 yi 107 y i 108 iog§4 iogyi 110 uoyi m yi

84H 91 91 92X 102^ 103ÏÎ io$yi 106 108yi no no 112

94 94yi 92 y i 103 ios^é io6yé io6pi noyi no yi 112 112^ 113X

1944 January February March April May June July August September October November December

105^ 105A 105 io 5 A

103 103yi 104^ 109 108yi 108% 109 noyi noyi 111H 112 112%

APPENDIX IV

209

Table B. Semianmial yields, Illinois Division 3}4's compared with Moody's Aaa rail bond yield averages. Source: M o o d y ' s yields from Moody's Bond Survey, 1029-1944-, Illinois Division 3 s prices in Table A. D a t a obtained on date nearest first of month.

Moody's Aaa rail bond yields (per cent) 1929 January July 1930 January July 1931 January July 1932 January July 1933 January July 1934 January July

i. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1.

1935 January July 1936 January July 1937 January July 1938 January July 1939 January July 1940 January July 1941 January July 1942 January July 1943 January July 1944 January July

i. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1.

4-S 2 4.71 4-74 4.46 4-36 4.40 5-54 S-So 4-52 4-S° 4.48 4.00 3.82 3-7i 3-7° 3-56 3.06 3-55 3-59 4.07 3-59 3-39 3.38 3-38 3i3 3-°9 3.21 3-19 3i3 3-°4 3 04 2-9S

yields computed from

Computed yields to maturity Illinois Division 3>i's (per cent) 4.60 4.78 4.67 4-45 4.20 4.20 5-3° 5-45 4-55 4.72 4.62 3-48 3-2 7 3.00 3.00 2.82 2.63 2-75 2.79 3-95 3-6 7 346 3.80 4.41 4.42 4-47 6.05 5-88 4.61 3-45 3-°7 2.20

210

P O L I C Y F O R M A T I O N I N RAILROAD

FINANCE

Table C. C.B.&Q. Railroad Company, reported cash assets monthly, iQ43~ig44. Source: Monthly Earnings Record, 1943-1945.

1943 January February March April May June July August September October November December

Cash

Temporary Cash Investments

Special Deposits

$15,801,632 19,315.439 22,929,519 25,485,883 26,186,611 27,452,238 33,760,766 39,683,674 24,490,337 35,215,321 41,247,563 36,144,819

$10,408,007 10,408,361 10,408,388 15,408,403 15,408,417 14,208,431 14,208,711 14,208,725 26,473,740 26,473,740 26,473,769 26,474,049

$ 1,874,732 1,385,456 192,429 560,322 154,537 748,5o 2 1,795,325 1,530,052 240,024 216,707 907,062 753, J 57

30,634,485 36,246,320 26,208,266 29,326,445 33,56i,339 22,666,269 24,564,981 28,599,740 25,443,900 25,160,462 28,531,586 16,077,091

36,699,064 36,699,079 36,699,093 36,699,107 36,699,107 30,139,122 30,139,418 30,139,433 30,139,447 30,139,447 30,139,476 26,144,491

1,841,982 1,414,344 217,725 583,155 179,763 694,797 1,840,436 1,402,804 269,746 155,45* 45,338,838 21,274,321

1944 January February March April May June July August September October November December

BIBLIOGRAPHY COLLECTIONS OF UNPUBLISHED DATA

Corporate Records of the Chicago, Burlington and Quincy Railroad Company (Abbreviated " C R " ) . Practically all of the records which form the basis of this study are located in the Law Department Files at the company's main office, 547 West Jackson Boulevard, Chicago, Illinois. The few exceptions are filed in the president's and secretary's offices at the same address. These records consist of correspondence, memoranda, copies of mortgage provisions, and mimeographed excerpts of minutes of both the board of directors and the executive committee. Burlington Archives, Chicago, Burlington and Quincy Railroad Company. This collection, located at the Newberry Library, Chicago, Illinois, consists of corporate correspondence and other documents relating to the affairs of the Burlington during the company's early years. PUBLIC DOCUMENTS

U. S. Congress, House. Regulation of Stock Ownership in Railroads. House Report 2789. 71 Cong., 3 Sess. Washington, 1931. Modification of Railroad Financial Structures. Hearings on H.R. 2298. 80 Cong., 1 Sess. Washington, 1947. U. S. Interstate Commerce Commission. Annual Report. Washington, 19401945Reports. Washington, 1921-1944. Statistics of Railways in the United States. Washington, 1940-1944. Preliminary Abstract of Railway Statistics. Washington, 1945. U. S. Supreme Court. Ecker v. Western Pacific Railroad Corporation, 318 U. S. 448. Washington, 1945. OFFICIAL CORPORATE DOCUMENTS

Chicago, Burlington & Quincy Railroad Company. Annual Reports.

1866-

I 94S-

Documentary History. Vol. I. Prepared by W. W. Baldwin, Chicago, 1928-1929. Illinois Division Mortgage. Chicago ( ? ) , 1899. Before the Interstate Commerce Commission — Finance Docket 14535, Application of the C. B. & Q. Railroad for Authority, April 20, 1944. Chicago (?), 1944. Supplement to Application of C. B. & Q. Railroad Company Before the Interstate Commerce Commission, April 24, 1944. Chicago ( ? ) , 1944.

212

BIBLIOGRAPHY

Before the Interstate Commerce Commission. Finance Docket No. 14535. Second Supplement to Application of Chicago, Burlington & Quincy Railroad Company, May 15, 1944. Chicago ( ? ) , 1944. Chicago, Burlington & Quincy Railroad Company and J. P. Morgan & Co., Trustee. Collateral Trust Indenture. New Y o r k ( ? ) , December 1, 1944. Louisville and Nashville Railroad Company. Prospectus. $60,000,000 Collateral Trust Bonds, $30,000,900 Ten Year % Capital Bonds dated January 1, 1940. Due January 1, 1950, $30,000,000 Twenty Year 4 % Bonds, Dated January 1, 1940, Due January r, 1950. Morgan Stanley & Co., Incorporated, New York, Chief of Underwriting Group. New Y o r k ( ? ) , December 29, 1939. FINANCIAL

SERVICES

Moody's Investor's Service. Moody's Manual For Investments. Railroad Securities. New York, 1939-1946. Moody's Bond Survey (title varies). New York, 1929-1945. Shields and Company. Bond Department Letters. New York, 1944. Standard & Poor's Corporation. Investor's Guide Bond Reports. N e w York, 1944. Standard Corporation Descriptions (title varies). New York, 19401946. NEWSPAPERS

AND

MAGAZINES

Barron's, 1939. Bank and Quotation Record, 1928-1945. Business Week, 1943. Commercial and Financial Chronicle, 193 9-194 5. Investment Dealers' Digest, 1944. Monthly Earnings Record, 1942-1945. New York Times, 1944. Wall Street Journal, 1943-1944. BOOKS

Dewing, A. S. Corporation Securities. New York, 1934. Guthmann, H. G. The Analysis of Financial Statements. New York, 1942. Guthmann, H. G. and Dougall, H. E. Corporate Financial Policy. Second Edition, New York, 1948. Overton, R. C. Burlington West. Cambridge, Massachusetts, 1941. — The First Ninety Years. Chicago, 1940. Ripley, W. Z. Railroads, Finance and Organization. New York, 1915. Sharfman, I. L. The Interstate Commerce Commission. Part I I I A. New York, 1935. MISCELLANEOUS

Meyer, B. H . " A History of the Northern Securities Case," Bulletin University of Wisconsin, no. 142. Madison, Wisconsin, 1906.

of the

BIBLIOGRAPHY

213

Hülse and Allen. "Stenographers' Minutes Before the Interstate Commerce Commission, Docket No. Finance 1069. In the Matter of the Application of the Chicago, Burlington and Quincy Railroad Company, etc. at Washington, D . C., November 22, 23, 1920." Typewritten transcript prepared by Official Reporters. Washington, D . C., 1920.

NOTES INTRODUCTION

1. Moody's Investor's Service, Bond Survey, vol. 34 (New York, 1942), pp. 376-3772. New York Times, April 23, 1944, sec. 5, p. 45. 3. H. G. Guthmann and H. E. Dougall, Corporate (New York, 1948), p. 559.

Financial Policy,

2d ed.

CHAPTER I. THE PROBLEM AND ITS BACKGROUND

1. See pp. 13®. The practice of other large railroad companies is described in Guthmann and Dougall, pp. 263-278, and W. Z. Ripley, Railroads, Finance and Organization (New York, 1915), pp. 105-120. 2. See, for example, testimony of Interstate Commerce Commissioner C. D . Mahaffie in U. S. Congress, House of Representatives. Committee on Interstate and Foreign Commerce. Modification of Railroad Financial Structures, Hearings on H.R. 2298. 80 Cong., 1 Sess. (Washington, 1947), pp. 9-12. 3. For reference see map, p. 31, which shows the various mortgage bonds of the Burlington and the mileage of the Burlington's lines pledged as security for these bonds. 4. C B Q Annual Report, 1936, pp. 21-22. 5. C B Q Documentary History, vol. I (Chicago, 1928-29), pp. 11, 36, 46, 97, and 5556. Ibid., p. 35. 7. A. H. Stockder, "The Burlington, Northern Pacific and Great Northern Systems," Regulation of Stock Ownership in Railroads, House Report No. 2789, 71 Cong., 3 Sess. (Washington, 1931), p. 1254. Also, C B Q Documentary History, I, 48. 8. C B Q Documentary History, I, 49. 9. Ibid., p. 556. 10. Richard C. Overton, Burlington West (Cambridge, Mass., 1941), pp. 3 1 43; esp. map p. 40. 11. C B Q Annual Report, 1866, p. 14. 12. R. C. Overton, The First Ninety Years (Chicago, 1940), p. 11. 13. C B Q Annual Report, 1876, p. 22. 14. Overton, The First Ninety Years, p. 12. 15. Ibid., p. 9. 16. C B Q Annual Report, 1900, p. 18. 17. Stockder, "The Burlington, Northern Pacific and Great Northern Systems," p. 1277. 18. The story of the purchase of the C. B. & Q. is fully discussed elsewhere. It is introduced here in abbreviated form because of the vital part the Northern

2IÓ

NOTES TO CHAPTER ONE

lines' control played in influencing and shaping entrepreneurial decisions of the C. B. & Q.'s managers during the road's later history. For details bearing on the purchase of the Burlington see Stockder, "The Burlington, Northern Pacific and Great Northern Systems"; Overton, Burlington West; B. H. Meyer, "A History of the Northern Securities Case," Bulletin of the University of Wisconsin, no. 142 (Madison, July 1906), pp. 225-241. 19. Overton, The First Ninety Years, p. 26. 20. Moody's Investor's Service, Moody's Manual for Investments, Railroads (New York, 1936), p. 695. 21. Interview with R. T. Cubbage, attorney, October 15, 1946. 22. CBQ Annual Report, 1874, p. 40, and Annual Report, 1899, pp. 24, 26. 23. CBQ Annual Report, 1874, "Trust Mortgage Indenture," p. 33. 24. Letter from President C. E. Perkins of the Burlington to Secretary T. S. Howland, dated January 18, 1899 (CR). 25. CBQ Documentary History, I, 390. CBQ Annual Report, 1899, p. 44. 26. These bond issues were the C. B. & Q. Convertible 5's of 1903 and the Kansas City, St. Joseph and Council Bluffs Mortgage 7's of 1907. 27. Interstate Commerce Commission, Finance Docket 1069, 67 I.C.C. 160 (Washington, 1 9 2 1 ) ; also, CBQ Documentary History, I, 403. 28. CBQ Documentary History, I, 413. 29. CBQ Annual Report, 1920, p. 31. 30. Interstate Commerce Commission, Finance Docket 1069, 67 I.C.C. 160. 31. CBQ Documentary History, I, 404. 32. Hulse and Allen, Official Reporters, "Stenographers' Minutes Before the Interstate Commerce Commission, Docket No. Finance 1069. In the Matter of the Application of the Chicago, Burlington and Quincy Railroad Company, etc. at Washington, D.C., November 22, 23, 1920." (Washington, 1920), p. 34. 33. Ibid., p. 74. 34. Ibid., p. 74. 35. Ibid., p. 34. 36. See above, p. 18. 37. "Although capital structure proportions are of doubtful significance . . . they will, nevertheless, frequently show the expected correlation with financial strength . . . A railroad with a funded debt in excess of . . . 50 percent of the combined bonds and net worth is likely to be in a weak position." Harry G. Guthmann, The Analysis of Financial Statements (New York, 1942), p. 3 1 1 . 38. Hulse and Allen, pp. 72ft. 39. Interstate Commerce Commission, Finance Docket 1069, 67 I.C.C. 156. 40. Hulse and Allen, p. 74. 41. Ibid. 42. Ibid., pp. 74-75. 43. Interstate Commerce Commission, Finance Docket 1069, 67 I.C.C. 156. 44. CBQ Documentary History, I, 446. 45. Ibid., 478. 46. Ibid., p. 482. 47. CBQ Annual Report, 1922, p. 36. 48. CBQ Annual Report, 1924, p. 34. 49. CBQ Annual Report, 1927, p. 40. 50. CBQ Documentary History, I, 473. 51. Ibid.

APPROACHING

MATURITY

OF

ILLINOIS

BONDS

217

CHAPTER II. THE APPROACHING MATURITY OF ILLINOIS DIVISION BONDS

1. Memorandum of discussion between R . W . Coglan and R . C. Overton, M a y 7, 1945 ( C R ) . 2. C B Q Annual Report, 1932, p. 15. 3. Interstate Commerce Commission, Finance Docket io6g, 67 I.C.C. 156. 4. C B Q Annual Report, 1927, p. 28. 5. T h e term "funded debt" as used here and in Tables 11, 26, and 27 is synonymous with "long-term debt" and therefore includes equipment obligations. This usage conforms to definitions in such texts as Guthmann and Dougall, p. 96. The I C C , on the other hand, breaks "long-term debt" down into such classifications as "funded debt," "receivers' certificates," and, since 1942, "equipment obligations." The general usage of the term "funded debt" is, however, the one employed here rather than the special meaning utilized by the Commission. 6. C B Q Annual Report, 1936, p. 11. 7. These bonds were callable as a whole only, with first call date for Series A being February 1, 1942, and February 1, 1952 for Series B. 8. Memorandum from Ralph Budd to R. C. Overton, April 13, 1945 ( C R ) . 9. Ibid. 10. Memorandum signed " C . H . L . , " from files of Morgan Stanley, dated August 12, 1936 ( C R ) . 11. Letter to Wood-Struthers from President Budd, June 16, 1936; letter to Bruce Scott, vice president and general counsel of the Burlington, from First Boston Corporation, November 5, 1936, and answer of November 12, 1936; memorandum from A. T . Williams to C. I. Sturgis, November 11, 1936 ( C R ) . 12. Letter from C. E. Perkins to F. W . Hunnewell, February 25, 1899 (Burlington Archives, CBQ, Hunnewell In-letters). 13. The Burlington Archives contain no record of an answer to Perkins' letter of February 25, 1899, where the question of callability was raised, so the precise manner in which this point was resolved cannot be stated. A. G. Stanwood, the company's assistant treasurer, in a letter to President Perkins on March 29, 1899 ( C R ) , discussed briefly the amount of premium to be recommended for bonds of different interest rates if they were called for redemption prior to maturity. However, he seems to have considered the question of calling the bonds academic, writing, ". . . it is not likely we should want to exercise that right." How far he was wrong was amply illustrated, however, as the Illinois Division bonds approached maturity. 14. C B Q Illinois Division Mortgage (n.p., 1899), Article I. Italics mine. 15. Letter from H. G. Smyth to J. C. James, April 13, 1944 ( C R ) . 16. Letter from J. C. James to H. G. Smyth, M a y 1, 1944 ( C R ) . Y e t , in a memorandum Mr. James had prepared November 16, 1943 ( C R ) , he had affirmed unequivocably that the bonds could not be called in part. (See below, Chap. V I and Appendix I.) This apparent conflict in the position taken b y the Burlington's General Counsel was discussed with him in an interview on M a y 13, 1947. A t that subsequent date Mr. James reported, "Although my reply to First Boston was evasive, it was phrased in such a way as to permit subsequent interpretation of call in part. W e felt certain that the mortgage could not be so construed, but there was no reason to express this view and definitely take a posi-

2 l8

NOTES TO C H A P T E R

TWO

tive stand." That is to say, refunding plans for the Illinois Division bonds had progressed to such a stage by May i, 1944, that partial redemption was out of the question. Mr. James did report, however, that Mr. Shelton, the General Counsel for the Burlington from 1936 to 1938, always believed that the Illinois Division bonds were callable as a whole only. 17. It will be noted that Table 12 compares fixed charges as a percentage of 1931-1940 average gross revenue for the Burlington and its competitive roads. While measurement of the full significance of the burden of fixed charges should properly relate these expenses to net revenue, the former procedure is followed here for two reasons. In the first place, significant variations in operating ratios which generally invalidate a comparison of fixed charges and gross revenues as between different railroads, are of relatively minor importance in comparing these five companies operating in similar areas and under similar conditions. Secondly, as discussed below in Chap. V, in the creation of the Burlington's financial policy, President Budd was acutely conscious of the potential threat to the Burlington's position which would come from a general reduction in rates and the resultant effect upon the company's revenues. 18. Standard and Poor, Standard Corporation Descriptions, Aug. 28, 1945, pp. 4238, 4190, 4207. 19. Interstate Commerce Commission, Finance Docket 10772, "Chicago Great Western Railroad Company Reorganization," 228 I.C.C. 585 (Washington, 1938). 20. Ibid., p. 627. 21. See Subsection (b) of Section 77 of the Bankruptcy Act; see also Interstate Commerce Commission, Chicago I. & L. Reorganization, 254 I.C.C. 539 (Washington, 1943). 22. Commissioner Mahaffie's dissenting opinion summarized clearly the position taken by the majority in the Great Western case. "The carrier is in trouble because of its fixed charges. The majority approve a plan that cuts obligatory interest severely and to a basis that in the past would, on the average, have been adequately covered." 228 I.C.C. 585 (631). It would be redundant to cite further cases in support of a position adhered to by the Commission at least through 1945. 23. Memorandum of interview among Ralph Budd, Kent Healy, and R. C. Overton, April 25, 1945 (CR). 24. Interstate Commerce Commission, Finance Docket 10028, 242 I.C.C. 298 (Washington, 1940). 25. Interstate Commerce Commission, Chicago, Rock Island and Pacific Railroad, 247 I.C.C. S33 (Washington, 1941), at p. 539. 26. Standard Corporation Descriptions, July 15, 1946, pp. 42, 48; and August 28, 194S, PP- 4190, 423727. CBQ Annual Report, 1940, p. 5, states interest on unfunded debt, amortization of discount on funded debt, and rent for leased roads and equipment to total $337,23428. CBQ Annual Report, 1940, pp. 16-17: Total assets $667,500,000 less current liabilities of $9,700,000 and unadjusted credits of $89,400,000. 29. See Guthmann and Dougall, p. 238. 30. Earnings based on total of net income and fixed charges as shown in Table 12. 31. See above, Table 12, for record of fixed charges and earnings for decade of the thirties. 32. Commercial and Financial Chronicle, August 6, 1938, p. 886. 33. Barron's, May 15, I939> P- 19-

FIRST EFFORTS TO FORMULATE FINANCIAL PLAN

219

34. See below, Chap. IV, n. 37, letter from Ralph Budd to F. J. Gavin. 35. Ibid. See also below, Chap. I l l , for evidence bearing upon the Burlington's dividend policy after 1940. CHAPTER III. FIRST EFFORTS TO FORMULATE A FINANCIAL PLAN

1. Bond Department Letter (Shields and Company, 44 Wall Street, New Y o r k ) , January 2, 1940. 2. Memorandum, Office of the Secretary, October 28, 1940 ( C R ) . 3. Memorandum from A. T . Williams to J. C. James, November 8, 1940 (CR). 4. Memorandum from R. T . Cubbage to J. C. James, November 7, 1940 (CR). 5. Letter from Ralph Budd to F. J. Gavin and C. E. Denney, November 26, 1940 ( C R ) . 6. Letter from J. C. James to F. G. Dorety and L. B. da Ponte, March 18, 1941 ( C R ) . 7. Memorandum from W. K . Bush to J. C. James, December 30, 1940 ( C R ) . 8. Ibid. 9. Ibid. 10. Memorandum from W. K . Bush to J. C. James, January 2, 1941 ( C R ) . 11. Memorandum from A. T. Williams to J. C. James, January 20, 1941 ( C R ) . 12. Memorandum from H. W. Johnson to J. C. James, January 20, 1941 ( C R ) . 13. Memorandum from H. W. Johnson to J. C. James, January 30, 1941 ( C R ) . 14. Letter from J. C. James to F. G. Dorety and L. B. da Ponte, March 18, 1941 ( C R ) . 15. Letter from F. G. Dorety to J. C. James, March 19, 1941 ( C R ) . 16. Memorandum from M. L. Countryman to L. B. da Ponte, March 26, 1941 (CR). 17. Letter from L. B. da Ponte to J. C. James, April 22, 1941 ( C R ) . 18. Ibid. 19. Letter from Dorety to James, June 6, 1941 ( C R ) . 20. Letter from L. C. da Ponte to J. C. James, June 13, 1941 ( C R ) . 21. Letter from J. C. James to F. G. Dorety and L. B. da Ponte, June 4, 1941; also letter dated June 3, 1941 ( C R ) . 22. Report of special committee, dated June 3, 1941 ( C R ) . 23. Ibid. 24. This restriction is found in the terms of the First and Refunding Mortgage Indenture, Article III, Sec. 4. 25. Memorandum from R. W. Coglan to R. Budd, dated M a y 20, 1944 (filed with letter of June 3, 1941) ( C R ) . 26. Letter from R. F. Berg of Great Northern to J. C. James, December 4, 1941, and letter from L. B. da Ponte to J. C. James, December 5, 1941 ( C R ) . 27. See above, Chap. II, n. 10. 28. See below, Chap. VI. 29. Standard and Poor, Investor's ¡Guide Bond Reports, M a y 21, 1942. 30. Ibid. 31. C B Q Annual Report, 1941, p. 5. 32. Letter from Ralph Budd to C. E. Denney and F. J. Gavin, M a y 7, 1942 (CR). 33. Memorandum on conversation held among Messrs. Budd, Kent Healy, and R. C. Overton, April 23, 1945 ( C R ) .

220

NOTES TO C H A P T E R

THREE

34. Letter from Ralph Budd to C. E. Denney and F. J. Gavin, May 7, 1942 (CR). 35. Letter from F. J. Gavin to R. Budd, May 8, 1942 ( C R ) . 36. Telegrams between R. Budd and C. E. Denney, May 14 and 15, 1942 ( C R ) . 37. Mr. A. T. Williams, treasurer from 1938 through 1940, was replaced upon retirement by Mr. Bert Vickery. CHAPTER IV. INITIAL APPLICATION OF DEVELOPED FINANCIAL POLICY

1. Moody's Bond Survey, June 8, 1942, p. 376. The above remarks and those immediately following refer to this same analysis. 2. Letter from C. E. Denney to Ralph Budd, June 11, 1942 ( C R ) . 3. Memorandum prepared by Ralph Budd, June 13, 1942 ( C R ) . 4. As indicated in Chap. I l l , this end was deemed most practicable in the special committee report. 5. Memorandum prepared by Ralph Budd, June 13, 1942 ( C R ) . 6. Compare above, pp. 37-39. 7. Memorandum I I , prepared by Ralph Budd, June 20, 1942 ( C R ) . Italics mine. 8. Ibid. Italics mine. 9. Memorandum, June 13, 1942, p. 2, Memorandum I, June 20, 1942, p. 3 (CR). 10. Memorandum I, June 20, 1942, p. 4 ( C R ) . 11. Interview of K. T. Healy with A. N. Jones, May 3, 1945 ( C R ) . 12. Letter from J. M. Meyer to Ralph Budd, June 27, 1942 ( C R ) . 13. In a subsequent interview, President Budd stated that he talked with the "people in New York" frequently during the period and probably conveyed his ideas on the subject, but credit for the J. P. Morgan memorandum should be given to Mr. Meyer. (Interview between Messrs. Budd, James, Cubbage, and the author, May 13, 1947.) 14. Memorandum prepared at J. P. Morgan and Company, June 25, 1942, p. 4 (CR). 15. Ibid. Incidentally, the error in the computed yields reported in the Survey was ignored. 16. Ibid. 17. Letter from John M. Meyer to Ralph Budd, June 27, 1942, pp. 1 - 2 ( C R ) . 18. Letter from Ralph Budd to J. M. Meyer, June 29, 1942 ( C R ) . 19. Letter from Ralph Budd to C. E. Denney, August 7, 1942 ( C R ) . Mr. Denney had asked Mr. Budd about the progress of the bond purchase program; and in response, Mr. Budd submitted the following data: Par of Range of Approx. Bonds Purchase Purchased Yield » Prices III. Div. 3}4s — Registered $330,000 82 - 8 5 6-5% 111. Div. 3>4s — Coupon 355,000 86 - 8 8 5-8% 111. Div. 4s — Registered 88 - 9 0 Y\ 55,ooo 5-9% 111. Div. 4s — Coupon 206,000 90>4-93/4 5-4% $946,000 a Computed on Median of Price Ranges The total cash cost of the six-week operation had been $832,554.10.

CLARIFICATION OF

OBJECTIVES

221

20. Memorandum prepared by J. W. Coglan for Mr. Budd, May 25, 1944, in answer to President Budd's inquiry "What are dates of Board resolutions authorizing purchase of Illinois Division Bonds . . . ?" ( C R ) . 21. Ibid., p. 1. 22. See above, n. 19. 23. Letter from J. M. Meyer to Ralph Budd, June 30, 1942 ( C R ) . 24. Letter from J. M. Meyer to Ralph Budd, July 7, 1942 ( C R ) . 25. Memorandum prepared by J. W. Coglan, May 25, 1944 (CR). 26. Letter from Ralph Budd to J. M. Meyer, October 27, 1942 ( C R ) . 27. Memorandum prepared in the treasurer's office of the C. B. & Q., dated November 18, 1942 ( C R ) . The exact cost of the bonds purchased, including those bought through November 16, 1942, was reported at $9,741,086. 28. Memorandum prepared by R. W. Coglan, May 25, 1944 ( C R ) . 29. CBQ Annual Report, 1942, p. 20. 30. Letter from J. M. Meyer to J. C. James, November 5, 1942 (CR). 31. Ibid. 32. Memorandum from R. T. Cubbage to J. C. James, November 24, 1942. See also memoranda prepared by R. T. Cubbage dated 25 and 28 November, 1942. (CR). 33. Letter from Ralph Budd to C. E. Denney and F. J. Gavin, December 10, 1942 ( C R ) . 34. Letter from C. A. Denney to Ralph Budd, December 17, 1942 ( C R ) . 35. Letter from F. J. Gavin to Ralph Budd, December 17, 1942 ( C R ) . 36. Letter from F. J. Gavin to Ralph Budd, December 23, 1942 (CR). 37. Letter from Ralph Budd to F. J. Gavin with copy to C. E. Denney, December 22, 1942 (CR). 38. Letter from F. J. Gavin to Ralph Budd, December 23, 1942 ( C R ) . 39. Letter from Bert Vickery to F. P. Brassar of the SEC, January 20, 1943, with enclosure of Form 8 - K ( C R ) . 40. Letter from J. C. James to John M. Meyer, Jr., dated February 13, 1943 (CR). 41. Letter from C. D. Dickey of J. P. Morgan and Company to J. C. James, dated February 18, 1943, reporting purchases as of the close of business February 17, 1943 (CR). 42. Letter from R. Budd to C. E. Denney and F. J. Gavin, February 27, 1943 (CR).

CHAPTER V. MODIFICATION OF POLICY AND CLARIFICATION OF OBJECTIVES

1. Memorandum prepared by S. B. Payne, January 20, 1943, attached to letter from John Meyer to J. C. James dated February 2, 1943 (CR). 2. See Budd's letter of December 22, 1942 (Chap. IV, n. 37). 3. Letter from John Meyer to J. C. James, February 2, 1943 ( C R ) . 4. Memorandum from J. C. James to Ralph Budd, February 6, 1943 (CR). 5. Memorandum from Ralph Budd to J. C. James, February 14, 1943 ( C R ) . 6. Letter from Ralph Budd to Henry S. Sturgis, Vice President, The First National Bank of New York, April 9, 1943 ( C R ) . 7. Interview between Messrs. Budd, James, Cubbage, and the author, May 13, 1947-

222

NOTES TO C H A P T E R

FIVE

8. Letter from H. W. Johnson to G. H. Hess, Jr., Great Northern Railway Co., April 10, 1943 ( C R ) . 9. Letter from Ralph Budd to Arthur M. Anderson, J. P. Morgan and Company, May 7, 1943 ( C R ) . 10. Memorandum from J. W. Coglan to Ralph Budd, May 25, 1944 ( C R ) . 11. Letter from Ralph Budd to Arthur Anderson, May 15, 1943 ( C R ) . 12. Ibid. 13. Letter from Arthur Anderson to Ralph Budd, May 13, 1943 ( C R ) . 14. Letter from Ralph Budd to Arthur Anderson, May 21, 1943 ( C R ) . 15. Letter from Ralph Budd to Arthur Anderson, June 19, 1943 ( C R ) . As of this date, 33 per cent of the last $1,000,000 order remained to be filled. 16. Letter from Arthur Anderson to Ralph Budd, June 14, 1943 ( C R ) . 17. See below, Chap. VI, Sec. A, for a different view of the desirability of this plan. 18. See above, Chap. I l l , n. 2. 19. Subsequent to February 16, when amount outstanding was $68,381,000, something over $6,200,000 had been purchased following the $5,500,000 appropriation of May 5, and the $1,000,000 appropriation of May 21. ' 20. Letter from Ralph Budd to C. E. Denney and F. J. Gavin, June 21, 1943 (CR). 21. Letter from C. E. Denney to Ralph Budd, June 22, 1943 ( C R ) . 22. Joseph D. Kelley, "Reorganization Railroads Among Best Situated for Post War Years; Debt Shrinkage Cuts Income Needs," Wall Street Journal, June 22, 194323. Memorandum by J. C. James, June 23, 1943 ( C R ) . 24. CBQ Annual Report, 1942, pp. 16 and 17. 25. Chap. II, Sec. B, discusses these considerations in detail.

CHAPTER VI. THE DEVELOPING FEASIBILITY OF CALLING THE ILLINOIS DIVISION BONDS

1. Letter from Ralph Budd to C. E. Denney, dated July 1, 1943 ( C R ) . Italics mine. 2. Letter from C. E. Denney to Ralph Budd, July 3, 1943 ( C R ) . 3. Letter from A. M. Anderson to Ralph Budd, July 26, 1943 ( C R ) . 4. Letter from Ralph Budd to C. E. Denney and F. J. Gavin, August 3, 1943 (CR). 5. Letter from Ralph Budd to C. E. Denney and F. J. Gavin, August 27, 1943 (CR). 6. Ibid. 7. Letter from Wallace Winter to Ralph Budd, July 10, 1943 ( C R ) . 8. Ibid. 9. Letter from A. M. Anderson to J. C. James, August 27, 1943 ( C R ) . 10. Letter from Ralph Budd to C. E. Denney and F. J. Gavin, August 27, 1943 (CR). 11. Letter from F. J. Gavin to Ralph Budd, August 30, 1943 ( C R ) ; Letter from C. E. Denney to Ralph Budd, August 31, 1943 ( C R ) . 12. Memorandum by R. W. Coglan, August 30, 1943, "Illinois Division Bonds, Purchase of part and call of balance." (CR). 13. Letter from Ralph Budd to Arthur Anderson, September 4, 1943 ( C R ) .

THE CREATION OF FINAL REFUNDING PLAN

223

14. Letter from Ralph Budd to Arthur Anderson, September 17, 1943 ( C R ) . 15. Statement from J. P. Morgan and Company, September 15, 1943 ( C R ) . 16. Letter from Ralph Budd to Arthur Anderson, September 17, 1943 ( C R ) . 17. Memorandum from J. C. James to Ralph Budd, May 5, 1944 ( C R ) . 18. Letter from Arthur Anderson to Ralph Budd, September 15, 1943 ( C R ) . 19. Ibid. 20. Notation by B. A. Henry on telegram from A. M. Anderson to R. Budd, dated November 18, 1943 ( C R ) . 21. Based upon prospectus prepared by Morgan Stanley and Company, December 29, 1939, entitled "$60,000,000 Louisville and Nashville Railroad Company Collateral Trust Bonds." 22. Letter from Ralph Budd to Arthur Anderson, October i , 1943 ( C R ) . 23. Ibid. 24. Ibid. .25. Letter from A. M. Anderson to Ralph Budd, October 6, 1943 ( C R ) . 26. Letter from Ralph Budd to Arthur Anderson, October 12, 1943 ( C R ) . 27. "Maturity of Illinois Division Mortgage Bonds in 1949," prepared by J. C. James, November 16, 1943 ( C R ) . This memorandum is reproduced in full below in Appendix I. 28. See below, Appendix I. 29. One of the unfavorable circumstances to which Mr. James called attention assumed particular importance when it was ultimately decided to refinance the Illinois Division bonds before maturity. Under section V - B , dealing with various factors which were held to indicate caution in immediate refunding, the problem of government restrictions was discussed. There Mr. James noted the probable impact upon the company of the Competitive Bidding Investigation which the Interstate Commerce Commission was holding under advisement. "Calling and refinancing the Illinois Division Bonds would be a complicated transaction, probably requiring underwriting, and compulsory competitive bidding would be a handicap." These complications will be referred to below in several places. 30. Letter from J. C. James to Ralph Budd, November 16, 1943 ( C R ) . 31. Letter from Ralph Budd to Arthur Anderson, October 9, 1943 ( C R ) . 32. Letters from Arthur Anderson to Ralph Budd, October 15 and November IS, 1943 ( C R ) . 33. Letter from Ralph Budd to Arthur Anderson, November 17, 1943 ( C R ) . 34. Letter from Ralph Budd to Arthur Anderson, November 24, 1943 ( C R ) . 35. Letter from Bert Vickery to F. P. Brassor of the SEC, January 8, 1944, which enclosed form 8 - K ( C R ) . 36. Memorandum from the Office of the Treasurer, October 23, 1943 ( C R ) . 37. Form 8 - K filed with SEC January 8, 1944 ( C R ) . 38. Interview, K. T. Healy with A. N. Jones, May 3, 194s ( C R ) . 39. Ibid. 40. Letter from Henry S. Sturgis to Ralph Budd, December 1, 1943 ( C R ) . 41. See map, p. 31. 42. Letter from Arthur Anderson to Ralph Budd, October 6, 1943 ( C R ) . CHAPTER VII. THE CREATION OF FINAL PLANS FOR REFUNDING ILLINOIS DIVISION MATURITIES

1. This aspect is discussed further in Chap. VIII. 2. See Chart I.

224

NOTES TO C H A P T E R

SEVEN

3. See above, p. 33. See also Chap. VI, n. 29, for Vice President James' reference to this complicating feature. Further mention of this "complicated" aspect is referred to below, p. 116 and p. 143, as the Burlington's officials were influenced by this provision in reaching important decisions. 4. CBQ Illinois Division Mortgage (n.p., 1899), Article I, p. 8. 5. Memorandum attached to letter from A. N. Jones to Thomas J. Wilson, May 22, 1950. Copy at Morgan Stanley and Company, Inc. 6. See Appendix I, Section V - B , Paragraph d. 7. See above, letter from Ralph Budd to F. J. Gavin, December 22, 1942 ( C R ) , quoted at Chap. IV, n. 37. See also p. 92. In 1942 extension at maturity of the Illinois Division bonds seemed the logical solution to the company's problem, but by mid-1943 the possibility had emerged of redeeming these bonds before maturity. At the year's end The First National Bank of New York advised that "an attempt should be made to be ready to accept the first favorable opportunity" to call the Illinois Division bonds. Letter from Henry Sturgis to Ralph Budd, December 1, 1943 ( C R ) . 8. Letter from Ralph Budd to F. J. Gavin and C. E. Denney, March 9, 1944 (CR). 9. Unsigned memorandum attached to letter from Ralph Budd to C. E. Denney and F. J. Gavin, March 20, 1944 ( C R ) . In a letter to E. Flynn dated March 22, 1944 (CR), President Budd identified J. C. James as author of the memorandum. 10. Between K . T. Healy and A. N. Jones, May 3, 1945 ( C R ) . 11. Memorandum from J. C. James, dated March 20, 1944 ( C R ) . 12. See above, n. 9. 13. Letter from Ralph Budd to C. E. Denney and F. J. Gavin, March 20, 1944 (CR). 14. Ibid. 15. Letter from A. N. Jones to Ralph Budd, March 20, 1944 ( C R ) . 16. Ibid. My italics. 17. Interview between K . T. Healy and A. N. Jones, May 3, 1945 ( C R ) . 18. Ibid. 19. Ibid. 20. Letter from Ralph Budd to Henry Sturgis, March 28, 1944 ( C R ) . 21. Letter from Ralph Budd to F. J. Gavin, March 24, 1944 ( C R ) . 22. Letter from A. N. Jones to Ralph Budd, March 20, 1944 ( C R ) . 23. Letter from Henry Sturgis to Ralph Budd, March 29, 1944 ( C R ) . 24. The proposed plan would pledge $103,294,000 General Mortgage bonds as security under the First and Refunding bonds. This would be equivalent to 57.89 per cent of the total first lien as represented by the $178,414,000 Generals to be outstanding according to the terms of the scheme. The $45,000,000 F & R bonds, or 45/155 of the F & R bonds which would be ultimately outstanding, would thus represent 45/155 of the 57.89% first-lien security of pledged Generals. Hence, Alternative B carried approximately 17 per cent of the total first-lien security over as collateral under the proposed long-term refunding issue. Alternative A, adding $7,500,000 Generals as security, thus carried an additional 7.5/178.4 or 4.21 per cent of the first lien to the Collateral Trust bonds, making the security approximately 21.2 per cent of the total first lien. 25. Letter from Henry Sturgis to Ralph Budd, March 29, 1944 ( C R ) . 26. Joint memorandum prepared by A. N. Jones, Henry Sturgis, and Arthur Anderson, March 29, 1944 ( C R ) .

EXECUTION

OF T H E

APPROVED

FINANCIAL

PLAN

225

27. Letter from J. C. James to Ralph Budd, March 31, 1944 ( C R ) . 28. Ibid. 29. Ibid. 30. This amount is accounted for as follows: $4,623,000 in the Treasury; $2,000,000 pledged as collateral to guarantee performance of the company's subsidiary, the Colorado Southern, under loan to the R . F . C . ; $3,250,000 pledged to secure the Collateral Trust note of 1946 placed with the Prudential Insurance Company. Thus, if James' proposed agreement were carried out, it would be necessary to stipulate that $5,250,000 would be pledged under the First and Refunding bonds as their release from prior pledge was obtained (Data in James' letter of March 31, 1944, to Ralph Budd ( C R ) ) . 31. Ibid. 32. Letter from Arthur Anderson to Ralph Budd, March 31, 1944 ( C R ) . 33. Interview, K . T . Healy with A. N . Jones, M a y 3, 1945 ( C R ) . 34. Letter from J. C. James to Oliver E. Sweet, Director of the Bureau of Finance, Interstate Commerce Commission, April 28, 1944 ( C R ) . Since the retirement of the Illinois Division bonds would, b y the "orthodox method," provide the Burlington with more First and Refunding bonds for use as collateral than was conceivably necessary, it is likely that the Burlington never raised serious objection to what amount of F & R bonds any financial adviser would recommend as collateral. Apparently the company stood ready, upon any recommendation, to use the entire $85,000,000 behind the $40,000,000 refunding issues. 35. Memo from J. C. James, " C . B. & Q.: Plan with Alternative C In Lieu of Alternatives A and B , " April 5, 1944, p. 4 ( C R ) . 36. Ibid., p. 5. 37. Letter from Ralph Budd to C. E. Denney and F. J. Gavin, April 5, 1944 (CR).

CHAPTER VIII. EXECUTION OF THE APPROVED FINANCIAL

PLAN

1. See memorandum prepared by J. C. Calvert of J. P. Morgan and Company, July 3, 1944 ( C R ) on subject of bonding capital additions; letter from A. N . Jones to J. C. James, July 26, 1944 ( C R ) ; memorandum prepared by J. C. James, September 29, 1944 ( C R ) ; and final agreement, letter from A. N. Jones to J. C. James, October 10, 1944 ( C R ) . 2. Letter from Ralph Budd to A. N . Jones, April 8, 1944 ( C R ) . 3. Letter from Ralph Budd to Henry Sturgis, March 28, 1944 ( C R ) . 4. Letter from Arthur Anderson to Ralph Budd, March 31, 1944 ( C R ) . 5. Letter from Arthur Anderson to Ralph Budd, April 10, 1944 ( C R ) . 6. Memorandum from the Office of the Treasurer, April 10, 1944 ( C R ) . 7. Ibid. 8. Appendix IV, Table C, presents the Burlington's cash assets during this period. 9. Letter from H. W . Johnson to J. C. James, April 14, 1944 ( C R ) . 10. Letter from J. C. James to Ralph Budd, April 12, 1944 ( C R ) . M y italics. 11. A subsequent interview held M a y 13, 1947, between Messrs. James, Cubbage, and the author confirmed the reasons suggested here for the decision to prepay the Illinois Division bonds in December, 1944. 12. Telegram from Morgan Stanley and Company to J. C. James, April 19, 1944 ( C R ) .

22Ó

NOTES TO CHAPTER

EIGHT

13. Ibid. 14. Press release signed "Ralph Budd," April 22, 1944 ( C R ) . 15. Memorandum prepared by J. C. James, March 20, 1944 ( C R ) . 16. Letter from Arthur Anderson to Ralph Budd, March 31, 1944 ( C R ) . 17. Excerpts from minutes of executive committee meeting, April 18, 1944 (CR). 18. Letter from Arthur Anderson to Ralph Budd, April 21, 1944 ( C R ) . 19. Ibid. 20. Ibid. 21. See below, Chap. I X , for further consideration of the relationship between the Burlington's refinancing and competitive bidding. 22. Letter from Ralph Budd to F. J. Gavin, April 21, 1944 ( C R ) . 23. "Supplement to Application of CB&Q Railroad Company Before the Interstate Commerce Commission, April 24, 1944." 24. Memorandum from J. C. James, March 20, 1944 ( C R ) . 25. Letter from Ralph Budd to Morgan Stanley and Company, April 20, 1944 (CR). 26. Ibid. 27. Letter from 0. E. Sweet to J. C. James, May 1, 1944 ( C R ) . 28. " D r a f t of Proposed Answer to the Interstate Commerce Commission," prepared at Morgan Stanley and Company, M a y 2, 1944, p. 4 ( C R ) . 29. Ibid., Appendix, p. 5. 30. "Before the Interstate Commerce Commission — Finance Docket 14535, Application of the CB&Q Railroad for Authority, April 20, 1944," p. 20. 31. Letter from J. C. James to 0. E. Sweet, May 17, 1944, p. 5 ( C R ) . 32. Memorandum prepared by R. T. Cubbage, July 30, 1948 ( C R ) . 33. Chicago, Burlington & Quincy Railroad Company and J. P. Morgan and Company Incorporated, Trustee, Collateral Trust Indenture, Dated as of December 1, 1944, p. 38. 34. Ibid., p. 39. 35. Letter from J. C. James to 0. E. Sweet, April 28, 1944 ( C R ) . 36. Ibid. 37. Letter from Ralph Budd to Edward E. Brown, M a y 5, 1944 ( C R ) . 38. Letter from J. C. James to 0. E. Sweet, May 1, 1944 ( C R ) . 39. Ibid. 40. "Before the Interstate Commerce Commission, Finance Docket No. 14535. Second Supplement to Application of Chicago, Burlington & Quincy Company, M a y 15, 1944," pp. 2 and 3. 41. Advertisements of offers to prepay were placed in the principal newspapers of twenty-two cities throughout the country on Monday, December 4, 1944. (Memorandum in C R . ) 42. Memorandum from the Treasurer's Office, January 27, 1945 ( C R ) . CHAPTER r x . PUBLIC ATTACKS UPON THE BURLINGTON'S

REFUNDING

PLAN

1. Development of public interest and regulatory policies relative to competitive bidding are reviewed in Interstate Commerce Commission, In Re Competitive Bidding in the Sale of Securities, Ex Parte 158 (Washington, 1944) 257 I.C.C. 129. The foregoing chronology of steps taken by governmental bodies is based upon the summary in Ex Parte 138, particularly at p. 136.

SUBSEQUENT R E F U N D I N G

OPERATIONS

227

2. Interstate Commerce Commission, Finance Docket 14106 (Washington, 1943), 254 I.C.C. 167. 3. Interstate Commerce Commission, Finance Docket 14261 (Washington, 1943), 254 I-C.C. 473. 4. Interstate Commerce Commission, In Re Competitive Bidding, etc., Ex Parte 158 (Washington, 1944), 257 I.C.C. 129, at p. 162. 5. Interstate Commerce Commission, Finance Docket 14106, 254 I.C.C. 167. 6. Ibid., p. 1 7 1 . 7. Ibid. 8. Interstate Commerce Commission, Finance Docket 14261, 254 I.C.C. 473, at p. 477. 9. Ibid., p. 482. 10. Ibid., p. 478. 11. Commercial & Financial Chronicle, June 3, 1943, p. 2086. 12. Interstate Commerce Commission, 57th Annual Report (Washington, 1943), p. 28. 13. Business Week, October 2, 1943, pp. 100-104. 14. Commercial & Financial Chronicle, March 9, 1944, p. 1001. 15. Interstate Commerce Commission, In Re Competitive Bidding in Sale of Securities (Washington, 1944), 257 I.C.C. 129. 16. Memorandum from Ralph Budd, April 13, 1944, reporting upon substance of telephone conversation with H. L. Stuart ( C R ) . 17. Ibid. 18. Letter dated April 28, 1944, and made public in U. S. Senate on May 2, 1944 ( C R ) . The deletions are remarks relative to the Pennsylvania's proposed refinancing, involving a similar fee of % per cent paid to Kuhn, Loeb and Company. 19. Memorandum dated May 2, 1944, addressed to Interstate Commerce Commission and prepared by Morgan Stanley and Company. ( C R ) . 20. Letter from J. C. James to 0 . E. Sweet, May 4, 1944 ( C R ) . 21. Ibid. 22. Letter from W. J. Patterson to Hon. Henrik Shipstead, May 1, 1944 ( C R ) . 23. Moody's Bond Survey, March 27, 1944, p. 474. 24. See Interstate Commerce Commission, In Re Competitive Bidding, Ex Parte 158, 237 I.C.C. 129, esp. pp. 1 3 9 - 1 4 1 . 25. Ibid. 26. Ibid. 27. Ibid. 28. Ibid. 29. See Chart I for prices of F & R 4 ^ ' s of 1977. 30. Letter from Ralph Budd to F. J . Gavin, with copies to all C. B. & Q. directors, M a y 10, 1944 ( C R ) . 31. Telegram from Ralph Budd to Otis and Company, May 10, 1944 ( C R ) . 32. Letter from Cyrus Eaton to Senator Burton K. Wheeler, May 10, 1944 (CR). 33. Letter from W. J. Patterson to Senator B. K. Wheeler, May 22, 1944 (CR). CHAPTER X . SUBSEQUENT REFUNDING OPERATIONS

1. Letter from J. C. James to 0 . E. Sweet, May 4, 1944 ( C R ) . 2. Letter from M. R. Baty to Ralph Budd, May 2, 1944 ( C R ) .

228

NOTES TO CHAPTER

TEN

3. Letter from Ralph Budd to M. R. Baty, May 4, 1944 ( C R ) . 4. William Blair and Company, Circular, Chicago, May 6, 1944 ( C R ) . 5. Letter from A. N. Jones to Ralph Budd, March 21, 1944 ( C R ) . 6. CBQ Annual Report, 1940, pp. 18, 19. 7. Ibid. 8. Computed from Pro Forma Statement of Long-Term Debt, except that interest on equipment obligations were taken from CBQ Annual Report, 1944, p. 27. 9. I. L. Sharfman, The Interstate Commerce Commission, Part I I I - A (New York, 1935), p. 553. 10. Standard & Poor, Standard Corporation Records, June 12, 1945, p. 35. 11. Standard & Poor, Standard Corporation Records, May 14, 1946, p. 42. 12. Interstate Commerce Commission, Finance Docket 1312s, Submitted December 18, 1945, Decided December 19, 1945, Mimeographed Report of the Commission, sheet 2. 13. CBQ Annual Report, 1945, p. 13. 14. Interstate Commerce Commission, Finance Docket 13125 (Mimeographed, December 19, 1945), sheet 4. 15. CBQ Annual Reports, 1921-1944 inclusive. 16. CBQ Annual Reports, 1899 et seq.

Index

INDEX Anderson, Arthur M., 59, 82, 90, 91, 94, 95, 126, 133, 142, 147 Bankruptcy: danger to Northern lines, 65 Bankruptcy Act of 1933, 37, 39 Barron's, 44 Baty, M . R „ 173 Blair, William, and Company, 174 Bond purchases, 78; continuance agreed to, 68; desirability of canceling, 7 1 ; formal termination, 104; magnitude, 75; openmarket policy, 6s; program accelerated, 7 1 ; program adopted, 7 1 ; program approval, 67; program terminated, 76, 94; by tender, see Tender Budd, Ralph, 2, 27, 29, 30, 34, 35, 38, 40, 4 i . 42, 43 . 44, 4S, So, 54, 55, 56, 58, 62, 63, 65, 88, 89ft., 161, 169 Bush, W. K., 52, 54 Business Week, 161 Callable bonds, 5; call features, 33, 170; complicating aspect, 112; provisions, 7. See also under individual bonds Capital structure: of reorganized competitors, 40, 41, 42, 216, n. 37 Capitalization: Interstate Commerce Commission findings, 29 Cash position, 144; estimate requested, 84; forecast for 1943, 88, 89 Chesapeake and Ohio Railroad, 157 Chicago, Burlington and Northern Railroad, 9 Chicago, Burlington & Quincy Railroad Company, 1 ; character of traffic, 1 1 - 1 2 ; competition, 35; development, 8 - 1 3 ; financial condition of competitors, 34; fixed charges, 37; mortgage map, 3 1 ; revenues, 28; territory served, 11 Chicago Great Western Railroad Company, 36, 37 Chicago, Milwaukee, St. Paul and Pacific Railroad, 12, 35, 40 Chicago and North Western Railway, 12, 35, 38, 40, 183 Chicago, Rock Island & Pacific Railway, 12» 351 381 39» 40, 183

Class I line-haul railways: capital structure, 42 Coglan, R . W., 93, 95 Collateral, n o , 117, 120, 121, 126, 127, 131, 133, 178; considerations underlying "revised" refunding plan, 128-129; effect upon interest cost, 117, 118, 120, 121, 126, 130, 132, 133; effect of seniority of lien, 125, 126; final determination of amount, 135; Interstate Commerce Commission questions basis, 153; market value considerations, 154; use of First and Refunding bonds, 108, 109; use of General Mortgage bonds, 109 Collateral Note, 115 Collateral Trust bonds, 57, 107, 116, 117, 145, 146, 175, 179; criteria for determining amount of security to be pledged, 108; Illinois Division bonds as security, 98; issued, 146; proposed security, 107108; purchase contract, 146; redeemed, 180; suggested use according to Louisville and Nashville pattern, 96; trustee, 142 Collateral Trust Indenture, 142 Collateral Trust plan, 174 Collateral Trust Serial Notes. See Serial Colorado and Southern General Mortgage bonds, 90 Colorado and Southern Railway, 9, n , 12 Commercial & Financial Chronicle, 160 Common stock, 24, 29 Competitive bidding, 113, 148, 149, 150, i57ff., 170, 177, 178, Appendix I (197198); adopted for Serial Collateral Trust Notes, 150; attitude of the Burlington, 163; comparative cost, 149, 163; complicated aspect of refunding problem, 164; conditions for exemption from requirement, 166; interest cost versus private negotiation cost, 165; lower cost on Serial Collateral Trust Notes, 155; requirement promulgated, 167 Conditional sales contracts, 53 Consolidated Mortgage 7's of 1903, 13, 14 Credit position, 43, 111, 174; effect of dividend policy, 44; effect upon interest cost

232

INDEX

in refunding plan, 130; improvement, 90 Cubbage, R . T., 50 D a Ponte, L . B., 54 Debt reduction, 66, 118, 170, 177; First and Refunding Series A, 175; magnitude contemplated, 64; over-all accomplishment, 182ft.; program adopted, 60; reorganized railroads, 84; total amount authorized, 89; total Illinois Division bonds purchased, 104 Debt structure, 28; arrangements of 1921, 25; problems, 21; rigidities, 7, 30 Denney, C. E., 50, 54, 59, 62, 65, 68, 72, 74, 82, 83, 88, 89, 93 Denver & Rio Grande Western Railroad, 12 Dividend policy, 11, 44, 54, 57, 58, 91; effect upon price of C. B. & Q. bonds, 47; large dividends foregone, 47 Dividends, 47, 66, 104; bond, 22, 23 Division 4, 1 S3 Dorety, F. G., 54. SS Earnings, 141, 144; basis for reorganization, 64; outlook in 1942, 70 Eaton, Cyrus, 157, 161, 169 Ecker vs. Western Pacific Railroad Corporation, 39 Equitable Life Assurance Society, 146 Erie Railroad Company, 158, 159 Ex Parte 138, 39 Ex Parte 158, 160, 161, 162, 166, 167, 177, 179 Extension, 51, 53, 63, 64, 99; denial of intent to pursue, 58; Illinois bonds, 53, 74; legality, 50; legality in doubt, 98; legality examined, 96; need for cash or equivalent to facilitate, 82, 83; position of General Mortgage, 57; possibilities, 49, 50. See also Illinois Division Mortgage bonds Fee, 117, 167; for developing and placing refunding issue, 150; economic justification, 164; Interstate Commerce Commission requests explanation, 151, 152; reasonableness, 151, 132 Financial advice: First National Bank of New Y o r k , 105; Morgan, J. P., and Company, 104; Morgan Stanley consulted, 56, 105, 164; Morgan Stanley's preliminary analysis, 106 Financial plan: developments of 1941, SS! 1942, 58 Financial policy, 11, 28, 29, 34, 63, 113, 137, 170, 171, 175, 176, 182; abandon cash build-up, 58; absence of financial experts in employ of Burlington, 164; application,

initial, 6iff.; attitude of majority stockholders, 66; conservatism, 114; considerations in collateralizing refunding issue, 124, 125; debt reduction, weight assigned, 43; decision to purchase Illinois Division bonds above par, 92; decision to buy U. S. Government rather than Illinois bonds, 81; development of refunding plans, 115; developments of 1941, SS; devote cash to retire outstanding debt, 58; difficulties encountered, 61; formulation contrasted with application, 139; formulation at end of 1942, 72ft.; Illinois bonds refunding integral part of over-all plan, 130; initial application of perfected plan, 140; initial development of refunding plans, 95; Moody's Bond Survey, 6 1 ; plan to purchase U. S. Government bonds rejected, 81; recommendation of Nov. 16, 1943, 103; regulated industry aspects, 37; return to program for purchasing Illinois Division bonds, 81-82; statement of available courses open in 1943, 101, Appendix I ( 1 8 9 ) ; strengthen cash, 58 Financial structure: reorganized railroads, 84 First Boston Corporation, 33 First National Bank of Chicago: appointed trustee, 154 First National Bank of New York, 105, 106, 147. 154 First and Refunding Mortgage, 22, 54, 79, 98; suggested use as refinancing medium, 77 First and Refunding Mortgage bonds, 27, 30, 102; authorization, 24; call feature inflexible, 29; earning power, 5 1 ; issuance restricted, 136; prices, 46, 1 1 2 ; purpose, 22, 24; use as collateral, 97, 108 First and Refunding Mortgage bonds, Series A : issued, 24; possibility of refunding, 149, 174, 175; redeemed, 179; yield, 172 First and Refunding Mortgage bonds, Series B : issued, 24; possibility of refunding, 149, 174, 175; use of tenders in refunding, 180; yield, 172 First and Refunding Mortgage bonds, Series of 1970, 180 First and Refunding Mortgage bonds, Series of 1974: issued, 179; redeemed, 180 First and Refunding Mortgage bonds, Series of 1985, 180 Fixed charges, 29, 118, 125, 137; magnitude of debt, implied, 86; Milwaukee Railroad, 40; North Western Railroad, 40; reduction attributable to reorganization, 38; relation to rates, 38, 86; Rock Island

INDEX Railroad, 40; selected railroads 1942, 85 Funded debt, 43, 86; changes through reorganization, 38; development 1874-1899, 13; growth to 1932, 29 Gavin, F. J . , 45, 5°, 54, 59, 72, 75, 76, 82, 88, 93

General Mortgage, 23, 24, 25, 118 General Mortgage bonds, 16, 18, 21, 30, 51, 54, 98, 113; authorization, 17; defects hypothetical, 25; earning power, 51; indenture, 18, 19; limitations as financing medium, 18, 19, 20; prices, 46, 112; use of tenders in refunding, 180 Great Northern Railroad, 9, 27, 28, 45, 46, 47. 54 Halsey Stuart and Company, 158, 159, 181, 182 Hannibal and St. Joseph Railroad, 9 Healy, K. T., 105 Hill, James J . , 10 Holden, Hale, 18, 19, 20, 23, 24, 27, 28 Illinois Central Railroad, 13, 35, 183 Illinois Division Mortgage bonds, 1, 8, 18, 24, 29, 48, 49, 50, 98, 124, 174; additional purchases authorized, 88; authorization, 14; call feature complex, 32-33; call provisions, 102, 115; calling impractical in 1936, 30; extension, 53, 55. 56, 63, 74; issue construed callable as whole, 33; market price, 53; Moody's analysis, 62; notice required for redemption, 33; paid, SS; possibility of redemption, 49, 92-93; practicality of calling, 99; prices, 112; provisions, 14, 16; purchase authorization, 82, 83; purchase finally terminated, 94; purchases at par, 88; purchases related to par, 90-91; purchases resumed, 89; purchases on yield basis, 91, 92; redeemed, 156; redemption date, 143; refunded, SS i request for tenders, 90; yield, 62 Institutional purchasers, 117, 120, 161 Insurance companies as purchasers, 117, 130, 146 Interest charges: First and Refunding Series A, 17s Interest cost, 117-119 Interstate Commerce Commission, 3, 19, 22, 23, 24. 27, 28, 29, 36, 37, 38, 39, 40, 64, 86, 148, 149, 165; Bureau of Finance, 152, 172; Ex Parte 138, 39; Ex Parte 158, 160-162, 166, 167, 177, 179 Investment Dealers' Digest, 173

233

James, J . C., so, S3. 54. 69, 71, 78, 80, 86, 91, 96, 116, 132, 145; analysis of Nov. 16, 1943, 101; submits alternative "C", 133 Johnson, H. W., S3 Jones, A. Northey, 66, 67, 105, 116, 120, 121, 126, 174 Kelly, J . D., 84 Kuhn, Loeb and Company, is8, 1S9 Louisville and Nashville Railroad, bonds as refunding model, 116

96;

Metropolitan Life Insurance Company, 146 Meyer, J . M., 67, 68, 71, 78, 79, 80, 82 Milwaukee Railroad, 35, 38, 40, 183 Moody's Bond Survey, 47, 6r, 62, 67, 173 Morgan, J . P., and Company, 3, 10, S9> 67, 68, 69, 76, 77, 79, 80, 82, 89, 93, 95, 97, 98, 103, 104, 109, 133, 142, 147, 148, 149; agent in bond-purchase program, 70; flexible program, 80, 81; memorandum analyzing financial problems, 98-100; named trustee, 142; recommendation to abandon further Illinois bond purchases, 80 Morgan Stanley and Company, 3, 56, 58, 59. 66, 104, 106, 109, 114, 132, 150, 158, 174, 179; fee determined, 150; submits alternative refunding plans, n 9-124 Mutual Benefit Insurance Company, 146 Nebraska Extension Mortgage bonds, 18, 24, 27; retired, 24 New England Mutual Insurance Company, 146 New York Stock Exchange, 151 Northern lines, 21, 43, 44, 65 Northern Pacific Railroad, 9, 12, 47, 54, 59 Northwestern Mutual Insurance Company, 146 North Western Railroad. See Chicago and North Western Railway Open-market purchases: policy recommended, 6s Operating revenues, 11; as base for allowable fixed charges, 86 Otis and Company, 157, 158, i59> i6i> i67> 172; proposal to underwrite, 167ft. Overton, Richard C., 2 Patterson, W. J . , 162, 164, 166, 169 Payne, S. B., 77, 78, 80 Pennsylvania Railroad, 158, 159 Plattsmouth, 9

234

INDEX

Private negotiation, 159, 160, 171, 177, 179; interest cost versus competitive bidding cost, 165; need for seen by President Budd, 161 Private placement, 148, 149 Private sale, 113 Public distribution, 117 Public sale, 113 Purchase commitments, 113 Purchase contract, 146 Rates as basis for allowable interest charges, 86 Reconstruction Finance Corporation, 158 Redemption: cost, 144, 145; double interest, 145; establishment of call premium, 155; timing, 144 Refinancing: definition, 4; developments, 32-40; methods, 4, 5; plans, 32-40; preliminary explorations, 48; timing, 5. See also Refunding Refunding, 114; plan, 94, 104, 120-124, 128, I34> 137; problem, 109, 112, 148, 170, 176 Rock Island Railroad. See Chicago, Rock Island and Pacific Railway Securities and Exchange Commission, 75 Security, 133, 178; underlying Collateral Trust bonds, 108. See also Collateral Serial Collateral Trust bonds, 52, 53 Serial Collateral Trust Notes, 107; advertisements for sale, 154; competitive bidding on, 148, 149, 150; construed as bank loan, 147-148; method of distribution, 147; technical shortcomings, 155; trustee, iS4 Serial issue, n o

Serial Notes, 95, 109, 116, 126, 146, 149; cash drain, 134; interest cost, 1 3 s ; suggested use as refinancing medium, 93 Sharfman, I. L., 177 Shields and Company, 48 Shipstead, Henrik, 158, 160, 164, 166; criticizes the Burlington's refunding plan, 162 Sinking-fund issue, n o , 116 Smyth, H. G , 33 Stuart, H. L., 161 Sturgis, Henry S., 105, 126, 127, 142, 147 Sweet, Oliver E., 163, 172 Tender: use in retiring General Mortgage and First and Refunding Series B bonds, 180; use in retiring Illinois Division bonds, 90, 146 Timing, 143, 145; call of Illinois Division bonds, 34; effect upon interest cost, 165 Trustee: appointed for Serial Collateral Trust Notes, 154; appointment, 142 Union Pacific Railroad, 9 Valuation: based on earnings, 39; for ratemaking, 39-40 Vickery, Bert, 59, 69, 70, 75, 76 Wall Street Journal, 84, 88 Wayne Hummer and Company, 173 Wheeler, B. K., 169 Williams, A. T., 49 Williamson, F. E., 27 Winter, Wallace, 91 Yield, 46, n o , 172; refinancing aspect, 182 Young, Robert, 157, 161