In May 1869, after he managed to merge all his railroad interests into New York Central, Vanderbilt recapitalised the company. Part of this recapitalisation involved the issuance of stock. ‘Watering down’, the practice of diluting existing shareholders by issuing new stock, was a common practice (or affliction) of the time. Vanderbilt and his son-in-law physically carried away the enormous sum of $6m (over $450m) as part of the recapitalisation.⁸ Estimates of the total amount of ‘watering down’ conducted by Vanderbilt in the New York Central run as high as $50m ($3.8bn). The dangers of investing in railroads for the outside investor were well understood at the time, but the level of optimism about expected returns was such that this was insufficient to deter the flow of both domestic and foreign capital to finance their expansion.
As in Britain, the expansion of the railroad system in the US changed the clocks. In America, where distances were multiples of those in Britain, the time problem was that much greater. Illinois alone had nearly 30 incremental measures of time and Wisconsin nearly 40. In 1883 the American Railway Association created four time zones and time shifted from “God’s time” to “Vanderbilt’s time”.⁹
2.3 – Holier than thou: the Economist knew of the Erie Railroad scandals
Source: Economist, 3 December 1870.
A game of monopoly: the fight for Erie
As an individual who had made a fortune by undermining publicly granted monopolies or subsidies, Vanderbilt was well aware of the benefits that accrue when competition is absent. It had long been recognised that railroads were a potentially natural monopoly. Stephenson, who built the Rocket, noted that the capital requirements favoured a monopoly structure. As Vanderbilt extended his network, he took control of smaller railroad companies. He also found himself subjected to the same treatment he had dealt out to the steamship lines and on more than one occasion he was forced to make payments to prevent competition. The method he used to pay for his high-priced acquisitions was simply to issue more New York Company paper to pay for his purchases.
Vanderbilt continually sought to protect his pricing power as his network expanded. In this regard, the Erie Railroad was by far the largest thorn in his flesh. Upon gaining control of New York Central, his network extended from the New York terminus in Harlem to Albany through the Hudson River Railroad and the New York Central to Buffalo. Other interests took his line to the point where he could almost connect with Chicago. To complete the link, he needed the Michigan Southern, which would also give him access to its Chicago terminal. Piece by piece, he had almost assembled a link from New York to Chicago. Vanderbilt was well aware of the dangers of price competition in such a capital-intensive business. In this regard, the biggest threat emanated from the Erie Railroad. Vanderbilt’s attempts to neutralise this threat led to one of the most Machiavellian episodes in financial history and brought him into conflict with another arch speculator of the time, Jay Gould.
Vanderbilt was well aware of the importance of the New York to Chicago route, as were all his principal competitors. The biggest threat to his gaining control of the Michigan and Southern route lay with the Erie Railroad. In order to avoid difficulties, Vanderbilt entered into negotiations with Daniel Drew, his longtime adversary. An agreement was swiftly reached which was intended to lead to Vanderbilt obtaining control of Erie. Thus began the saga of ‘the fight for Erie’ which in many was to symbolise all that was wrong with the stock market and investment at the time. Features of the battle included profiteering, share price manipulation and anti-competitive practices.
At the time there was no clear unitary legal framework within either US company or securities law. Different states vied with each other, and even within states there was potential for conflict. New York’s judicial system conferred equal authority on each of its 33 Supreme Court justices. This was the ‘Tammany Hall’ era of Boss Tweed, when political favours were common, almost to the point of being a publicly traded good. Such was the influence and notoriety of William Tweed and his cohort that ‘Tammany Hall’ has become synonymous with corruption in local government. Both Vanderbilt and Drew had substantial experience of paying for Tweed’s power and influence over transportation franchises. Protection or support from the law was usually simply a matter of the amount one was willing to pay.
It helped that overseas investors owned a substantial proportion of shares in the railroad companies. The owners took little active part in the companies and voted few of these shares, the majority being left as proxies with local brokers. This conferred great power on the proxy holder, whose interests rarely coincided with those of the beneficial owners. Second, the ‘watering down’ of holdings by equity issuance should have been prevented by the General Railroad Act of 1850, which restricted the issuance of new shares. A huge gap was left, though, in that the railroads were allowed to issue convertible bonds if their purpose was railroad construction. This enabled the unscrupulous to issue bonds ostensibly for that purpose, but which they later converted into equity.
There was little in the way of legal protection for shareholders, and what protection there was could easily be swayed by financial inducement. Finally, those with the biggest financial exposure and hence most likely to be harmed – foreign shareholders – did little to protect their interests, and, by their own negligence, conferred additional power on those most willing to abuse it. It was little wonder that, in such conditions, and with such potential rewards, there emerged a new breed of ruthless personalities, of the type who became known as the ‘robber barons’.
The Erie Railroad was an unlikely candidate to feature in one of the most notorious financial episodes in American history. It was originally charted in 1832 to build a connection between the ocean traffic of the Great Lakes and New York City. It was completed in 1851, but as a result of poor construction, poor linkages and poor routing its share price had fallen from $33 to $9 in 1859 and the company went into receivership. Recovery came with reorganisation, acquisition of better port linkages, access to the coal fields of Pennsylvania and a tie-up with the Atlantic and Great Western Railroad which brought with it valuable oil freight. The Civil War boosted freight levels, and as a consequence, the route’s prosperity.
Much of the credit for the recovery and the accompanying debt reductions was due to Nathaniel Marsh, who had taken over as president of the railroad at the time of its receivership. In 1864, however, Marsh died suddenly and two new shareholders came to the fore. Daniel Drew had been investing in the company since 1854, when he loaned the company $1.5m, and he subsequently became treasurer. Drew used his position, often financed by the treasury of the company itself, to profit from short selling the stock whenever the opportunity presented itself. The company’s history therefore was one of poor construction, an appalling accident record and persistent stock market manipulation by insiders, even before Vanderbilt’s arrival on the scene.
Despite its chequered history, Vanderbilt was sufficiently concerned about the threat to the profitability of his New York Central line to be drawn into an agreement with Daniel Drew to gain control of the Erie Railroad. In 1866 he began purchasing stock in Erie and was soon confidently announcing his intention to incorporate it into his network. Despite his success with the Harlem and Hudson railroad operators, however, Vanderbilt quickly discovered that his enemies had learned lessons from previous stock market battles with him. Other than Vanderbilt, the main protagonists were Drew and his associates, Jay Gould and Jim Fisk, and a Boston consortium headed by John Eldridge. Vanderbilt probably believed he had control by virtue of the stock he owned and his agreement with Daniel Drew. Unfortunately for him, Drew reneged on his agreement. This may have been caused by a desire to recoup losses from previous failed bear raids on Vanderbilt, or simply an irresistible opportunity. Whatever the reasons, Drew flooded the market with stock.
This stock came from a deal where Gould and Fisk had bought a small railroad company and leased its assets to Erie for an inflated price. Payment was in Erie convertible bond
s, which were then converted into stock and sold to Vanderbilt. The Eldridge group had bought stock in Erie in a bid to persuade the company to fund a road between Boston and the Hudson River. Vanderbilt entered into a secret agreement with the Eldridge group to guarantee $4m of their debts on condition that they voted with him to remove Drew. Outmanoeuvred, Drew capitulated and sought to mend fences with Vanderbilt. Although he temporarily resigned, in 1867 two of his contemporaries, Gould and Fisk, were appointed to the Board.
The peace was short-lived. Vanderbilt called a meeting of the New York Central and Erie Railroad directors to pool traffic and set prices, only to find that Gould and Fisk, the Erie directors under Drew’s control, had voted against him. Even worse, Erie started negotiations with Michigan Southern and at the same time issued $10m of convertible bonds to allow further dumping of Erie stock. This meant that despite all Vanderbilt’s stock purchases, and his success in obtaining foreign owners’ proxies from local brokers, he still did not have control. His holdings were being diluted by the day against the backdrop of a falling Erie share price. Unable to stop Drew and his cohorts directly, Vanderbilt sought assistance from the law. New York Supreme Court Judge George Barnard, a member of the ‘Tweed Ring’¹⁰ issued a series of injunctions on his behalf, requiring the return of 25% of the recently issued securities, $3m of convertibles and the cessation of any further issues. As a result, the Erie share price rose from $50 to $84, a welcome movement for Vanderbilt who now owned 200,000 shares.
2.4 – A choice of two evils: monopoly or corruption
Source: New York Times, 28 March 1868.
The rule of law – or corruption?
It was at this point that the vagaries of the New York legal system really began to impose themselves. Drew et al reacted by recruiting a different Supreme Court judge, who stayed all Vanderbilt’s actions and removed his appointee, Frank Work, from the Erie board. While the injunctions were passing back and forwards, Drew continued to issue stock and Vanderbilt was forced to purchase this. Drew also set aside $500,000 for ‘legal purposes’ and published his railroad superintendent’s report on the need to raise funds to upgrade the railroad. These reports were useful propaganda tools supporting the bond issue (whose true purpose was simply to drive down the share price and take capital from Vanderbilt). Eventually matters came to a head. Vanderbilt’s financial position became precarious and liquidity dried up as Drew removed $7m in cash for the stock sales he had made. Vanderbilt had Judge Barnard issue contempt orders on 11 March. With the benefit of advance notice, Drew, Fisk and Gould managed to avoid arrest by fleeing to New Jersey, carrying the $7m in cash and as much of the company’s paperwork as they could manage.
The war of injunctions was to continue through 1868, during which time the Drew group continued with both legal and physical protection, to the extent of installing cannons on the wharves near their headquarters, and receiving backup from a squad of New Jersey policemen (to augment their own armed guards). On one occasion a group of insurgents was only repelled by superior numbers.¹¹ Vanderbilt, on the other hand, survived by threatening to bring down the whole financial system if further capital was not advanced to him.
The end of the first installment of this saga came with Gould seeking the assistance of the New York state legislature in Albany. Aided by his ‘legal purposes’ fund, Gould assiduously lobbied for the legalisation – or validation – of Erie’s bond issues. Although Gould was to prevail, the state senators proved capable negotiators and the cost to Gould was more than $1m. Gould outbid Vanderbilt’s inducements to the politicians, and consequently Tweed’s cohorts swung behind him. The bill legalising the bond issues was passed with a clause prohibiting the same group from controlling both the New York Central and Erie Railroad.
This key clause meant Vanderbilt’s stock in the Erie Railroad was to all intents and purposes a burden to him. He only escaped from this sticky position when the ever-duplicitous Daniel Drew double-crossed Gould. Between them, Drew and Vanderbilt were able to organise sufficient directors to control the Erie Board and authorise a series of transactions which effectively reimbursed Vanderbilt for his loss of control. The cost to Erie was $9m in debt. Gould was left with what appeared to be an empty shell.
Having issued $20m of bonds and shares, but with no capital expenditure or improvements to show for it, the shell company was certainly not a valuable entity as it stood. Recognising the need for political patronage, Gould appointed the Tammany leader William Tweed to the board. This appointment brought with it the legal and political support that had been critical in previous battles. What followed was a repetition of past behaviour, with insider short selling, followed by short squeezes or ‘corners’. A further $20m of capital was issued to complete the work the previous bond issues had ostensibly been arranged to finance. It was followed by a shorting operation in August 1869 when Gould took his revenge upon Drew. Gould enticed him into a share shorting operation and then trapped him with a classic liquidity squeeze, thus forcing the price up.
Unlike Vanderbilt, Gould offered Drew no avenue to extricate himself. Drew tried to threaten retribution with a legal suit, but only succeeded in alerting Gould, who used the suit (from foreign investors aimed at preventing further stock issues and at appointing a receiver) to his own advantage. Through the efforts of his “favorite” judge, Judge Barnard, Gould managed to have himself appointed receiver. This was swiftly followed by a legal action for recovery of the funds Vanderbilt had received in the original settlement. Vanderbilt claimed he had never received funds from Erie, only to have Gould’s associate Jim Fisk show the press the original cheque stubs.¹²
The relationship with Tweed was critical to Gould’s operations. Not only did it provide the aforementioned political and legal umbrella, it also gave him access to the New York City funds that allowed Gould, with the connivance of Tweed, to manipulate the amount of monetary liquidity in the market. “It was widely known that on certain occasions Henry H. Smith of the brokerage firm of Smith, Gould and Martin, together with Tweed, drove up to the Tenth National Bank, the Black Friday institution, in a cab, and drew their balances out, Smith alone taking $4,000,000 with him which he kept several days at home under lock and key.”¹³ As liquidity tightened, the cost of borrowing rose, pushing down the prices of stocks and commodities. This benefited Gould, who had already established short positions.
Gould gradually acquired more interests in railroads and other businesses that could not resist his overtures, due to their reliance on his transportation links. Not all these attempts were successful. His bid to acquire the newly completed Albany and Susquehanna (A&S) Railroad was thwarted by its pugnacious president, Joseph Ramsay, and an emerging New York financier by the name of John Pierpoint Morgan. Ramsay countered Gould’s moves in the stock market with the assistance of Morgan, and on the ground with the assistance of his own armed party, which routed the Erie irregulars comprised of “Bowery toughs and sheriff’s deputies”. J. P. Morgan added to Ramsay’s defence by finding another home for the A&S railroad and in doing so took a seat on the board.
Eventually Gould lost control of Erie, as the protective umbrella of Tweed and Tammany Hall came under fire for its manifest corruption. Combined with the murder of Fisk by his mistress’s lover, and a renewed assault by disenfranchised British stockholders, Gould was forced to extricate himself from Erie on the best possible financial terms as part of a reorganisation which installed J. P. Morgan, among others, to the Erie board. The process by which a new form of control was to be exerted was in its infancy, but was to grow quickly. Financiers had always maintained an important position through their ability to fund operations, but the time was advancing where their influence was to increase to active participation in the management of companies and, more importantly, the structure of industries.
New York Central Railroad
The New York Central Railroad of the Vanderbilts differed substantially from its Erie counterpart. The stock watering which took plac
e at the NYC did so during its recapitalisation in the late 1860s. The problem for investors was not so much that the company was being manipulated by its principal shareholders, but that its top-line growth began to turn down sharply. From the early 1870s onwards, revenue growth averaged just 4%. In increasingly competitive conditions, margins fell and net income growth slipped to 3%. Shareholders continued to expect a full payout of net earnings. Whether this produced a reasonable total return depended very much upon the time of purchase; it certainly was not rewarding while the manipulation was occurring. As insiders, the Vanderbilts took out $50m in cash from a company whose total assets at that time amounted to some $130m.
Summarising the investment picture, revenue growth in the early years soon became pedestrian as competition from other railroads increased. Vanderbilt knew – and pointed out – that too many railroads were trying to service the same customer base. This lay behind his repeated attempts to gain control of the Erie Railroad. He was to be ultimately frustrated in this ambition, although, as the analysis of its finances demonstrate, this may well have been a blessing. Competition not only took away revenue, but directly hit margins when price wars broke out. Even when railroads were the dominant form of transport for goods and passengers, profitability remained good rather than outstanding. Later on the NYC was to find that big customers such as Standard Oil were able to dictate terms and could use their access to competing pipelines as bargaining counters. Despite the apparently commanding position of the railroads in connecting the major commercial centres in America, there were insufficient barriers to entry to protect their position.
Engines That Move Markets (2nd Ed) Page 7