THE FAILURE OF BANKER-MANAGEMENT
There is not one moral, but many, to be drawn from the Decline of the
New Haven and the Fall of Mellen. That history offers texts for many
sermons. It illustrates the Evils of Monopoly, the Curse of Bigness,
the Futility of Lying, and the Pitfalls of Law-Breaking. But perhaps
the most impressive lesson that it should teach to investors is the
failure of banker-management.
BANKER CONTROL
For years J. P. Morgan & Co. were the fiscal agents of the New Haven.
For years Mr. Morgan was _the_ director of the Company. He gave to
that property probably closer personal attention than to any other of
his many interests. Stockholders’ meetings are rarely interesting or
important; and few indeed must have been the occasions when Mr. Morgan
attended any stockholders’ meeting of other companies in which he was
a director. But it was his habit, when in America, to be present at
meetings of the New Haven. In 1907, when the policy of monopolistic
expansion was first challenged, and again at the meeting in 1909
(after Massachusetts had unwisely accorded its sanction to the Boston
& Maine merger), Mr. Morgan himself moved the large increases of stock
which were unanimously voted. Of course, he attended the important
directors’ meetings. His will was law. President Mellen indicated this
in his statement before Interstate Commerce Commissioner Prouty, while
discussing the New York, Westchester & Boston--the railroad without a
terminal in New York, which cost the New Haven $1,500,000 a mile to
acquire, and was then costing it, in operating deficits and interest
charges, $100,000 a month to run:
“I am in a very embarrassing position, Mr. Commissioner, regarding the
New York, Westchester & Boston. I have never been enthusiastic or at
all optimistic of its being a good investment for our company in the
present, or in the immediate future; but people in whom I had greater
confidence than I have in myself thought it was wise and desirable; I
yielded my judgment; indeed, I don’t know that it would have made much
difference whether I yielded or not.”
THE BANKERS’ RESPONSIBILITY
Bankers are credited with being a conservative force in the community.
The tradition lingers that they are preëminently “safe and sane.” And
yet, the most grievous fault of this banker-managed railroad has been
its financial recklessness--a fault that has already brought heavy
losses to many thousands of small investors throughout New England for
whom bankers are supposed to be natural guardians. In a community where
its railroad stocks have for generations been deemed absolutely safe
investments, the passing of the New Haven and of the Boston & Maine
dividends after an unbroken dividend record of generations comes as a
disaster.
This disaster is due mainly to enterprises outside the legitimate
operation of these railroads; for no railroad company has equaled the
New Haven in the quantity and extravagance of its outside enterprises.
But it must be remembered, that neither the president of the New Haven
nor any other railroad manager could engage in such transactions
without the sanction of the Board of Directors. It is the directors,
not Mr. Mellen, who should bear the responsibility.
Close scrutiny of the transactions discloses no justification. On the
contrary, scrutiny serves only to make more clear the gravity of the
errors committed. Not merely were recklessly extravagant acquisitions
made in mad pursuit of monopoly; but the financial judgment, the
financiering itself, was conspicuously bad. To pay for property several
times what it is worth, to engage in grossly unwise enterprises, are
errors of which no conservative directors should be found guilty;
for perhaps the most important function of directors is to test
the conclusions and curb by calm counsel the excessive zeal of too
ambitious managers. But while we have no right to expect from bankers
exceptionally good judgment in ordinary business matters; we do have
a right to expect from them prudence, reasonably good financiering,
and insistence upon straightforward accounting. And it is just the
lack of these qualities in the New Haven management to which the
severe criticism of the Interstate Commerce Commission is particularly
directed.
Commissioner Prouty calls attention to the vast increase of
capitalization. During the nine years beginning July 1, 1903, the
capital of the New York, New Haven & Hartford Railroad Company
itself increased from $93,000,000 to about $417,000,000 (excluding
premiums). That fact alone would not convict the management of
reckless financiering; but the fact that so little of the new capital
was represented by stock might well raise a question as to its
conservativeness. For the indebtedness (including guaranties) was
increased over twenty times (from about $14,000,000 to $300,000,000),
while the stock outstanding in the hands of the public was not doubled
($80,000,000 to $158,000,000). Still, in these days of large things,
even such growth of corporate liabilities might be consistent with
“safe and sane management.”
But what can be said in defense of the financial judgment of the
banker-management under which these two railroads find themselves
confronted, in the fateful year 1913, with a most disquieting floating
indebtedness? On March 31, the New Haven had outstanding $43,000,000 in
short-time notes; the Boston & Maine had then outstanding $24,500,000,
which have been increased since to $27,000,000; and additional notes
have been issued by several of its subsidiary lines. Mainly to meet its
share of these loans, the New Haven, which before its great expansion
could sell at par 3 1/2 per cent. bonds convertible into stock at
$150 a share, was so eager to issue at par $67,500,000 of its 6 per
cent. 20-year bonds convertible into stock as to agree to pay J. P.
Morgan & Co. a 2 1/2 per cent. underwriting commission. True, money was
“tight” then. But is it not very bad financiering to be so unprepared
for the “tight” money market which had been long expected? Indeed, the
New Haven’s management, particularly, ought to have avoided such an
error; for it committed a similar one in the “tight” money market of
1907–1908, when it had to sell at par $39,000,000 of its 6 per cent.
40-year bonds.
These huge short-time borrowings of the System were not due to
unexpected emergencies or to their monetary conditions. They were of
gradual growth. On June 30, 1910, the two companies owed in short-term
notes only $10,180,364; by June 30, 1911, the amount had grown to
$30,759,959; by June 30, 1912, to $45,395,000; and in 1913 to over
$70,000,000. Of course the rate of interest on the loans increased
also very largely. And these loans were incurred unnecessarily. They
represent, in the main, not improvements on the New Haven or on the
Boston & Maine Railroads, but money borrowed either to pay for stocks
in other companies which these companies could not afford to buy, or
to pay dividends which had not been earned.
In five years out of the last six the New Haven Railroad has, on its
own showing, paid dividends in excess of the year’s earnings; and the
annual deficits disclosed would have been much larger if proper charges
for depreciation of equipment and of steamships had been made. In
each of the last three years, during which the New Haven had absolute
control of the Boston & Maine, the latter paid out in dividends so much
in excess of earnings that before April, 1913, the surplus accumulated
in earlier years had been converted into a deficit.
Surely these facts show, at least, an extraordinary lack of financial
prudence.
WHY BANKER-MANAGEMENT FAILED
Now, how can the failure of the banker-management of the New Haven be
explained?
A few have questioned the ability; a few the integrity of the bankers.
Commissioner Prouty attributed the mistakes made to the Company’s
pursuit of a transportation monopoly.
“The reason,” says he, “is as apparent as the fact itself. The present
management of that Company started out with the purpose of controlling
the transportation facilities of New England. In the accomplishment of
that purpose it bought what must be had and paid what must be paid. To
this purpose and its attempted execution can be traced every one of
these financial misfortunes and derelictions.”
But it still remains to find the cause of the bad judgment exercised
by the eminent banker-management in entering upon and in carrying out
the policy of monopoly. For there were as grave errors in the execution
of the policy of monopoly as in its adoption. Indeed, it was the
aggregation of important errors of detail which compelled first the
reduction, then the passing of dividends and which ultimately impaired
the Company’s credit.
The failure of the banker-management of the New Haven cannot be
explained as the shortcomings of individuals. The failure was not
accidental. It was not exceptional. It was the natural result of
confusing the functions of banker and business man.
UNDIVIDED LOYALTY
The banker should be detached from the business for which he performs
the banking service. This detachment is desirable, in the first
place, in order to avoid conflict of interest. The relation of
banker-directors to corporations which they finance has been a subject
of just criticism. Their conflicting interests necessarily prevent
single-minded devotion to the corporation. When a banker-director of a
railroad decides as railroad man that it shall issue securities, and
then sells them to himself as banker, fixing the price at which they
are to be taken, there is necessarily grave danger that the interests
of the railroad may suffer--suffer both through issuing of securities
which ought not to be issued, and from selling them at a price less
favorable to the company than should have been obtained. For it is
ordinarily impossible for a banker-director to judge impartially
between the corporation and himself. Even if he succeeded in being
impartial, the relation would not conduce to the best interests of
the company. The best bargains are made when buyer and seller are
represented by different persons.
DETACHMENT AN ESSENTIAL
But the objection to banker-management does not rest wholly, or perhaps
mainly, upon the importance of avoiding divided loyalty. A complete
detachment of the banker from the corporation is necessary in order to
secure for the railroad the benefit of the clearest financial judgment;
for the banker’s judgment will be necessarily clouded by participation
in the management or by ultimate responsibility for the policy actually
pursued. It is _outside_ financial advice which the railroad needs.
Long ago it was recognized that “a man who is his own lawyer has a
fool for a client.” The essential reason for this is that soundness
of judgment is easily obscured by self-interest. Similarly, it is not
the proper function of the banker to construct, purchase, or operate
railroads, or to engage in industrial enterprises. The proper function
of the banker is to give to or to withhold credit from other concerns;
to purchase or to refuse to purchase securities from other concerns;
and to sell securities to other customers. The proper exercise of
this function demands that the banker should be wholly detached from
the concern whose credit or securities are under consideration.
His decision to grant or to withhold credit, to purchase or not to
purchase securities, involves passing judgment on the efficiency of
the management or the soundness of the enterprise; and he ought not
to occupy a position where in so doing he is passing judgment on
himself. Of course detachment does not imply lack of knowledge. The
banker should act only with full knowledge, just as a lawyer should act
only with full knowledge. The banker who undertakes to make loans to
or purchase securities from a railroad for sale to his other customers
ought to have as full knowledge of its affairs as does its legal
adviser. But the banker should not be, in any sense, his own client. He
should not, in the capacity of banker, pass judgment upon the wisdom of
his own plans or acts as railroad man.
Such a detached attitude on the part of the banker is demanded also
in the interest of his other customers--the purchasers of corporate
securities. The investment banker stands toward a large part of his
customers in a position of trust, which should be fully recognized.
The small investors, particularly the women, who are holding an
ever-increasing proportion of our corporate securities, commonly
buy on the recommendation of their bankers. The small investors do
not, and in most cases cannot, ascertain for themselves the facts on
which to base a proper judgment as to the soundness of securities
offered. And even if these investors were furnished with the facts,
they lack the business experience essential to forming a proper
judgment. Such investors need and are entitled to have the bankers’
advice, and obviously their unbiased advice; and the advice cannot be
unbiased where the banker, as part of the corporation’s management, has
participated in the creation of the securities which are the subject of
sale to the investor.
Is it conceivable that the great house of Morgan would have aided in
providing the New Haven with the hundreds of millions so unwisely
expended, if its judgment had not been clouded by participation in the
New Haven’s management?