If the amount the public should pay for the service were to be determined by the amount of stock issued, the result would be that the body having the power to determine the amount of stock would fix the return, and all consideration of the fair value of the investment used in the public service would go for naught. A stock dividend of say 100 per cent doubles the amount of the stock, but has no proper effect upon the rate the public pays. Such dividend neither increases nor diminishes the fair value of the property used in serving the public. It merely rearranges as between the shareholders the form and number of the pieces of paper showing their rights between themselves to the net earnings and to the property itself if ever divided among them.

There has grown up, for some reason, a very peculiar and illogical notion with reference to the protection of so-called innocent investors in the stock of a public service corporation which deserves a little attention at this point.

The underlying conception upon which this notion is based is that the return the public is to pay is based upon the amount of stock and not upon the amount of the investment: that it should be reckoned upon the figures printed upon the title deed to the property rather than upon thé value of the property itself. There is no law justifying any such view, and certainly no equity or justice. Once it is clearly apprehended that a person buying stock in such a corporation is buying only a right to a certain proportion of the dividends, the confusion disappears and the whole matter is put upon a just basis. The amount of the dividends depends wholly upon the business success of the corporation, and no one pretends that there is any principle justifying an exaction from the public of more than a fair return upon the value of the property used in the public service.

If a purchaser is foolish enough to pay more for the stock of such corporation than would be justified by the reasonable amount of dividends, there is no principle of equity which requires that the loss should be borne by the public, but every principle of equity and law requires that it should be borne by the person making the investment. No one at the present

time, in any careful consideration of the subject, attempts to maintain that the public should pay a return upon the stock. Every one concedes that the return should be upon the investment; and yet from time to time we are met with a plea to protect the stock which is the title deed and disregard the investment which is the matter of substance.

§ 1041. Nebraska Commission.

Re Application of Lincoln Telephone and Telegraph Company for authority to increase rates 32 involves the valuation of a telephone plant for rate purposes by the Nebraska State Railway Commission. The Commission holds that existing capitalization need not be considered in an estimate of fair value for rate purposes. The Commission says (at pages 149-150):

The outstanding stocks and bonds of a corporation which were issued prior to regulation, whether the same express the actual value of the plant, or whether they are in excess, or are for a less amount than the real value, have only collaterally any effect, and are not necessarily taken into consideration in the matter of making rates for the future, and when so treated it will be readily seen that any question of overcapitalization in the past is absolutely eliminated and need not enter into the problem.

Stocks and bonds are in fact not certificates which will determine or designate the rate that a corporation shall charge, or that will necessarily determine the rate of return which the corporation shall be permitted to earn, but are in fact merely certificates designating the ratio of ownership in the plant and reciting the ratio in which the profits above actual operating expenses may be divided among the holders.

The bond itself as to principal is merely a mortgage in most cases and proclaims that at a certain definitely fixed date the corporation will pay back to the holder thereof a certain amount, or in case of dissolution that the holder shall first be reimbursed

32 19 A. T. & T. Co. Com. L. 134, June 26, 1913, Nebraska State Railway Commission.

in the principal sum before any distribution is made between holders of other securities. As to the interest, such a bond promises first to the holder a definite sum at specified dates and that such interest shall be paid before any dividend is declared to the stockholders, whose claims are always secondary.

As a net result, the only value that the certificate of stock really has, regardless of the amount written in, whether it be $1.00 or $100.00 face value, is nothing other than a determination of the ratio of ownership and the ratio in which the holder shall have a right to net profits, if there be any.

In the matter of the application of the Omaha, Lincoln and Beatrice Railway Company for authority to issue $2,250,000 of bonds and $850,000 of stock, decided February 25, 1913, the Commission points out that the rule of caveat emptor applies to purchasers of securities authorized by the Commission. Such purchasers are not exempt from the business risks involved in the possibility of the corporation issuing the securities being overcapitalized. The Commission quotes with apparent approval from the decision of the New Hampshire Commission in the matter of the petition of the Milford Light and Power Company, decided December 30, 1911, in which the New Hampshire Commission states that an approval of securities does not constitute a guaranty in any way that rates may be charged to enable the company to pay dividends at any given rate upon such securities and that whenever the Commission is called upon to exercise its rate-making power its action will be controlled by the amount of money shown to have actually been invested and the fair value of the property regardless of the amount of securities outstanding.

$1042. St. Louis Commission.

The St. Louis Public Service Commission in an investigation of the United Railways Company of St. Louis found

that the company had a capitalization of $101,380,300 and that the fair value of its property liberally estimated and including no deduction for accrued depreciation was about $37,638,000. Of the capitalization approximately $42,000,000 was in stock and $59,000,000 in bonds. The capitalization of the company was equal to $219,914 per mile of single track. Of the 461 miles of single track, 110 miles were suburban construction. Moreover, the company bought approximately 45 per cent of its power, thus reducing the necessary investment in generating plants. The Commission discusses the question of overcapitalization as follows (pages 8-9): 33

The evil arising from the overcapitalization of public utilities is one of the greatest to be contended with in their proper regulation. Not only is the creation of "water" in securities against the spirit and letter of the laws of the state, but in the case of public service companies it is bound ultimately to perpetrate wrong either against the purchasers of the securities or against the consuming public.

It appears to be a sound principle of regulation that the public, in return for special privileges granted, should be required to pay to the public service companies a reasonable return only upon the capital actually devoted to the public service, and the right to earn on inflated capital should be denied.

It is much to be regretted that in many instances the creators and exploiters of inflated values in public utilities have been able to profit by the sale of securities at prices above the amounts actually devoted to the public service, and thus to transfer the consequences of just regulation to individuals who are generally called the "innocent investors." The term "innocent investor" is not always suitable to the buyers of "watered" securities. The laws of this state and of many other states, and the rulings of the courts in valuation and regulation cases, are plain notice that fictitious values can not be recognized

33 Report on the United Railways Company of St. Louis by the St. Louis Public Service Commission, November 19, 1912.

in public utilities corporations, and the investor who from ignorance of the wrong attempted against the public or from motives of mere speculation buys watered securities can not justly expect the public to assume losses which are the result of ignorance or desire for speculative gain.

It is claimed by some financiers that capital could not be obtained for public service enterprises without the device of "watered" securities. This may have been partially true, but if so it was due largely to the fact that the very risks created by speculative financiering prevented the entrance into the enterprises of any but speculative capital which would take large risks and demand the opportunity for large speculative profits.

The extravagance and wastefulness of overcapitalization can be seen immediately by taking the example of a company which has issued security obligations in excess of its real assets and then is obliged to obtain more capital for extensions, betterments or replacements. By its former issues the credit of the company is impaired and the new issues if sold at all must be marketed at an extravagant discount.

It can not reasonably be claimed in such a situation that the consequences of the evils created by speculation in "franchise values" (see page 42) and the hope of exploiting the public should be assumed by the public.

In an advertisement printed in the daily newspapers of St. Louis, the United Railways Company of that city takes the ground that securities once issued must now be recognized regardless of the present value of the property. It threatens the public with the evil results that may follow insolvency and reorganization unless this overcapitalization is recognized. The following is from the advertisement of the company:

34

The present mortgage debt of the United Railways is in round numbers $59,000,000. This mortgage debt has been legally issued, is outstanding in the hands of the investing public, and must be recognized by the company. Any indebtedness now 34 Quoted in the Electric Railway Journal, April 12, 1913, page 688.