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

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

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

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

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

⁶ For a thorough introduction to problems of asymmetric information in historical context, see Baskin, Jonathan Barron, “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.CrossRefGoogle Scholar

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

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

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

¹⁰ See Kane, “Technology and Regulation of Financial Markets.”

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

¹² Chandler, Alfred D. Jr, “Patterns of American Railroad Finance, 1830–50,” Business History Review 28 (Sept. 1954): 261.CrossRefGoogle Scholar

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 die 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 Dewing, Arthur S., The Financial Policy of Corporations (New York, 1919), 43.Google Scholar) Also see Klein's, Maury extensive biography, The Life and Legend of Jay Gould (Baltimore, Md., 1986)Google Scholar, as well as Grodinsky's, JuliusJay Gould: His Business Career 1867–1882 (Philadelphia, Pa., 1957).Google Scholar

¹⁴ This notion was formalized by Myers, Stewart C. in “Determinants of Corporate Borrowing,” Journal of Financial Economics 5 (Nov. 1977): 147–176.CrossRefGoogle Scholar

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

¹⁶ Arthur S. Dewing, The Financial Policy of Corporations, 103. Ripley, William Z., Railroad Finance and Organization (New York, 1915), 386.Google Scholar 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.” Carr, William, Receivers' Certificates (Philadelphia, Pa., 1895), 3.Google Scholar

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

¹⁸ William Carr, Receivers' Certificates, 3.

¹⁹ Akerloff, G., “The Market for ‘Lemons’: Qualitative Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 84 (Aug. 1970): 488–500.CrossRefGoogle Scholar

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

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

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

²³ “Railroad Mortgages as Securities,” Commercial and Financial Chronicle (26 May 1877): 479–480.

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

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

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

²⁷ Weiner, Joseph, “Conflicting Functions of the Upset Price in a Corporate Reorganization,” Columbia Law Review 27 (Feb. 1927): 135–6.CrossRefGoogle Scholar

²⁸ Paul D. Cravath, “The Reorganization of Corporations” and Byrne, James, “Foreclosure of Railroad Mortgages” in Some Legal Phases of Corporate Financing, Reorganization and Regulation, ed. Ballantine, A., et al. (New York: Macmillan, 1917), 204 and 141Google Scholar, 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; Dewing, Arthur S., Study of Corporate Securities (New York, 1934), 964Google Scholar, Lyon, W. Hastings, Corporation Finance (Boston, Mass., 1916), 249–50Google Scholar, and Joline, Adrian H., The Reorganization of Corporations (Cambridge, Mass., 1910), 87.Google Scholar

²⁹ The new and old firms often had very similar names, presumably to minimize any confusion by its former customers. For example, Caldwell, Henry Clay, “Railroad Receiverships in the Federal Courts,” American Law Review 30 (March/April 1896): 161–175Google Scholar 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.Google Scholar

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

³⁷ Stuart Daggett, Railroad Reorganization, 351.

³⁸ 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 stock holders 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 Campbell, E.G., The Reorganization of the American Railroad System, 1893–1900 (New York, 1938), 145–189.Google ScholarChernow, Ron, The House of Morgan: An American Dynasty and the Rise of Modern Finance (New York, 1990), 67.Google Scholar On Morgan's role in general, see Carosso's, Vincent P. standard work, The Morgans: Private International Bankers 1854–1913 (Cambridge, Mass., 1987).Google Scholar

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 arival 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. Stover, John F., History of the Illinois Central Railroad (New York, 1975), 206–214.Google Scholar Harriman played an important policy-making role in reorganizing and then rebuilding the Union Pacific after its receivership in the early 1890s. See Klein, Maury, Union Pacific: The Rebirth, 1894–1969 (New York, 1989), 48–68.Google Scholar

⁴⁷ Warner, Jerold B., “Bankruptcy Costs: Some Evidence,” Journal of Finance 32 (May 1977): 337–347.CrossRefGoogle ScholarOpler, Tim C. and Titman, Sheridan, “Financial Distress and Corporate Performance” Journal of Finance 49 (July 1994): 1015–1040.CrossRefGoogle Scholar

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

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

⁵⁰ Swain, H. H., “Economic Aspects of Railroad Receiverships,” Economic Studies 3 (1898): 98–99.Google Scholar

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 Tufano, Peter, “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. Blair, Margaret M. (Washington, D.C., 1993), 289–320.Google Scholar 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 rail-roads, 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 Evans, George H. Jr's, British Corporate Finance 1775–1850 (Baltimore, Md., 1936), 73.Google Scholar 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 Evans, George H. Jr's articles, two, “The Early History of Preferred Stock in the United States,” The American Economic Review 19 (March 1929): 43–58Google Scholar, 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–ci.

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

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

⁶¹ Stuart Daggett, 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 Berle, Adolf A. and Means, Gardiner C. in The Modern Corporation and Private Property (New York, 1932).Google Scholar

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

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 Leavitt, John A., The Voting Trust: A Device for Corporate Control (New York, 1941), 23.Google Scholar

⁶⁷ Stuart Daggett, Railroad Reorganization, 382.

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

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

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 Horwitz, Morton J., The Transformation of American Law, 1780–1860 (Cambridge, Mass., 1977)Google Scholar and Horwitz, , The Transformation of American Law, 1870–1960: The Crisis of Legal Orthodoxy (Oxford, 1992).Google Scholar 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 Jones, Leonard A., A Treatise on the Law of Corporate Bonds and Mortgages (Indianapolis, Ind., 1879), preface.Google Scholar

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 Modem 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 die separate parts.

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

⁸⁰ Metcalfe, Lyne S., “Priority over Mortgage of Debts Contracted by Railroad before Receivership,” Central Law Journal 39 (Sept. 1894): 241–244.Google Scholar

⁸¹ Dickson, Charles A., “Rights of Material and Supply Men in Railroad Foreclosures” American Law Review 30 (July/Aug. 1896): 520–534.Google Scholar

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 Hurst, James Willard, Law and Markets in United States History (Madison, Wise., 1982), 39–40.Google Scholar

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

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 didnot. 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 Dewing, Arthur S., “The Position of Income Bonds, as Illustrated by Those of the Central and Georgia Railway,” Quarterly Journal of Economics 25 (May 1911): 397.CrossRefGoogle Scholar 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 ir 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 Stetson, Francis L., Some Legal Phases of Corporate Financing Reorganization and Regulation (New York, 1917), 69–70.Google Scholar 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.”