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Business failure, judicial intervention, and financial innovation: restructuring U.S. railroads in the nineteenth century.

Business historians have focused on the American railroads as sources of innovation. Alfred D. Chandler, Jr., for instance, has given due credit to the railroads for the invention of modern corporate finance, management, and labor relations practices.(1) Also, thanks to financial historians such as Vincent Carosso, we have come to know much about the symbiotic relationship between the railroads and American investment banking firms, most notably the House of Morgan.(2)

Recently, the role of investment banks in the development of American industry has been a subject of renewed interest among financial economists. J. Bradford De Long, for example, has asked whether the presence of J. P. Morgan or his associates on corporate boards added value to the common stock issued by railroads and other firms. He concludes that it could raise common stock prices by as much as 30% in the era before World War I. Likewise, Carlos Ramirez has argued that Morgan's influence might have lowered the cost of financial capital, thereby inducing firms to enter capital markets instead of using their own earnings to fund expansion.(3)

Along similar lines, this paper seeks to use microeconomic theory and empirical analysis to explain a class of financial innovations that arose in the United States during the late nineteenth century. While at least one present-day scholar has argued that "no period in recorded history" has produced as many financial innovations as the 1970s and 1980s, a close inspection of the late 1800s reveals a period of rapid change in financial contracting.(4) In particular, the American railroad industry pioneered the use of new kinds of securities and new means of corporate governance, including preferred stocks, income bonds, deferred coupon debt instruments, bond covenants, and voting trusts.

In this article, I argue that the form and timing of these innovations were influenced by the financial distress experienced by many railroads in the late nineteenth century. The late nineteenth century witnessed years of exceptional distress, with as much as one-fifth of the nation's railroad mileage in the hands of court-appointed receivers. To resolve the economic ills of the railroad industry, there were creative responses by both public and private parties. Public parties the courts - changed the rules of the game by modifying existing security contracts, and private parties - the investment bankers like J. P. Morgan - established new security contracts and governance structures.

The railroads fell into distress so often because they had exceptionally high fixed costs while facing bitter competition in many regions of the country.(5) The bankers who were called upon to draft reorganization plans for bankrupt railroad firms had to solve two practical problems. First, in the short term, the failed roads needed to raise a substantial amount of cash in order to continue running. Second, in the long term, they needed new capital structures, along with more stable and accountable systems of corporate governance, which together would reduce the likelihood that the railroad would fail again.

Economic theory suggests that solving these two basic problems would be inherently complicated, for a variety of reasons. First, the terms of debt contracts which existed prior to default made new investors reluctant to contribute funds to the distressed firm. Economists refer to this problem as "debt overhang." Second, raising new funds from outside investors was difficult owing to the large disparities, or asymmetries, in the information held by more and less knowledgeable investors.(6) Third, reorganizations were subject to heavy transactions costs, in the form of fees charged by investment bankers for taking charge of reorganizations and issuing new securities. Fourth, the reorganization negotiations among existing claimants were complicated by the possibility of hold-outs among the existing claimants. Fifth, the success of a reorganization plan might depend on whether potential conflicts of interest between managers and investors could be overcome through closer monitoring and control of corporate actions.

As we will see in Part I of the paper, the federal courts played a critical role in addressing many of these issues, but especially the debt overhang and hold-out problems. In order to keep the nation's railroads moving, judges intervened in the private contracting process by redefining the terms of existing security contracts, thereby allowing firms to raise short-term capital. Specifically, the courts gave firms permission to issue receivership certificates, which legally superseded even the most senior existing claims.

The courts overcame many potential conflicts in the negotiations among existing claimants by establishing the process of equity receivership, the key component of which was the setting of upset values that limited the negotiating power of junior claimants. Through this process, bankers like Morgan could coerce junior claimants to provide new cash in the form of assessments to finance distressed railroads, thereby allowing firms to solve the hold-out problem and avoid having to raise funds from new investors. This point is consistent with the historian Albro Martin's argument that the receivership process, in particular so-called "friendly receiverships," strengthened the hand of railroad managers and their investment bankers - as opposed to the individual investors - in reorganizing distressed firms.(7) In a book that treats this same subject, the political scientist Gerald Berk argues that the rules of equity receivership were established by judges to satisfy ideological rather than specifically economic goals. He argues that the judges' main goal was to foster the continued development of the nation's railroads as a nationally integrated system.(8)

This paper addresses a narrower set of questions: From the perspective of investors, were the rules of equity receivership historically necessary to resolve the financial problems of distressed railroads? And, how did investors respond to these rules in the type of contracts they wrote?

Although the rules of equity receivership allowed distressed railroads to solve their short-term cash problems, the long-term problem of firm stability and effective governance by investors required more than court intervention. Part II of the paper argues that the private responses to railroad distress were embodied in innovations in financial contracting - especially contingent-charge securities, deferred charge securities, and voting trusts. The form of these innovations suggests that investment bankers who designed the securities sought to reduce the likelihood of reorganized roads' falling back into distress. By designing new contracts that reduced the financial constraints on firms, yet increased the ability of investors to monitor the actions of the firms through voting trusts, bankers like Morgan mediated the information asymmetries which existed in the market for railroad securities. The pattern of adoption of these financial innovations strongly suggests that they were a direct response to the distress of the railroads.

The rules of equity receivership solved the railroads' immediate needs, but caused problems for investors. In Part III of the article, I argue that judicial intervention not only revealed new uncertainty in how private contracts might be upheld in the courts, but more specifically, the courts emasculated the traditional corporate bond relative to what had been "weaker" security contracts. Therefore, one can offer a second explanation of the form and timing of the financial innovations in the late nineteenth century: these new contracting devices can be seen as a means to reduce the need for judicial involvement, and to substitute ex ante monitoring for ex post settling-up. Because financial distress and judicial intervention went hand-in-hand in this period, we cannot disentangle these complementary explanations for the innovation of the period.

It is a rewarding, though daunting, task for scholars to understand how financial innovation is a response to "hold out" or "debt overhang" problems by a cast of characters including federal judges, investment bankers, and relatively unknown investors. Often scholars observe an outcome, in this case financial innovation, and depending on their prior training, they each use their own frames of reference to understand the causes of this outcome. To gain an understanding of the phenomenon, an economist might study an institution-free model, a legal historian might carefully examine the language in particular ruling, and a business historian might search through company records or the memoirs of famous financiers. The "truth" reflects all of these points of view.

For economists, the history of nineteenth century railroad reorganizations reveals how a shock to an economic system can gave rise to inter-dependent creative responses. In the case of late nineteenth-century railroads, these responses took place both at the public level by the courts, and at the private level by bankers, who designed security contracts. These two reactions are related by what modern finance theorists have dubbed the "innovation spiral," whereby one innovation begets a series of others.(9) Here, endogenous judicial innovations in turn affected private contracting in railroad securities. Modern theory suggests that all economic systems share this dynamism, with changes in regulations, technologies, or risk factors giving rise to new innovations.(10) In more recent times, we have seen government policy choices lead to high volatility in exchange rates and interest rates, which have spread to the development of derivative instruments for the control of these risks.(11)

For historians, the history of railroad receiverships directly affects the larger understanding of the emergence of big business in the United States. Just as the railroads can be credited with innovating many tools of modern management, they also played an important role in innovating many capital-market instruments. By applying the lens of economic analysis to the history of the railroads, we can reinterpret the actions of investment banks or the jurists of the day as economic responses to fundamental economic problems.

I. Fundamental Problems in Raising Cash for Distressed Railroads

Prior to the 1850s, common stock had provided much and sometimes all of the railroad capitalization in the United States. Bonds had been issued only with reluctance, largely because they usually carried a strict lien on the real property of the road in the form of a mortgage.(12) But rapid expansion in the late nineteenth century forced the railroads to raise more and more capital through debt, as shown in Table 1. When faced with economic downturns, railroads often had insufficient resources to pay the interest required on their bonds. In theory, the distressed railroads could have liquidated, but there was usually a consensus that most railroads were worth more as on going entities than their liquidation value.(13) In any case, distressed railroads were in desperate need of cash, not only to pay off creditors, but also to meet current expenses and to fund new capital investments. Yet, distressed firms would face inherent problems in raising cash.
Table 1

Dollar Increase in Stocks and Bonds Issued
by U.S. Railroads, 1875-1895

                 Stocks       Bonds      Ratio of Bonds to
               (million)   (million)        Stocks (%)

1875-1879       $  405       $  250                62
1880-1884        1,367        1,350                99
1885-1889          733        1,159               158
1890-1895          687          813               118

Source: Poor's Bureau of Information and Investigation, Poor's
Manual of Railroads (New York, 1900), 1vii. Stocks include common
and preferred shares. Bonds include all indebtedness. These figures
reflect increases in the book values of all these securities issued
by the entire railroad industry.


Debt Overhang: The Problem of Raising Short-Term Cash from Any Investors

In theory, when a distressed firm has a significant overhang of prior senior debt claims, new lenders will be especially unwilling to take subordinate claims in a risky firm. This reluctance stems from the strong legal rights of existing senior lenders.(14)

A capital contribution to a distressed firm will serve to strengthen the economic claim of the most senior debt in the firm. The cash, in effect, is a reserve which makes these lenders' claims less risky. For example, suppose that new cash was received, only to be paid out to the most senior claimants. There would be no value creation inside the firm, merely a redistribution of value to these senior creditors. Because the most senior claimants have preferred claims against the assets of the firm, they would be better off with the cash infusion, even were it not paid out. As a result, whenever the incremental value of new capital is absorbed by senior claimants, no investor will be willing to make the capital contribution as a junior claimant.

Senior lenders have little incentive to voluntarily weaken their claims in favor of subordinate lenders. Especially in cases involving multiple senior lenders, no single senior claimant is likely to step forward to accept a more junior position. Nor are individual senior lenders likely to accept a reduction in rights unless they are well compensated for any concessions made. Finally, the negotiations surrounding such private recontracting efforts might well be very slow, and are made even more difficult by the fact that the courts might subsequently invalidate the transaction.

To break this logjam and free up short-term credit, the courts intervened directly in many late nineteenth-century railroad reorganizations by substantially redefining the claims of senior debt holders. The courts permitted receivers to issue short-term notes called receivers' certificates, by which the railroad borrowed from investors against the credit of the "whole estate" of the railroad. One of the first mentions of these supersenior borrowings, comparable to today's debtor-in-possession (DIP) financing, came in a case in Alabama in 1872.(15) The practice spread gradually, and in the late 1880s and thereafter, receivers' certificates became a routine form of interim financing for failed railroads.(16) Receivers' certificates were a means to raise cash quickly to meet the distressed railroad's immediate needs, but they did not solve the railroad's need for long-term capital.

While receivers' certificates were private obligations of the firm, they were judicially-sanctioned contracts. Thus, in the panoply of legal contracts, receivers' certificates were considered the most senior and secure of contracts, holding what one observer at the time called "an impregnable position."(17) Receivers' certificates were unique insofar as they took precedence over prior contractual obligations of the firm, including senior mortgages. A contemporary jurist noted that "the subject of receivers' certificates derives its importance, not merely from the large investments represented by them, but from a legal standpoint it becomes also highly important in that the priority given to them is apparently a violation of the established principles of the law of liens."(18)

Receivers' certificates were an effective means whereby the courts enabled distressed firms to raise cash immediately from outside investors. With the guarantee that their claims would be senior above virtually all others, investors in receivers' certificates were no longer troubled with the problem of debt overhang. On the other hand, the fact that senior claims could be weakened in times of distress was itself a serious problem for railroad seeking to attract long-term capital.

Problems in Raising New Capital from Outside Investors

In raising cash from new investors, there were two fundamental problems: information asymmetries and transaction costs. The former refers to differences in the information and knowledge of the various parties involved in the investment process. New investors, or outsiders, naturally have a different set of information from that available to corporate insiders or their close financial advisors. The result is the classic "lemons problem,"(19) in which the price of a used car has to be discounted heavily because of the buyer's fear of acquiring a lemon. In the case of a distressed firm, it may be especially difficult for outsiders to ascertain whether the firm's problems are the result of temporary bad luck, or of poor management decisions that are likely to be repeated.

Apart from investors' natural bias against a distressed firm, raising funds from outside investors is problematic because of high transaction costs. Transaction costs can take many forms. In the simplest expression, they reflect the expense involved in identifying potential investors, making presentations to them, and executing the paperwork necessary to create legal contracts. Steep transaction costs also are likely to arise when a firm sells assets to raise cash.

In theory, when an entire industry is plagued by financial distress, the combination of information asymmetries plus transaction costs is likely to raise the cost of new capital to prohibitive levels.(20) Firms may be able to sell assets only at fire-sale prices, or in some cases funds might be unavailable altogether. This was the kind of situation facing many distressed railroads in the late nineteenth century. In the 1870's, the distressed Erie Railroad sold 7% bonds at a 47.5% discount.(21) Investors apparently demanded an effective interest rate of 13.3% when "average" railroad bonds yielded 7.6%. Other firms approaching distress, such as the Philadelphia & Reading Railroad, could find willing lenders at no price.(22)

Holdouts and Transaction Costs - Problems Raising Capital from Inside Investors

The alternative to raising money from new investors was to seek additional financing from the existing investors of the distressed railroad. Yet, in negotiations among existing claimants, individual creditors had little incentive to contribute new funds voluntarily. Instead they generally preferred to wait for other investors to voluntarily contribute first. By threatening to hold out, and thereby hold-up the reorganization, a claimant could seek to be "bought out" by the majority. Among other things, this kind of squabbling could lead to sizable transaction costs. Nineteenth-century journalists described this kind of situation as "a maze of legal proceedings which are clear as to nothing except that they consume costs and time."(23)

In recent times, theory and empirical research have suggested that hold-out problems may be particularly acute for firms with large numbers of claimants, especially when smaller creditors can effectively stand in the way of the successful restructuring of a bankrupt firm.(24) This may have been the case in the late 1800s, a time when railroads commonly issued dozens of different mortgage bonds, each secured by specific portions of track, terminals, or rolling stock. Nineteenth-century observers recognized the potential obstruction and extortion that could be inflicted by hold-outs ("dissenters"). Judges overseeing railroad reorganizations were concerned that "a dissenter be not permitted to create a maneuvering value in his bonds by opposing confirmation."(25)

If raising funds from existing investors were to be feasible, this hold-out problem had to be solved. The solution lay in the process of equity receivership, and in particular the use of "upset values." This was a judicial invention that could be used to coerce junior claimants to refinance the distressed railroad and thus avoid having to rely on new investors for funds.

Before the equity receivership process was instituted, the legal resolution of financial distress for large corporations was quite unsettled. Congress passed its first Bankruptcy Act in 1800, but repealed it within three years. Four decades later, in 1841, a new Bankruptcy Act was passed, only to be repealed within eighteen months. After the Civil War, the Bankruptcy Act of 1867 was passed, but was repealed in 1878. Each of these three acts established procedures for bankruptcies of individuals and merchants, but not for large corporate enterprises. Despite the magnitude of business failure plaguing the economy in general and the railroad industry in particular, until the passage of the 1898 Bankruptcy Act, there was no national bankruptcy law in place for most of the nineteenth century.(26)

In the absence of statutory provisions, federal courts developed the set of rules known as equity receivership to resolve disputes arising from financial failures of the major enterprises of their day and to create a means to reorganize these firms. Figure 1 below displays the key steps involved in the equity receivership process. Once a firm defaulted on its debt obligations, a federal court would respond to a creditor's petition for relief by appointing a receiver - an interim manager - to run the firm while a reorganization plan was drafted.

The first step toward the financial restructuring of the firm was the setting up of one or more protective committees by groups of investors. Often each class of securities was represented by a separate protective committee. Negotiations then proceeded until a single reorganization committee was formed, representing, in theory, all claimants. Once established, the reorganization committee drafted a formal reorganization plan, which was submitted to the defaulting firm's security holders. These plans typically proposed a series of exchanges through which the existing security holders would surrender their claims in the old railroad in return for securities in a newly reorganized firm.

In part to protect the interests of investors dissatisfied with reorganization plans (called dissenters), in 1885 federal courts began to establish "upset prices" for each of the claims of the defaulted railroad.(27) The upset price was the amount of cash a dissenting security holder had to be paid by the assenting security holders in the event of a successful reorganization. An individual investor had to choose between assenting to the reorganization plan, that is, accepting the terms of the proposed exchange, or dissenting from the plan and receiving the cash upset value. In setting upset prices, judges explicitly traded off protecting the rights of the minority (the dissenters) against their desire to ensure a successful reorganization. High upset prices would give more power to dissenters but would make a successful reorganization less likely. But judges in fact usually set upset values quite low, and this was a major factor in successful reorganizations.

If the investors responded favorably to the plan, the reorganization committee was free to proceed. The legal ceremony by which a reorganization plan was ratified was called a "judicial foreclosure sale." While the title calls to mind a lively auction among many bidders, in practice, the "sale" was a mere formality. The only bidder was the reorganization committee.(28) At the "sale," the committee delivered to the court the securities of the assenting holders, along with cash sufficient to make upset payments to the dissenting holders and to pay off the expenses of the receivership. The old railroad and its old obligations then ceased to exist, a new corporate entity with a new name and new capital structure was formed, and the receiver was removed.(29) The wiping clean of old obligations played a critical role in the economics of the receivership process.

In addition to exchanging old securities for new ones, reorganization plans typically demanded of securities holders a cash payment called an "assessment."(30) Funds raised by assessing existing claimants helped newly reorganized railroads to pay off non-assenting security-holders and holders of receivers' certificates. Assessments were also used to fund new capital expenditures on the reorganized railroad. While assessments on security holders were used to raise funds as early as 1862, they came to be used extensively in financing the reorganizations of the 1880s and especially the 1890s.(31) One observer reported that during the 1890's, eleven of fourteen of the major railroad reorganizations assessed security holders to raise funds.(32) Poor's Bureau reported that $96 million in new funds were raised through assessments by 37 of the 57 railroad reorganized in the 1880s and 1890s.(33)

Table 2 gives the terms of one such reorganization plan, in simplified form:
Table 2

A Reorganization Proposal from the 1890s

In exchange for:            Old holder receives:

One old common share +      $50 (face value) of 4% bonds +
$50 assessment in cash      $75 (par value) common stock.

One old preferred share +   $50 (face value) of 4% bonds +
$50 assessment in cash      $100 (par value) common stock.

                            $500 (face value) 4% bond +
One old 5% junior bond      $500 (par value) preferred stock with
($1,000 face value)         6% dividend.

One first mortgage bond     One $1,000 face value first mortgage
($1,000 face value)         bond with same terms as old bond.

Source: W. Hastings Lyon, Corporation Finance, 275-287.


In this example, the former common and preferred share holders were assessed $50 per share, but the senior bond claimants paid no cash assessment. This pattern was the norm: of the $96 million paid in assessments by security holders of railroads, $87 million came existing stockholders (common and preferred), and $9 million from bondholders.(34)

Conceptually, the reorganization plan was the outcome of a negotiation among private parties. In such a negotiation, each party's bargaining leverage is a function of its stake in the firm and its ability to control the process. What upset values did was to establish the bargaining power of each class of security holders. A party's bargaining power can be thought of as the upset value divided by the "true" value of its claims. If the ratio is high, a party can credibly threaten to obstruct the plan, and walk away with the upset value. If this ratio is low, the security holder's threat is less credible, because his departure would not be in his own best interest.

A hypothetical example can clarify how the imposition of upset prices could solve the hold-out problem and motivate junior claimants to invest in the reorganized railroad. Suppose an investor has a share of common stock with a market value of $40, and the court sets its upset value at $10. The reorganization committee proposes that the claimant pay $29 in cash (an "assessment") and receive a claim in the new firm worth $40. The claimant has two choices: accept the $10 cash upset value, or net $11 by paying an assessment of $29 and receiving the new claim. Claimants must pay $29 in cash to effectively continue to hold the claim with a market value of $40. They cannot credibly hold out, or else they end up worse off. Put another way, in the example, the investor gives up a $40 market value claim plus $29 in cash to receive a $40 claim. It is the destruction of prior claims at the end of the reorganization process, along with the deliberately setting of upset values, that effectively makes the $40 claim suddenly worth only $10, its cash upset value. Thus, court actions made "compulsory" assessments feasible and thereby created "one of the most useful tools of the majority for forcing recalcitrants into line."(35)

In the example above, the equity holder's bargaining power is particularly weak because the upset value is set as only one-fourth of the "true" value of its claims.(36) Junior claimants would therefore be most "assessable" because their bargaining position was the weakest. With upset values set equal to or near zero, junior claimants effectively could either pay the assessment and continue to invest, or take a complete capital loss.(37) Senior claimants with higher upset values could more credibly demand cash, and were less likely to be assessed.

The existence of four competing legal theories of upset values gave judges great latitude in setting the actual prices. Upset prices could reflect scrap values, on-going value, a purely "nominal value," or the "highest figure which will permit the reorganization to succeed."(38) In practice, courts leaned toward low upset values.(39) Weiner reports evidence that upset values typically ranged from 10% to 80% of the traded market value of the claims.(40) Thus, low upset values probably played a key role in forcing junior claimants to accept the terms of reorganization plans, as they gave all parties strong incentives to make the voluntary plan work.
Table 3

Returns to Paying Assessments, 1893-1898

                                    Price Six
                   Assessment      Months After    Annualized
                      Paid          Assessment      Return

Atchison             $10.00            $13.13          72%
B & O                 20.00             56.75         705
Erie                  12.00             14.13          39
N. Pacific            15.00             13.25         -22
Reading               20.00             22.25          24
Richmond              10.00             11.38          29
E. Tennessee           7.20              6.20          26
Union Pacific         15.00             20.00          78

Average               13.65             19.63         107

Source: Stuart Daggett, Railroad Reorganization, 353. In each of
these cases, former common stock was valued as worthless and the
holders were entitled to no cash settlements. Common stock holders
paid assessments and received shares in the reorganized firm. The
final column shows the annualized return from paying the assessment
and selling the new stock after six months.


In order to understand whether courts set relatively lower upset values for junior claimants than senior claimants, we would need court records which are, to date, not available. However, one implication of the argument is that investors who paid the cash assessment and received the new securities should have enjoyed attractive returns. Indeed, a study by Daggett, summarized in Table 3, shows that the average holder earned a 107% annualized return from paying an assessment and holding the security for six months.(41)

Additional evidence that assessments were positive net present value investments lies in the fact that unsecured creditors who were not offered the right to pay assessments and participate in the reorganization sued to gain this right.(42)

The explanation above suggests that the legal system, embodied in the rules of equity receivership and upset values, was the primary means by which senior bondholders could force junior claimants to invest new cash in the enterprise. However, from a historical perspective, this contention raises a number of questions: Where did judges get the information on which to base their valuations? Upon whose advice did they rely? Unlike later public utility valuation in rate and eminent-domain cases, courts did not have access to "voluminous engineering appraisals" or "extremely lengthy and technical hearings."(43) There is some anecdotal evidence that reorganization committees provided considerable advice and counsel to judges:

If we look at the upset price from the point of view of the reorganization committee we see that [it] has an idea of how much money can be raised by the plan and inferentially how much can be spared for dissenting bondholders. A figure strikingly in excess of that . . . will seriously jeopardize the reorganization. This consideration has been urged upon the courts and urged successfully, if we are to judge by what they have done in the past two decades.(44)

Thus, in many cases reorganization committees may have been able to influence the courts in the setting of upset prices. By encouraging the courts to set lower upset values, they could all but force the railroad's investors to the negotiation table. There they would face bankers like J.P. Morgan and his partners, Samuel Spencer and Charles Coster, who brought superior financial acumen to each step of the process.(45) Also, while in theory there could be more than one reorganization committee, such competition was relatively infrequent. In most cases, if only a minority of investors were dissatisfied with reorganization plan, they had little real choice but to accept its terms.(46) At the negotiating table, the weak position of the junior claimants allowed the reorganization committee to force them to exchange cash for new claims upon the firm. While much of the history of railroad reorganizations focuses on these financiers, understanding how the minutiae of the reorganization process empowered them is a subtle but important point.

II. Restructuring Distressed Railroads

Cash infusions, facilitated by the structure of legal rules, were only part of the solution to the ills of the railroad industry. Long-run solutions would also require more fundamental restructuring of the companies' liabilities and their governance structures, so as to make future distress less likely. The innovations that would address these issues were the results of the actions of private parties rather than of the courts.

Current theory and empirical research suggest that distress not only leads to a siphoning off of value in direct costs (lawyers, court fees) but also to the deterioration of value of the business franchise. The divided attention of managers, competitive exploitation by rivals, or uneasiness of outside suppliers to deal with the firm all come into play.(47)

One way to stave off future distress is to reduce the constraints under which the firm operates by lowering its required cash payments. Recent research shows that distressed firms that fail to substantially alter their capital structures (reduce debt) are substantially more likely to experience subsequent bankruptcy than those that do not.(48) Nineteenth-century bankers appreciated this fact, and one important goal of reorganizations was to reduce fixed financial charges so as to make distress less imminent. At a very simple level, we can interpret many of the financial innovations popularized in conjunction with railroad reorganizations as serving to reduce fixed charges, and thereby make distress less likely.

The reduction in fixed charges is a relatively mechanical solution to the problems of distressed railroads. However, if distress was the product of poor management, a more fundamental solution would be needed. During the wave of railroad distress in the 1890s, it was clear to most observers that something would also have to be done about the often dismal record of many railroad managements. These issues have featured prominently in a great many railroad histories, including the works of Maury Klein and John F. Stover.(49)

The court-instituted equity receivership process by itself did little to address this problem. Courts routinely appointed the managers of defaulted railroads as their receiver. In over 90% of receiverships from 1867 to 1897, existing railroad managers were appointed receivers. One study of 150 receiverships found that courts appointed as receivers 80 presidents of the distressed firm, 25 former general managers, 17 former superintendents, and 16 vice-presidents.(50) Once appointed, the receiver served for an average of two or three years, but on one occasion for as long as 29 years.(51) In addition to managing the day-to-day operations of the firm, receivers were legally empowered to break leases and contracts, to withhold interest payments due existing creditors, and, as we saw above in the case of receivers' certificates, to obtain interim financing to keep the distressed railroad running.

Reducing Fixed Charges through Financial Innovation

Innovations aimed at lowering fixed charges took a variety of forms. Some, like deferred coupon debt, merely lowered the periodic cash payments called for by bonds, sometimes by lengthening the term of the contract. Others, such as contingent-charge securities, were innovations that lay between bonds and stocks, which changed the legal requirements to pay cash periodically. These two innovations, especially the contingent-charge securities, were popularized in conjunction with their use in railroad reorganizations.

Deferred Coupon Debt. The railroad reorganizations of the 1880s and 1890s led to the widespread use of three new types of deferred coupon debt. While these instruments had a typical "bond" structure, the level of their periodic coupon payments was lower than that for normal bonds. First, with "adjustment bonds," existing bondholders in reorganizations accepted temporary reductions in interest with the coupon rate stepping up over time as the firm was expected to regain its financial strength.(52) Second, reorganizers often paid interest on existing bonds with additional bonds (similar to today's pay-in-kind bonds). For example, the Erie Railway reorganization of 1875 paid interest on junior bonds by issuing the holders new 7% bonds. This method became common in railroad reorganizations of the 1870s and 1880s.(53) Third, reorganizations occasionally issued bonds with an extremely long maturity - often exceeding 100 years - but low interest rates. Some low-interest, long-maturity bonds were issued in conjunction with the railroad reorganizations of the 1880s, and the method was popularized by reorganizations of the 1890s.(54) A century later, in the 1980s, instruments identical to these were used to finance a large fraction of the financial needs of firms that found themselves strapped for finances.(55)

For many nineteenth-century railroads, deferred-interest securities reduced cash interest payments, preventing a rapid return to default. In return, the investors of these instruments - former senior creditors who accepted the instruments in exchanges - appear to have locked in long-term investments which were perceived to be attractive at the time. It was said, for instance, that

Reorganization mortgages . . . tend to be large mortgages at a lessened rate of interest. They are also blanket mortgages with an inferior lien. Some inducement besides the compulsion of necessity is useful in securing the assent of old bondholders to the proposed exchanges of these bonds for outstanding securities. The long-term bond protects the holder against the probable steady fall in the rate of interest on capital. It promises him advantage in the future in return for surrender in the present.(56)

Contingent-charge Securities. While deferred-interest debt changed the level of periodic cash payments, contingent-charge securities changed the legal status of these payments. Contingent- charge securities permitted annual cash servicing to be skipped completely without giving rise to default/and court intervention. Hence, their charges were not fixed, but rather contingent on some future outcome.

These instruments took two forms: income bonds and preferred stock. With income bonds, the contingency was accounting-based, which meant that the requirement to pay interest was based directly on the earnings of the firm. Preferred stocks paid dividends at the discretion of management. Failure to pay preferred dividends typically did not bring about court intervention, although the drafters of the contract usually included other legal provisions to protect holders rights out of court.

Preferred stocks could take a variety of forms, but in general their dividends were paid prior to any common stock dividends - hence the term "preferred." In essence, these securities were hybrids; like bonds they had limited upside returns, but like stocks they offered no guarantee of dividend payments. By surrendering the right to push a company into default, the holders of these securities gave up one way to protect their interests.

While predecessors of preferred stock had been "invented" as early as 1698, the innovation of modern preferred stock was popularized in American corporate finance in conjunction with railroad reorganizations.(57) By aggressively using innovative securities like preferred [TABULAR DATA FOR TABLE 4 OMITTED] stocks, income bonds, and deferred coupon debt, reorganized railroads substantially reduced their fixed financial charges. Table 4 shows the combined results of 57 major railroad reorganizations between 1894 and 1899. Together, these roads substantially reduced not only the absolute level of their debt, but also the annual interest charges on the debt and the level of indebtedness relative to fixed assets. For the railroads included in this sample, post-reorganization earnings could drop 35% from the level that would have caused default prior to reorganization without triggering default.

The Timing of Financial Innovations

If contingent-charge securities were a response to the failure of the railroads, we should expect to observe a direct correlation between their rate of adoption and the severe business cycles which affected the industry in the late nineteenth century. This proposition can be tested empirically by looking at which railroads adopted contingent- charge securities, and when they adopted them. We would expect that this innovation would be adopted first by railroads experiencing distress, and then more widely diffused among other firms. We see this pattern in the data.

Figure 2 plots the mileage of U.S. railroads that defaulted on debt obligations and were in equity receivership in the years listed. From it, we can see that throughout the late nineteenth century, the American economy - and especially the railroads - experienced waves of business failure with an intensity matching any more recent experience, with peaks in each of the last three decades of the nineteenth century. Both large and small railroads failed. Poor's Manual lists 517 railroads that defaulted on debt obligations and came under the court-appointed process of receivership in the period 1884 to 1900.(58) The average defaulted railroad owned 152 miles of road, ranging from 3 miles for the Gunpowder Valley to 4,438 miles for the Atchison, Topeka and Santa Fe.

If innovation was intimately associated with the pattern of financial innovation, we should see rapid adoption of contingent-charge securities around peak periods of railroad distress. Furthermore, we should see the most immediate responses by railroads in financial difficulty, with a later and slower response by other railroads.

This hypothesis is tested empirically here, using data summarized in the appendix. Two separate questions are addressed: (a) whether railroads made greater use of contingent-charge securities when they emerged from rather than entered distress, and (b) whether distressed railroads adopted these instruments earlier than other railroads did.

To test the first of these propositions, a study was made of three samples of railroads that failed and were reorganized in each of the three peaks of railroad distress in the 1870s, 1880s, and 1890s. The railroads' balance sheets (in book values) were examined at common points in time prior to entering receivership and subsequent to exiting receivership. For example, the 1870s "distressed" sample includes fifteen railroads that fell into difficulty from 1873 through 1875. The 1872 balance sheets of these railroads, before the first of any of their defaults, were compared to their 1882 balance sheets, after the last of all of their reorganizations.

To test if contingent-charge securities were adopted earlier among distressed firms, a control group of railroads was compared to a sample of distressed firms during given periods of time. For the 1880s and 1890s, the comparison set is the aggregate balance sheet for all railroads, as taken from the Interstate Commerce Commission's Statistics of Railways in the United States (1890, 1900) and the U.S. Department of the Interior, Bureau of the Census' Report on the Agencies of Transportation in the United States (1883). As aggregate data is not available for the 1870s, the comparison sample for that period is a matched sample of railroads that mirrors the distressed railroads in mileage, geography and organizational form, but which did not default on debt obligations in the 1870s. The appendix describes the relevant samples and provides summaries of the balance sheet comparisons, which are displayed graphically in Figure 3.

Figure 3 confirms that railroads used more contingent-charge securities upon leaving, rather than entering, distress. For railroads defaulting in the 1870s, less than 8% of their capital structure consisted of contingent-charge securities in 1872 prior to entering distress. In 1882, after all of the fifteen railroads had been reorganized, contingent-charge securities accounted for over 25% of their capital structure. This pattern, of firms substantially increasing their use of contingent-charge securities after leaving reorganization, is consistent for each of the samples of failed firms studied.

By comparing the failed railroads with the control samples, we can contrast the rate at which distressed firms adopted contingent-charge securities with the rate at which non-distressed firms adopted them. For example, in the 1870s, while distressed railroads boosted their use of contingent-charge securities from 7.8% to 25.3%, a matched sample of railroads increased their usage of these securities from only 1.1% to 2.4%. While railroads generally increased their use of contingent-charge securities over the final three decades of the century, troubled railroads adopted contingent-charge securities earlier.

Over time, however, this disparity in adoption rates between distressed firms and comparable railroads narrowed considerably. The appendix also includes data on distressed railroad balance sheets in the midst of a downturn in the 1910s. In this later period, the balance sheets of distressed railroads entering and leaving distress look very similar to those of the average U.S. railroad. These results support the view that these innovations were adopted first and most rapidly among distressed firms, and later became more broadly diffused throughout railroads.

Improving Corporate Monitoring and Governance

Securities such as deferred-income bonds and contingent-charge obligations reduced the likelihood that a firm would default, but they did so by adversely affecting what had once been thought to be one of the most powerful fights of investors in firms: the right of senior lenders to seize the assets secured by their notes. Under such conditions, it became imperative that the problem of poor management be addressed, especially given the degree to which it was ignored by judges who appointed the old managers to serve as the receivers of the railroad. Thus, in conjunction with the financial innovations embodied in deferred-interest securities and contingent-charge securities, the nineteenth century railroad reorganizations led to basic innovations in corporate governance. In exchange for giving up the right to seize the assets of the firm, investors in the new types of securities adopted two innovations to better control and monitor the actions of management: covenants and voting trusts.

Securities Covenants. The railroad reorganizations of the 1890s produced many new covenants in securities contracts, as noted by Rodgers, Draper, Stetson, and other scholars.(59) Theory suggests that covenants can control the conflicts among security holders and give stock holders value-maximizing incentives.(60) If we look at a few of the 1890s covenant innovations, we see evidence of investors seeking direct control over firm actions, requiring that firms consult with claimants before making important decisions.

For instance, by the 1890's all reorganizations that issued preferred stock protected preferred holders "from future introduction of new bonds between them and their property.(61) In most instances, a majority of preferred holders had to approve any new issue of preferred stocks or mortgages.(62) This type of financing constraint forced managers to get explicit approval before creating new senior claims. Unless they could sell equity, managers either lived within tight cash-flow constraints or gave preferred stockholders a say in what new funds could be raised.

While not technically a covenant, innovative contracts of this period often gave investors in preferred shares exceptionally strong voting rights, under varying circumstances. Preferred stocks created in the 1890s by formerly distressed firms gave voting rights, and even some degree of control, to preferred stockholders upon failure to pay dividends. The reorganization of the Norfolk and Western Railroad is called "fairly typical" of the 1890's preferreds:

The holders of the adjustment preferred stock are to be entitled during the period of five years after the reorganization of the new company, unless three full yearly dividends of 4% per annum shall have been paid on the adjustment preferred stock before the expiration of the period, to elect two-thirds of the whole board of directors.(63)

In this case, preferred shareholders could effectively control the board unless their dividends were paid.

Voting Trusts. Of course, merely giving security holders the right to vote will not lead to better monitoring unless voters are informed, competent, and motivated. It is well known that widely dispersed shareholders will tend to be poor monitors, as each would hope to free-ride on the others' diligent oversight.(64) To create better monitors than dispersed shareholders, voting trusts were established so that monitoring would be carried out by groups of three to five professional trustees.(65) These trustees were acknowledged experts, including, most notably, J.P. Morgan and his associates. Voting trusts were typically empowered for five years, or until a firm could resume regular dividend payments following reorganization.(66) Over half of the reorganizations in the 1890s employed voting trusts and, by 1908, they had come into general use after receiverships.(67) A 1941 study reported data on 138 business trusts set up between 1864 and 1939. It concluded that:

The voting trust was first used in connection with the railroad consolidations and reorganizations between the Civil War and 1880, but not until the late eighties and nineties was it popularized by the railroad reorganizations of the period. Following 1900 trusts were commonly used in public utility and industrial reorganizations, and at times, under other circumstances, while after 1923 they were used more commonly in corporate promotions.(68)

The purpose of the voting trust was clear: to create a vigilant and active set of monitors to safeguard investors' interests. However, while voting trusts were formally initiated by shareholders, in practice they usually were more concerned with protecting bondholder interests. Cushing, a staunch supporter of voting trusts, plainly admits this purpose:

Ordinarily, the object aimed at in a voting trust has been the protection of bondholders, not indeed by actually improving in any technical manner the status of their securities, but chiefly by procuring for them such practical advantage as may arise from a well considered conduct of a corporation's affairs.(69)

By control over reorganization committees, bankers like Morgan could come to gain power over the railroads, and by voting trusts they could maintain some modicum of direct control, at least until a distressed railroad's finances were once again on solid ground.(70)

Little evidence exists concerning the degree of influence voting trusts had on decisions affecting reorganized railroads. In some cases voting trusts appeared to have exercised little control, although it is possible that trustees in such cases merely kept a low profile. For example, at the termination of the Northern Pacific trust in 1901, the Commercial and Financial Chronicle wrote,

It is rather noteworthy that the voting trustees appear to be little concerned to give prominence to their own part in the work [putting] 'this large concern on its feet.' It would be difficult to find a stronger list of names than that comprising the voting trust, it consisting of J. P. Morgan himself and of August Belmont, Charles Lanier, Johnson Livingston and Dr. Georg von Siemens.(71)

The empirical question of whether the voting trusts were effective agents of control, ex post, is beyond the scope of this paper. Although the operation of firms under the control of voting trusts has not received a great deal of attention by modern-day economists or historians, the issues they raise are intriguing. For instance, when a trustee has allegiances to both bond holders and equity holders, as J.P. Morgan had, whose interests were actually favored? Given the possibility for transfers of value between bond and stock holders, how did the voting trust structure work to mitigate these moral hazard conflicts? Is there any evidence that a governance structure beholden to all stakeholders will create more value than one beholden primarily to the interests of equityholders? For example, the De Long study cited on the first page of this article looks exclusively at the effect of Morgan and his partners on the value of the common stock of the firms on whose boards they sat. It would be equally interesting to study how the bond holders of these firms fared.

III. Private Besponses to the Redefinition of Securities Contracts

In fashioning rules to reorganize the railroads, which were the United States' largest and most strategically important industry, federal judges repeatedly invoked the "public interest" as justification for their actions. Courts held that railroads could not be shut down, liquidated, or torn apart without harming their users and the economy.(72) Viewed from the perspective of the firm, the judicial innovations embodied in the receivership process represented solutions to pressing problems. And yet, the public interest and the private interests of security claimants need not be coincident, and often were not.

Viewed from the perspective of investors, at least some of the judicial innovations surrounding equity receiverships constituted serious problems in themselves. Most serious was the degree to which courts in effect invalidated existing contracts which led to uncertainty about the efficacy of many types of private contracts. From this perspective, private security innovations can be interpreted not only as responses to the underlying problem of distress, but also to the public solutions embodied in the equity receivership process.(73)

Judicial Reinterpretation of Securities Contracts

American railroads in the late nineteenth century had relatively complex capital structures, often consisting of scores of different mortgages; but the laws which defined the rights and obligations of the parties to these security contracts were unclear. As late as 1879, legal texts made clear that American securities law had only recently come to be clarified: "Prior to the year 1860, the courts had only in a few instances been called upon to enforce Railroad Mortgages; and the cases adjudicated since 1870 are far more numerous than all that have been decided before that time."(74)

Over time, the rights of mortgage holders were defined through a series of decisions handed down in connection with specific railroad reorganizations. In total, the late nineteenth century witnessed a great deal of revising (and in most cases weakening) of existing security contracts. As noted earlier in this article, these developments included the unilateral imposition of supersenior borrowings through receivers' certificates, the abrogation of secured lenders' rights to gain possession of and sell off secured property, and the reversal of long-standing rules that gave secured lenders priority over unsecured lenders. The process of setting upset values allowed the courts to value assets quite distinctly from the ways in which the market might have valued them.

Supersenior Borrowing. As described above, the creation of receivers' certificates solved the problem of debt overhang and allowed firms to raise funds. Yet from the existing investors' perspective, the development of receivers' certificates was a contentious issue. A receiver's fight to issue supersenior claims, especially without the permission of the mortgagees, was hotly contested in the courts from at least 1872 to 1886. Among jurists, it was a highly important subject because it was not only a "violation of the established principles of the law of liens" but also "a striking example of judicial legislation."(75) As late as 1884, the financial community continued to express surprise and indignation over this development:

Prominent among the events of the week affecting investors' confidence in Wall Street values, has been the issue of receivers' certificates by the Wabash Railroad for its floating debt . . . (S)hoving in, ahead of bonds, receivers' certificates . . . is quite a new sensation to the average investor . . . (W)e fail to understand how a certificate like this could be authorized in any proceedings in which the bondholders were not actually or constructively parties.(76)

It was not until the case of Union Trust Co. v. Illinois Midland Co. 117 U.S. 435 (1886) that the U.S. Supreme Court upheld the federal courts' fight to issue receivers' certificates over the objections of bondholders. The Court ruled that bondholder "consent is desirable, but is seldom practicable." In a review of Supreme Court decisions from the 1870s and 1880s supporting receivers' certificates, Dewing writes:

It is this power of the courts . . . that jeopardizes both the spirit and the letter of railroad mortgages . . . It has been called the 'extreme limit of the most extraordinary powers of a court of chancery.' Quite so, and one might call it an unjustifiable emasculation of the substance of presumably inviolable contracts.(77)

Rights of Secured Lenders. The courts held that holders of defaulted railroad mortgages could not exercise their liens by seizing assets and then selling them to collect the proceeds. The public interest in keeping the railroads running led the courts to deny holders of railroad mortgages the fight "to have separate sales of the constituent parts as they were strictly entitled to do."(78) In 1877, a writer in the Commercial and Financial Chronicle remarked that "several years ago" investors had first learned that "bondholders have no effectual way of getting possession of the property if they wish to do so."79

Moreover, the courts enabled firms to repay debts they owed to trade creditors whose debts were legally unsecured before they made payments to mortgage holders. According to one scholar, prior to 1878 no judicial decision had failed to recognize the principle that legal rights acquired under a mortgage could not be impaired by unsecured claims.(80) In 1878, in the case of Turner v. Indianapolis Railway 8 Biss. U.S. 315 (1878), the Supreme Court held that certain classes of unsecured debts previously incurred by the railroad could be paid without regard to prior liens held by mortgage bondholders. The following year, in the landmark case of Fosdick v. Schall, 99 U.S. 235 (1879), the Supreme Court affirmed that certain unsecured creditors could indeed be repaid by the receiver before payments were made to mortgage bondholders. In Fosdick, the unsecured claimant whose payment was affirmed had supplied the railroad with railway cars.

Over the next two decades, in dozens of cases the exact types of unsecured debts that might receive priority - taxes, wages, payment for rails and railway cars, charges for connecting lines - were adjudicated. But the exact meaning of Fosdick remained murky, and judges exercised wide latitude. According to a contemporary legal observer, "The decisions of the federal circuit courts have reflected the uncertainty of the Supreme Court, and the fate of each claim has depended to quite an extent on the ideas of the judge who happened to be sitting in the case."(81) From the perspective of a holder of mortgage bonds, the Fosdick case represented a radical redefinition of the concept of security. Traditional practice had held that unsecured claims could not be paid off before secured creditors were paid in full. Given the great legal uncertainty surrounding the precedent in Fosdick, bondholders could hardly expect to know what claims would or would not be granted precedence if default were to occur and the firm were placed under a receivers' control. In 1884, The Commercial and Financial Chronicle expressed investors' confusion and dismay in the midst of a wave of railroad failures:

LESSONS OF RAILROAD DEFAULTS

Among the things learnt in each period are, that a bond is not always what it seems to be or professes to be - that the security which it nominally possesses may be no adequate security; that priority of lien is not necessarily a bar to subordination of the lien to obligations subsequently created; that a mortgage does not convey all the property of a corporation even if in general terms such conveyance has apparently been made; and that the character of different types of obligations and their relation to specific liens on particular property are by no means clearly defined.(82)

Judicial Valuation. We have seen how courts could use the setting of upset values to encourage existing junior claimants to provide cash to refinance a distressed railroad. While this process solved the immediate cash problem of the distressed firm, investors did not always find the solution acceptable. In dealing with failed railroads, it was the courts - and not market forces which effectively controlled the value of railroad securities. Investors at the time clearly understood that values set by the legal system were different from those set by the market. In 1916, Heft's manual for holders of foreclosed railroad bonds said that "generally speaking, a railroad security may be said to have three values. It has a market value, the price at which it can be bought and sold (probably) in the market. It has an intrinsic value, depending on the solvency of the issuing company and the property or security behind it. It has a legal value, founded upon the rights and remedies its ownership confers."(83)

The nineteenth-century financial press, writing to an audience of investors, expressing its editors' and its readers' bewilderment that courts could modify the substance of previously made, even well- written contracts. As an article in the Commercial and Financial Chronicle put it in 1884,

So far as these difficulties (in obtaining their fights) arise from the nature or wording of the instrument, the purchasers are not wholly without blame . . . But a point of more present interest is the disposition . . . to throw difficulties in the way of enforcing the fights of bondholders, even when the defects . . . are not found in the mortgage deed . . . (The bondholder is) involved in a maze of legal proceedings which are clear as to nothing except that they consume costs and time, uncertain whose interests are identical with his own, and whose are contrary to his own, compelled to choose between putting in more money as assessments to carry on the contest or to abandon his investment as hopeless.(84)

In sum, the decisions of the federal courts involving the reorganization of distressed railroads provided investors with new information as to the relative efficacy of a wide range of securities contracts. In this respect, we can interpret the private financial and governance innovations in this period as direct responses to judicial intervention in financial markets.

Financial Innovation as a Private-Sector Response to Judicial Reinterpretation of Claims

Financial distress instructs investors not only about the general state of the firm, but also about the efficacy of previously-written contracts. Many contractual provisions - including seniority, security interests, and preferences - take on practical meaning only in distress. When their contractual terms were put to the test in the late nineteenth century, investors learned that traditional mortgage bonds were much less secure and less enforceable contracts than had been previously imagined. Investors were reminded that all contracts are inherently incomplete because it is impossible to spell out all possible contingencies in advance. Investors may have hoped that courts would fill in these gaps and protect their rights. However, they learned that courts were the very agents by which their property rights were compromised, once public-minded judges effectively invalidated what, by tradition, had been strong contracts.(85)

How would have a rational investor responded to this news about the state of legal contracting? He would probably have sought to devise "better" contracts than those rewritten by judicial fiat. At first glance, "better" contracts might have been ones with even stronger seniority and greater security interests. However, the nineteenth-century investor's experience would have shown these contracts to be inherently flawed because stronger property rights would have made reorganization more difficult, thus encouraging judges to strike down or weaken these terms. Therefore, we observe an apparent paradox: investors wrote relatively "weak" contracts with firms that had fallen into distress, giving investors little protection in the form of seniority or security.

However, "weak" contracts like contingent charge securities may be superior in that they had the potential to reduce one element of risk faced by investors; namely, judicial redefinition. By reducing the likelihood of triggering contractual default, these weak contracts were less likely to require judicial enforcement, and thereby were less likely to be reinterpreted by the courts.(86) Of the contingent charge innovations described in this paper, the one that ultimately proved to be the least successful - income bonds - was the one that required the greatest court involvement to enforce.(87)

Furthermore, through innovations like voting trusts, security designers were able to trade one type of investor protection for another: while weak contracts might require investors to surrender traditional mortgage property rights, innovations such as covenants and voting trusts attempted to protect investor rights in advance of default by gaining a greater measure of control over the firm. We see this articulated in the language used to describe voting trusts, which sought to prevent problems and control firm actions, not to give holders stronger, court-enforceable rights if problems did occur. Voting trusts sought "the conservative management of property" and "continuity of efficient and proper management."(88)

History has repeated itself recently on the substitution of weaker contracts for "stronger" - but judicially-emasculated - contracts. In the 1980s, creditors in debt obligations secured by oil and gas contracts written in the southern United States found that courts were reinterpreting these contracts liberally in favor of debtors. While debt is normally thought of as a more secure contract than equity, legal engineers have used the weaker contract to provide stronger property rights. Using equity-like contracts called Volumetric Production Payments that allow their holders to take possession of the oil and gas assets in the event of financial difficulties, investors could avoid the process of court-run reorganization, which has a tendency to rewrite private contracts. This modern "innovation" was a revival of a pre-1930's financing vehicle that was all but eliminated due to the prohibition of U.S. banks from holding equity. But it illustrates the type of impulse that I attribute to security designs of the late nineteenth century: innovation that controls the risk of judicial reinterpretation of previously-set contracts.

IV. Conclusions and Future Research

The financial distress experienced by U.S. railroads in the late nineteenth century led to innovation at many different levels. It spurred innovation in legal processes as courts acted to prevent wholesale liquidation of the nation's railroads, and to provide distressed firms with cash to continue their operations. It stimulated the adoption of financial innovations in the form of securities that made future distress less likely by eliminating or reducing fixed financial charges. Finally, it encouraged innovation in governance systems in the form of covenants and voting trusts that in part compensated investors for accepting "weaker" securities.

We can interpret the financial and governance innovations as responses also to the uncertainty and weakening of mortgage claims brought about by judicial intervention through equity receivership. Because financial distress and judicial innovation went hand in hand, we cannot disentangle the complementary explanations for financial innovation. Future research for other periods or other countries may make it possible to separate these effects.

The existing histories of railroad reorganization suggests that the process of reorganization was one in which bondholders were weakened and managers strengthened.(89) This article confirms that interpretation. Examining the evidence we currently have, we can conclude that judicial innovations in the late nineteenth century substantially weakened the rights of bondholders, by taking away or substantially modifying the rights of seniority and security. However, we should note that the period did not witness an outright abrogation of control by investors over the actions of managers. Rather, investors and bankers responded to the uncertainty by establishing new ways to control management, which were less dependent on the direct control of assets and the threat of liquidation, as had been the case with senior mortgage instruments. The most obvious symbol of the new regime was the voting trust, which sought to provide a more effective monitoring vehicle than a host of dispersed shareholders.

Voting trusts were populated by powerful, experienced monitors who sought to protect the interests of both bondholder and stockholder. For "Morgan's men," the voting trust was an effective way to establish formal control over some of the critical decisions of a firm, including the selection of its board and top managers. These monitors did not represent faceless investors, but often represented particular coalitions of investors who sought to gain control of the railroad. Often the voting trust was a means by which senior bond holders could exert some direct, preventative control over the action of the firm, rather than wait to press their claims when default reoccurred. This change in the method of protecting property rights was an important conceptual innovation. It will take additional research to adequately measure the extent to which judicial innovations, security innovations, and governance innovations were successful in enhancing social welfare, reducing the likelihood of financial distress, and creating value for the bondholders and stockholders of the firm.
Appendix: The Shift Toward Contingent-Charge Securities

Period 1: 1872-1882

Sample:          Common Stock   Contingent-charge   Fixed-charge

Failed    1872      40.5%             7.8%             51.7%
          1882      40.6%            25.3%             34.1%

                 Common Stock   Contingent-charge   Fixed-charge

Control   1872      65.9%             1.1%             33.0%
          1882      57.1%             2.4%             40.6%

Period 2: 1880-1890

Sample:          Common Stock   Contingent-charge   Fixed-charge

Failed    1880      35.3%            14.4%             50.2%
          1890      36.7%            22.1%             41.2%

                 Common Stock   Contingent-charge   Fixed-charge

Control   1880      46.2%             7.5%             46.2%
          1890      42.6%             7.6%             49.8%

Period 3: 1890-1900

Sample:          Common Stock   Contingent-charge   Fixed-charge

Failed    1893      28.7%            12.2%             59.2%
          1900      31.2%            27.1%             41.7%

                 Common Stock   Contingent-charge   Fixed-charge

Control   1890      42.6%             7.6%             49.8%
          1900      39.6%            13.5%             46.9%

Period 4: 1907-1917

Sample:          Common Stock   Contingent-charge   Fixed-charge

Failed    1907      24.3%            11.4%             64.3%
          1917      27.2%            23.9%             48.9%

                 Common Stock   Contingent-charge   Fixed-charge

Control   1907      36.9%            10.8%             50.3%
          1917      34.5%            28.8%             36.7%


Period 1 - Failed Sample: 15 railroads reorganized between 1873 and 1882. Criteria: (1) Railroad must have defaulted on more than $5 million of bonds between 20 September 1873 (the "Panic of '73") and January 1876. Source: "Railroads in Default," The Commercial and Financial Chronicle (1876), 16-20. (2) Railroad must then have been reorganized before 1882. Source: Poor's. These criteria yielded a group of 20 railroads. Five were dropped from the above sample because they had merged with other railroads in the process of reorganization. Control Sample: 15 railroads not in distress between 1872 and 1882. Criteria: Railroads were matched to the failed sample by location, mileage and capitalization. In most cases, matching railroads are in the same geographic area as the distressed road, and mileage and capitalization are within 20 percent of the distressed roads' mileage and capitalization. Source: Poor's.

Period 2 - Failed Sample: 13 railroads reorganized between 1884 and 1890. These were identified by a 1900 article in Poor's which listed 57 leading railroads that had been reorganized since 1884. The thirteen in this sample were those which had been reorganized between 1884 and 1890 and not bought out in the process. Poor's, "A Study in Railway Statistics" (1900). The balance sheet data is from Poor's (1881, 1891). Control Sample: All U.S. railroads in 1880 and in 1890. The 1880 data is from the "Report on the Agencies of Transportation in the United States," in the Census of the United States (1883). The 1890 data is from the Interstate Commerce Commission, (ICC) Statistics of Railways in the United States (1890).

Period 3 - Failed Sample: 40 railroads reorganized between 1893 and 1900 and not bought out in the process. Sources are the same as the failed sample for period 2. Control Sample: All U.S. railroads. Source: ICC Statistics (1890, 1900).

Period 4 - Failed Sample: 15 railroads operating at least 500 miles of line, which were reorganized between 1907 and 1917. Source: a study by Daggett (1918), 473. Control Sample: All U.S. railroads. Source: ICC Statistics (1908, 1918).

1 See Alfred D. Chandler, Jr., ed. and comp., The Railroads: The Nation's First Big Business (New York, 1965). See also Chandler's article, "The Railroads: Pioneers in Modern Corporate Management," Business History Review 39 (Spring 1965): 16-40.

2 On the rise of investment banking institutions, see Vincent Carosso, Investment Banking in America: A History (Cambridge, Mass., 1970). In addition, Fritz Redlich's classic work, The Molding of American Banking, vol. 2, 1840-1910 (New York, 1951), provides a useful overview of the pioneer investment banking houses.

3 J. Bradford De Long, "Did J. P. Morgan's Men Add Value?" in Inside the Business Enterprise: Historical Perspectives on the Use of Information, ed. Peter Temin (Chicago, Ill., 1991), 205. Carlos Ramirez, "Did J. P. Morgan's Men Add Liquidity? Corporate Investment, Cash Flow, and Financial Structure at the Turn of the Twentieth Century," The Journal of Finance 50 (June 1995).

4 Merton Miller, "Financial Innovation: The Last Twenty Years and the Next," Journal of Financial and Quantitative Analysis 21 (Dec. 1986): 459-471, argues that the current period is unique in producing financial innovation. Peter Tufano, "Securities Innovations: A Historical and Functional Perspective," Journal of Applied Corporate Finance 7 (Winter 1995): 90-103, documents the financial innovations that took place in the nineteenth and early twentieth centuries.

5 See, for example, Keith L. Bryant, Jr., History of the Atchison, Topeka and Santa Fe Railway (New York, 1974), and Maury Klein, The Great Richmond Terminal (Charlottesville, Va., 1970).

6 For a thorough introduction to problems of asymmetric information in historical context, see Jonathan Barron Baskin, "The Development of Corporate Financial Markets in Britain and the United States, 1600-1914: Overcoming Asymmetric Information," Business History Review 62 (Summer 1988): 199-237.

7 Albro Martin, "Railroads and the Equity Receivership: An Essay on Institutional Change," Journal of Economic History 34 (Sept. 1974): 685-709. For a discussion of the interrelationship between railroad managers and investment bankers in the nineteenth century, see Alfred D. Chandler, Jr., The Visible Hand: The Managerial Revolution in American Business (Cambridge, Mass., 1977), 89-94 and 171-175.

8 Gerald Berk, Alternative Tracks: The Constitution of American Industrial Order, 1865-1917 (Baltimore, Md., 1994), 47-72.

9 Robert C. Merton, "A Functional Perspective of Financial Intermediation," Financial Management 24 (Summer 1995): 23-41, discusses the concept of the innovation spiral. In the context of the interplay between public and private innovations, Edward Kane, "Technology and Regulation of Financial Markets," in Technology and the Regulation of Financial Markets, ed. A. Saunders and L. White (Lexington, Mass., 1986), discusses the related notion of the "regulatory dialectic."

10 See Kane, "Technology and Regulation of Financial Markets."

11 Charles W. Smithson and Clifford W. Smith, Jr., with D. Sykes Wilford, Managing Financial Risk: A Guide to Derivative Products, Financial Engineering and Value Maximization (Chicago, Ill., 1995).

12 Alfred D. Chandler, Jr., "Patterns of American Railroad Finance, 1830-50," Business History Review 28 (Sept. 1954): 261.

13 To use a modern analytic device, a railroad can be thought of as a "call option," which gives its holder the right, but not the obligation, to buy a set of future cash flows. It is generally not optimal to prematurely exercise, or kill, a live option. In the case of distressed railroads in the 1890s, it was generally held that the capitalized value of a reorganized railroad's earnings - which reflected the market's assessment of the future prospects of the firm - would exceed the liquidation value of the road's tangible and real assets, namely its equipment, terminals, rights-of-way, etc. It seems apparent that many of the judges who presided over railroad receiverships were easily persuaded that the railroads were worth more intact than broken up. In the famous case of the Wabash railroad, Jay Gould and his allies argued in their petition for receivership that, "If the lines are broken up and the fragments placed in the hands of various receivers, and the rolling stock, materials and supplies seized and scattered abroad, the result would be irreparable injury and damage to all persons having any interest in said line of road." (Quoted by Arthur S. Dewing, The Financial Policy of Corporations (New York, 1919), 43.) Also see Maury Klein's extensive biography, The Life and Legend of Jay Gould (Baltimore, Md., 1986), as well as Julius Grodinsky's Jay Gould: His Business Career 1867-1882 (Philadelphia, Pa., 1957).

14 This notion was formalized by Stewart C. Myers in "Determinants of Corporate Borrowing," Journal of Financial Economics 5 (Nov. 1977): 147-176.

15 Cited in Meyer v. Johnston 53 Ala., 237 (1875).

16 Arthur S. Dewing, The Financial Policy of Corporations, 103. William Z. Ripley, Railroad Finance and Organization (New York, 1915), 386. Writing in 1895, William Carr noted that, "They have obtained a prominent place among railroad securities, as is evidenced by the large sums that are yearly secured by the issue of such certificates of indebtedness." William Carr, Receivers' Certificates (Philadelphia, Pa., 1895), 3.

17 Quote is taken from Arthur S. Dewing, The Financial Policy of Corporations, 68.

18 William Carr, Receivers' Certificates, 3.

19 G. Akerloff, "The Market for 'Lemons': Qualitative Uncertainty and the Market Mechanism," Quarterly Journal of Economics 84 (Aug. 1970): 488-500.

20 Andrei Shleifer and Robert W. Vishny, "Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance 47 (Sept. 1992): 1343-1366.

21 Arthur Stone Dewing, The Financial Policy of Corporations, vol. 1 (New York, 1920), 108.

22 Stuart Daggett, Railroad Reorganization (Cambridge, Mass., 1908), 81. See also Stuart Daggett, "Recent Railroad Failures and Reorganizations," Quarterly Journal of Economics 32 (May 1918): 446-487.

23 "Railroad Mortgages as Securities," Commercial and Financial Chronicle (26 May 1877): 479-480.

24 Mark Roe, "The Voting Prohibition in Bond Workouts," Yale Law Journal 97 (Dec. 1987): 232-279. Robert Gertner and David Scharfstein, "A Theory of Workouts and the Effects of Reorganization Law," Journal of Finance 46 (Sept. 1991): 1189-1222. Stuart C. Gilson, "Transactions Costs and Capital Structure Choice: Evidence from Financially Distressed Firms," Journal of Finance (forthcoming).

25 Samuel Spring, "Upset Prices in Corporate Reorganizations," Harvard Law Review 32 (March 1919): 500.

26 See Douglas G. Baird and Thomas H. Jackson, Cases, Problems, and Materials on Bankruptcy (Boston, Mass., 1990): 26-34.

27 Joseph Weiner, "Conflicting Functions of the Upset Price in a Corporate Reorganization," Columbia Law Review 27 (Feb. 1927): 135-6.

28 Paul D. Cravath, "The Reorganization of Corporations" and James Byrne, "Foreclosure of Railroad Mortgages" in Some Legal Phases of Corporate Financing, Reorganization and Regulation, ed. A. Ballantine, et al. (New York: Macmillan, 1917), 204 and 141, speeches published in a compilation of addresses to the Association of the Bar of the City of New York. See also Samuel Spring, "Upset Prices in Corporate Reorganizations," 493; Joseph Weiner, "Conflicting Functions of the Upset Price in a Corporate Reorganization," 137; Arthur S. Dewing, Study of Corporate Securities (New York, 1934), 964, W. Hastings Lyon, Corporation Finance (Boston, Mass., 1916), 249-50, and Adrian H. Joline, The Reorganization of Corporations (Cambridge, Mass., 1910), 87.

29 The new and old firms often had very similar names, presumably to minimize any confusion by its former customers. For example, Henry Clay Caldwell, "Railroad Receiverships in the Federal Courts," American Law Review 30 (March/April 1896): 161-175 notes that the Memphis & Little Rock Railroad Company was reorganized in three different foreclosures over the years. Its three incarnations were as the Memphis & Little Rock Railway Company, the Little Rock & Memphis Railroad Company, and finally the Little Rock & Memphis Railway Company.

30 William Z. Ripley, Railroad Finance and Organization, 396.

31 Arthur S. Dewing, The Financial Policy of Corporations, 109-115.

32 Stuart Daggett, Railroad Reorganization, 352.

33 Unfortunately, Poor's does not report the dollar value of securities issued to the public for cash as part of these reorganizations. Poor's Bureau of Information and Investigation, Poor's Manual of Railroads (New York, 1900), xx.

34 Poor's Bureau of Information and Investigation, Poor's Manual of Railroads, pp. xx.

35 Joseph Weiner, "Conflicting Functions of the Upset Price in a Corporate Reorganization," 145.

36 John E. Tracy, Corporate Foreclosures, Receiverships and Reorganization (Chicago, Ill., 1929), 13.

37 Stuart Daggett, Railroad Reorganization, 351.

36 Joseph Weiner, "Conflicting Functions of the Upset Price in a Corporate Reorganization."

39 Adrian H. Joline, The Reorganization of Corporations, 83.

40 Joseph Weiner, "Conflicting Functions of the Upset Price in a Corporate Reorganization," 143.

41 Stuart Daggett, Railroad Reorganization. These results are curious, because stockholders who paid assessments would have been better off to not pay the assessment, wait one month and then purchase the stock in the market.

42 See Louisville Trust Co. v. Louisville, New Albany and Chicago Railway Co 174 U.S. 674, (1899), and Northern Pacific Railroad Company v. Boyd 228 U.S. 482 (1913).

43 Samuel Spring, "Upset Prices in Corporate Reorganizations," 502-503.

44 Joseph Weiner, "Conflicting Functions of the Upset Price in a Corporate Reorganization," 142. Emphasis added.

45 John E. Tracy, Corporate Foreclosures, Receiverships and Reorganization, 13. For examples of reorganization committees, see E. G. Campbell, The Reorganization of the American Railroad System, 1893-1900 (New York, 1938), 145-189. Ron Chernow, The House of Morgan: An American Dynasty and the Rise of Modern Finance (New York, 1990), 67. On Morgan's role in general, see Vincent P. Carosso's standard work, The Morgans: Private International Bankers 1854-1913 (Cambridge, Mass., 1987).

46 An example of competition to establish committees can be found in the 1894 Erie reorganization, in which J. P. Morgan was pitted against E. H. Harriman, who formed a rival committee. See E. G. Campbell, The Reorganization of the American Railroad System, 164-165. In many railroad firms, financiers played an active management role, well beyond raising capital. A good example is Harriman, a Wall Street stockbroker and investor who acted as a top manager for the Illinois Central in the 1880s. John F. Stover, History of the Illinois Central Railroad (New York, 1975), 206-214. Harriman played an important policy-making role in reorganizing and then rebuilding the Union Pacific after its receivership in the early 1890s. See Maury Klein, Union Pacific: The Rebirth, 1894-1969 (New York, 1989), 48-68.

47 Jerold B. Warner, "Bankruptcy Costs: Some Evidence," Journal of Finance 32 (May 1977): 337-347. Tim C. Opler and Sheridan Titman, "Financial Distress and Corporate Performance" Journal of Finance 49 (July 1994): 1015-1040.

48 See Stuart C. Gilson, "Transactions Costs and Capital Structure Choice."

49 See Maury Klein's two volume work, Union Pacific (New York, 1987) and his earlier history, The Great Richmond Terminal. Among John F. Stover's many works, see History of the Baltimore & Ohio Railroad (West Lafayette, Ind., 1987), and History of the Illinois Central Railroad.

50 H. H. Swain, "Economic Aspects of Railroad Receiverships," Economic Studies 3 (1898): 98-99.

51 William Z. Ripley, Railroad Finance and Organization, 385.

52 W. Hastings Lyon, Corporation Finance, 294.

53 Arthur S. Dewing, The Financial Policy of Corporations, 132.

54 Arthur S. Dewing, Study of Corporate Securities, 224-228.

55 Peter Tufano, "Financing Acquisitions in the late 1980s: Sources and Forms of Capital," in The Deal Decade: What Takeovers and Leveraged Buyouts Mean for Corporate Governance, ed. Margaret M. Blair (Washington, D.C., 1993), 289-320. Deferred- interest obligations were used to finance almost 30% of the debt raised in conjunction with the financing of leveraged buy-outs in the 1980s. Like late nineteenth-century railroads, these firms faced imminent financial distress based on their high level of fixed financial charges.

56 Stuart Daggett, Railroad Reorganization, 365.

57 The earliest security resembling preferred stock reportedly was issued in 1698 by Mine Adventurers' company in the United Kingdom. See George H. Evans, Jr.'s, British Corporate Finance 1775-1850 (Baltimore, Md., 1936), 73. The earliest uses of preferred stock in this country were in conjunction with the recapitalization of failed railroads in the late 1840s and 1850s. See George H. Evans, Jr.'s two articles, "The Early History of Preferred Stock in the United States," The American Economic Review 19 (March 1929): 43-58, and "Preferred Stock in the U.S. 1850-1878," The American Economic Review 21 (March 1931): 56-62. Later in the present article, I document the large relative increase in the use of preferred stock from historical levels in conjunction with the railroad reorganizations of the 1870s, 1880s, and 1890s.

58 Poor's Bureau of Information and Investigation, Poor's Manual of Railroads, xcviii-cl.

59 Churchill Rodgers, "The Corporate Trust Indenture Project," The Business Lawyer 20 (April 1965): 551 - 559; Cecil M. Draper, "A Historical Introduction to the Corporate Mortgage," Rocky Mountain Law Review 2 (Feb. 1930): 71-98. Francis L. Stetson, Some Legal Phases of Corporate Financing Reorganization and Regulation (New York, 1917).

60 Clifford W. Smith and Jerold B. Warner, "On Financial Contracting: An Analysis of Bond Covenants," Journal of Financial Economics 7 (June 1979).

61 Stuart DaggeR, Railroad Reorganization, 367.

62 W. Hastings Lyon, Corporation Finance, 23-4.

63 Arthur S. Dewing, Study of Corporate Securities, 195.

64 This notion is raised by many authors, including Adolf A. Bede and Gardiner C. Means in The Modern Corporation and Private Property (New York, 1932).

65 E. S. Mead, Corporation Finance (New York, 1920), 457.

66 J. P. Morgan was personally a trustee for the Philadelphia and Reading (1886), Chesapeake and Ohio (1888), Southern Railway (1894), Erie (1895), Northern Pacific (1896) and the Reading (1896); see John A. Leavitt, The Voting Trust: A Device for Corporate Control (New York, 1941), 23.

67 Stuart Daggett, Railroad Reorganization, 382.

68 John A. Leavitt, The Voting Trust: A Device for Corporate Control, 35-36.

69 Harry A. Cushing, Voting Trusts: A Chapter in Modern Corporate History (New York, 1927), 15.

70 For example, the trust agreement might specify that the trust would be terminated at the end of a fixed period of time, when mortgage bonds (or preferred stock) had received full interest payments over a given number of years, or "until such time as the property gets thoroughly on its feet." See Harry A. Cushing, Voting Trusts, 19.

71 Cushing, Voting Trusts, 72.

72 Samuel Spring, "Upset Prices in Corporate Reorganizations," 498.

73 This argument is related to the more general thesis that legal innovations had a direct bearing on the evolution of competition and development. See Morton J. Horwitz, The Transformation of American Law, 1780-1860 (Cambridge, Mass., 1977) and Horwitz, The Transformation of American Law, 1870-1960: The Crisis of Legal Orthodoxy (Oxford, 1992). In these works, Horwitz traces the development of property rights in the American legal system. He notes how legal innovations were used to promote business competition and economic development through private enterprise. Horwitz also discusses the changing status of the corporation in American political and legal history.

74 Leonard A. Jones, A Treatise on the Law of Corporate Bonds and Mortgages (Indianapolis, Ind., 1879), preface.

75 William Carr, Receivers' Certificates, 3.

76 The Commercial and Financial Chronicle, 21 June 1884, 720.

77 Arthur S. Dewing, The Financial Policy of Corporations, 105. Dewing here cites A. W. Machen, Jr., A Treatise on the Modern Law of Corporations (1908).

78 Quoted from Samuel Spring, "Upset Prices in Corporate Reorganizations," 492, 498. An early case that raises this issue is Munn v. Illinois, 94 U.S. 113, 125 (1876), in which the Court held that holders of conflicting liens could not break apart a railroad and force sale of the separate parts.

79 "Railroad Mortgages as Securities," Commercial and Financial Chronicle, 26 May 1877, 480.

80 Lyne S. Metcalfe, "Priority over Mortgage of Debts Contracted by Railroad before Receivership," Central Law Journal 39 (Sept. 1894): 241-244.

81 Chades A. Dickson, "Rights of Material and Supply Men in Railroad Foreclosures" American Law Review 30 (July/Aug. 1896): 520-534.

82 Commercial and Financial Chronicle, 30 Aug. 1884, 3.

83 Heft's Manual (1916), 1.

84 "Railroad Mortgages as Securities," Commercial and Financial Chronicle, 26 May 1877, 479-480.

85 See James Willard Hurst, Law and Markets in United States History (Madison, Wisc., 1982), 39-40.

86 The idea of writing contracts that circumvent court enforcement has recently been discussed by economic theorists. See Robert Merton, "No Fattit Default: A Possible Remedy for Certain Dysfunctional Consequences of Corporate Leverage," Unpublished manuscript (1991) and Alan Schwartz, "Contracting About Bankruptcy," Journal of Law, Economics & Organization 13(April 1997): 127-46.

87 Income bonds fell into disfavor early in the twentieth century, even though federal income taxes, first levied in 1913, favored bonds over stocks. The rights of income bond holders are contingent on accounting results, but firms could manipulate earnings. Railroads could redefine "capital improvements" as "maintenance expenses." In Union Pacific Railroad Co. v. U.S. 99 U.S. 420 (1878), the court held that the latter reduced the income to which an income bond holder could claim, but the former did not. Earnings could also be hidden through a variety of transfer prices. For example, the Supreme Court of Georgia found that the Central of Georgia Railroad, which reported five year cumulative earnings of $32.95, actually had earned $1,321,934 and thus had defrauded its income bond holders. See Arthur S. Dewing, "The Position of Income Bonds, as Illustrated by Those of the Central and Georgia Railway," Quarterly Journal of Economics 25 (May 1911): 397. Stetson, who was the foremost corporate lawyer of his day and who was known as "Morgan's attorney general," made clear that the real problem with income bonds was going through the courts to enforce them: "Much litigation in respect of income bonds has arisen because of the disputes as to the computation of earnings . . . The case of Mackintosh v. Flint & P.M. R. Co. illustrates the difficulty of determining the amount of net earnings, and the difficulty even greater of finding a judicial officer fully equal to solving the problem." See Francis L. Stetson, Some Legal Phases of Corporate Financing Reorganization and Regulation (New York, 1917), 69-70. If the goal of the deferred-interest and contingent-charge securities was to reduce court intervention and the uncertainty it created, then income bonds' ultimate failure was that they required courts to enforce their terms.

88 Harry A. Cushing, Voting Trusts, 17.

89 See Albro Martin, "Railroads and the Equity Receivership."

I would like to thank Peter Botticelli, Tom McCraw, and three anonymous referees for their invaluable contributions to this piece. Earlier drafts benefited from comments from many, including Dan Raft, Naomi Lamoreaux, Margaret Levenstein, Jerry Warner, and seminar participants at the National Bureau for Economic Research, Harvard Business School, the American Finance Association, and the University of Michigan. Financial support was provided by the Harvard Business School Division of Research, as part of the Global Financial Systems project.

PETER TUFANO is associate professor in the finance area at the Harvard Business School.

Peter Tufano is associate professor in the finance area at the Harvard Business School. He received an A.B. degree in Economics from Harvard College, an M.B.A. from Harvard Business School, and his Ph.D. in Business Economics from Harvard University. He has taught at HBS since 1989. His research has focused on the process of financial innovation and the use of financial engineering by corporations to solve a variety of problems. His work has been published in the Journal of Finance, the Journal of Financial Economics, the Harvard Business Review, the Journal of Applied Corporate Finance, and the Journal of Financial Engineering. Along with various colleagues in the Finance area, he has co-authored two books, Cases in Financial Engineering, and Global Financial Systems: A Functional Perspective.
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