5

tributed to the efforts of this lawyer to surmount a legal obstacle. The Pennsylvania courts would not allow that a "conditional sale" of the moving equipment by the trustee to the road should serve as the basis of an obligation as against a third party. That is, the trustee could not hold unquestioned title to the equipment, even though the title remained in his name, if he sold it to the road on the usual instalment plan. Accordingly he adopted the legal subterfuge of holding absolute ownership of the equipment until it had been entirely paid for by the road. Such a legal subterfuge has proved sound, provided it involves no intentional deceit nor injustice. As advanced by the Supreme Court, long ago in one of its few adverse decisions: "Contracts by which railways, insufficiently equipped with rolling stock of their own, lease or purchase, under the form of a conditional sale, such equipment from manufacturers are not of uncommon occurrence, and when entered into bona fide® for the benefit of the road have been universally respected by the courts.'

997

Early case, Lehigh, etc. v. Field, 8 Watts and Sergeant 232.

Pennsylvania is probably the only state which does not permit the “conditional sale" to form a proper basis for security of a lien on equipment. Although this anomaly has proved very annoying to the railroads and their attorneys, the circumventions adopted by lawyers to avoid it have given rise to the strongest known form of equipment obligation. This will be described in detail presently as the so-called Philadelphia plan.

It is very important that the equipment trust be bona fide. Important decisions adverse to equipment obligations have brought out the fundamental principles that there shall be no direct or constructive fraud attendant upon their issue. The entire proceeding must be clear and nothing must occur to give rise to the implication that some creditors are in danger of being defrauded. Under no circumstances must directors of railroads become parties in such manner that they may profit individually. See Drury v. Cross, 74 U. S. 7 Wall. 299; Twin Lick Oil Co. v. Marbury, 91 U. S. 587; Wardell ▼. U. P. Rd. Co., 103 U. S. 651. One of the most interesting of the adverse cases showing constructive fraud in a variety of lights is McGourkey v. T. and O. C. Ry., 146 U. S. 536. It actually shows the strength of the equipment obligations issued under the form of the Philadelphia plan because it involved the admission, by every member of the Supreme Court, that such obligations, when issued bona fide, were legal. Furthermore, although the entire evidence showed that the form of the lease was resorted to in this case merely as a legal subterfuge to cover up actual fraud-never has there been a clearer case of attempted fraud-the Chief Justice of the Supreme Court and one other dissented on the ground that even constructive fraud did not invalidate the priority of the equipment trust lien in favor of a third party.

7 McGourkey v. T. and O. C. Ry., 146 U. S. 551 (1892). A careful summary of the court decisions and legal opinions down to 1885, when the fundamental

Although conceived in the beginning as a means of enabling new3 or impoverished roads to acquire equipment when their own borrowing capacity was small, equipment obligations are now used by the strongest roads in the country as a means of borrowing to better advantage than through the issue of general mortgage bonds. The growth of their use was slow at first because associated with emergency financing. By 1890 the total outstanding volume of equipment obligations was less than $50,000,000 while in 1899 the amount had declined to approximately $42,000,000. Due largely to the use of the equipment loans by the strongest roads in the country the total of such obligations rose with great rapidity from 1902 to 1905-from less than $90,000,000 to approximately $200,000,000.10 Since then the practice of financing separately the purchase of equipment has become so common that at the beginning of 1915 the United States and Canadian roads had outstanding over half a billion dollars of equipment obligations,1 attitude of the courts was being shaped is given by Rawle, op. cit., p. 277. The legal phrases were carried down to 1894 in Car Trusts in the United States, by Gherardi Davis and G. Morgan Browne, Jr. For important decisions note particularly U. S. v. N. O. Rd. 79 U. S. 12 Wall 362; Fosdick ▼. Schall, 99 U. S. 235; Meyer v. Western Car Co., 102 U. S. 1. These cases have, apparently, established the fundamental law of equipment obligations. Their strength, from the legal point of view, is shown by the fact that there are few if any important recent Supreme Court decisions dealing with the legal status of this form of security. Although a multitude of railroad failures have involved the adjustment of equipment obligation claims, the law upholding their strength has been so firmly established that it has not been thought worth while to carry to the court of last resort a point of possible difference.

11

8 Stated directly as late as 1894 by Davis and Browne, op. cit., as the chief reason: "Inasmuch as a very large number of railroads are not, at the time of their organization, in a condition to purchase a sufficient amount of rolling stock outright, and as, at the same time, manufacturers and owners of rolling stock would often hesitate to accept the obligation of a railroad of perhaps doubtful future, even when secured by collateral, in payment for cars and engines, some other security or means of protecting the manufacturer became necessary."

In 1890, $49,478,215 and in 1899, $42,058,348. These figures are those of the I. C. C. adjusted by the editor of the Commercial and Financial Chronicle (vol. LXXXI, p. 1760). They include the Canadian Pacific but not the other Canadian roads. The equipment obligations of the Canadian Pacific alone amounted to approximately $2,000,000 for both years.

10 Com. & Fin. Chron., vol. LXXXI, p. 1760. Same basis of computation as described in preceding note.

11 Coggeshall and Hicks, New York bankers, computed with great care the outstanding equipment obligations as of Dec. 2, 1914, as $519,000,000. Freeman and Co., New York, have also published a detailed manual giving the outstanding trusts, as of Jan. 2, 1917.

an amount over twelve times as great as that of 1899.12 The practice, having been firmly established among steam railroads, has now been extended to other carriers-particularly electric railroads. It should be said, however, that there is still a general prejudice against the use of equipment loans by electric roads and their use is even now an indication of poor credit.13

There are various reasons that have led railroads to use equipment obligations, but two are of especial importance-economy and the avoidance of the "after acquired property clause." Subordinate reasons call for little comment as the present rapid increase of equipment loans never would have occurred had the railroads not found it possible to borrow cheaper in this way than by the issue of junior securities.

Most railroads long ago have mortgaged, to the full, their main lines, so that the only available basis of credit remaining is an inferior lien. The securities based on this inferior lien would naturally command a low market price-another way of stating the fact that the new money obtained from the sale of these junior securities would cost the road a high rate of interest. When at first the issue of equipment obligations was looked upon as a sign of weakness investors avoided them as an inferior makeshift security. The rates paid by the carriers were, therefore, no lower than what would be paid on the junior securities. But gradually banks and investors realized that equipment obligations constituted a special 12 The following table shows the growth in the amount of outstanding equipment obligations, among some of the stronger roads. (Even thousands.)

With one road the amount seemed to vary with its credit.

Missouri Pacific

(including Iron Mountain) 1,043,000

12,970,000

7,397,000

13 Such instances are the three issues by the Hudson & Manhattan Railroad and the recent (Sept., 1916) one by the Connecticut Company.

14 The early equipment obligations were issued almost exclusively to give new or impoverished roads equipment, and the low credit of the road was carried over to the equipment obligations. All issued before 1885 bore high rates of interest. For illustration, the Ohio Central Car Trust created in 1880 bore 8 per cent interest. Rates as high were by no means uncommon prior to

class by themselves to which the ordinary canons of railroad credit did not apply. The strength given them by the early court decisions has, too, so increased the demand for them that the rates at which equipment issues are taken by the public now compare favorably with those of any other single class of corporate securities.

This low rate of yield for equipment issues is shown empirically by comparing their average yields with that of the senior and junior issues of the same road.15 To accomplish this comparison, the average yield of all equipment issues of a single road, that commanded a general market, was computed.16 This average is the entry in the first column. (P. 360.) The yield for the senior bond issues of the same roads was computed by averaging the yields on all the first mortgage, main-line bonds. In some cases not more than one or two issues could be used, but as these command a wide general market they indicate clearly the position of the road's fundamental

15 In the actual computation I made a more or less random selection of six roads typical of each of four grades of railroad credit: Class A, roads of very strong credit; Class B, roads of medium credit; Class C, roads of poor credit; and finally Class D, roads in the hands of receivers. The spring of 1916 was selected as, on the whole, the best time to use as the basis of the calculation, and March 16, 1916, was chosen arbitrarily as the day to use as the basis for bond prices. The reasons for selecting this time were as follows: Some recent date should be chosen, or else one considerably antedating the European war, in order to minimize the influence of international factors on railroad credit. During the spring of 1916 many roads were in the hands of receivers, but these same roads were enjoying some degree of prosperity, so that their credit was not regarded as hopeless. Subsequent to the spring of 1916 plans for the reorganization of several of these roads had been published so that the market values of their various securities depended more on the treatment at the hands of reorganization committees and only incidentally upon their fundamental credit position. Furthermore since the middle of 1916 there have been on the one hand so many short-time foreign loans that the attention of banks has been directed away from all domestic short-time securities and, on the other hand, a plethora of gold has very much befogged the judgment of bankers regarding their security investments. Banks are large customers of railroad equipment obligations. On the whole, therefore, economic and monetary conditions seem to make the spring of 1916 a better time to select for a comparison of railroad credits than any time since.

16 Although these issues are not regularly quoted in the exchanges this computation was relatively simple. Three investment houses in New York make a specialty of these issues. From one or all of these it is possible to obtain a "bid" on practically every equipment issue and a firm "offer” of a great many issues. Furthermore half a dozen brokers are more or less specialists in "equipments" and their "subject offers" afford a close market. No distinction was made between "Philadelphia plan” certificates and equipment bonds,

credit. The junior or general credit of the road was computed in the same manner from the average yield on the refunding and the general mortgage bonds" and the debentures-if any-but without reference to the guaranteed issues.18

Summarizing these results, therefore, it appears that the average investment yield for solvent roads was 4.31 per cent for the equipments, 4.61 per cent for the senior mortgage bonds, and 5.29 per cent for the junior or general credit bonds. The economy of borrowing through equipment obligations is apparent. It is also apparent that the equipment obligations of insolvent roads maintained a credit hardly second to that of their underlying first mortgage bonds. This conclusion is in accordance with the actual practice of railroad administration. A road which cannot sell bonds can always sell equipment obligations and that at rates which make the borrowing in no sense a burden. Even when refunding and debenture bonds can be sold easily it is ordinarily more economical for the management to issue equipment obligations, to cover such expenditures as must be made for new rolling stock.19

The second advantage concerns the "after acquired property clause." Bridges, terminals, and branch lines are frequently built by subordinate corporations so that the new property may not pass, automatically, under some old mortgage which contains a clause to the effect that all property subsequently owned by the road becomes subject to it. In the same way, the trustee of an

17 In several cases first mortgage bonds on unimportant branch lines were considered as general credit obligations. Convertible issues of all kinds were omitted.

18 The practice of some statisticians of using the guaranteed issues of a road as a basis of computing its general credit is misleading. Besides the anomalous character of a guarantee—as shown by the Western Pacific case on the one hand, and the Ozark and Cherokee Central case on the other-the value of a guaranteed bond rests, in the minds of investors, much more on the value of the property than on the guarantee. Take the Southern Pacific, for example, a system prolific in guarantees. Its general credit, based on the San Antonio and Aransas Pass 1st 4s would be 7% per cent on the Houston and Texas Central 1st 5s, 42 per cent-both guaranteed branch line roads. The guaranteed and the unguaranteed Houston East and West Texas 1st 5s sell on exactly the same basis.

19 It stands to reason that money cannot be borrowed on equipment and used for other purposes. In the old Ohio Central case (146 U. S. 536), one of the few instances of the abuse of equipment obligations, over a quarter of the total money borrowed on the equipment was used to purchase a coal property and to pay off previous indebtedness of the road.