STATEMENT OF THE PRUDENTIAL INSURANCE CO. OF AMERICA ON H. R. 3237 (AS INTRODUCED ON APRIL 28, 1947)

Before the Subcommittee on Bankruptcy and Reorganization of the House Committee on the Judiciary

(George D. Gibson, Electric Building, Richmond, Va., special counsel)

MAY 13, 1947.

I. SUMMARY

Section 1 of H. R. 3237 affords permissive procedure for semivoluntary adjustments of railroad debt where fair and feasible, while still leaving means for ultimate enforcement of creditor rights where that becomes necessary. Some procedure for that purpose is needed and desirable.

But section 2 of H. R. 3237 would apply that procedure in a mandatory way to all roads in reorganization at the date of its enactment and at the same time eliminate as to them all means for enforcement of creditors' rights. The purpose is to preserve all of the old stock intact. So where a railroad borrows and cannot pay, the bondholders are cut down but the stockholders cannot be hurt.

Such a principle strikes at the root of railroad credit, for bonds are marketable only by virtue of the assurance that, in times of trouble, they will be paid before anything goes to stockholders. Without ability to obtain capital on cheap terms through sale of bonds, the railroad industry will be crippled in the performance of its public service. In another way also, and no less directly, the public interest suffers, for if reorganizations are prevented (as section 2 proposes) from reducing the amount of the old capitalization in any case, however excessive it may be, the dead hand of the past must infect the long-term future.

Because section 2 of H. R. 3237 threatens the continued efficient operation of the railroad industry by private initiative, and beyond that carries disturbing implications for the whole economy, Prudential Insurance Co., as a large investor of family savings, feels in duty bound to present these fundamentals of the problem for the committee's consideration. It hopes that by presenting them, in terms of the important principles without elaboration of technical detail, it may be of some help in the labors of the committee, which has always so notably desired to give fair and full consideration to every side of every controversy. For these reasons, Prudential respectfully submits that section 2 of H. R. 3237 is against the national interest and should not pass.

II. THE INTEREST OF PRUDENTIAL

Prudential Insurance Co. is one of the larger mutual life insurance companies, with a considerable portfolio of investments, including railroad bonds. It is interested, therefore, to receive just treatment for those bonds when reorganization becomes necessary. So it is directly interested in the subject of H. R. 3237. Even more, Prudential, as the custodian of the savings of 26,000,000 policyholders throughout the country, is interested in the preservation of an economy that makes it worth while for people to save for their families. If a proposed change in the rules be such as to threaten a serious dislocation in that respect, the interests of all the people must be weighed against the narrower interests of those seeking the change.

From both these points of view, Prudential fears that section 2 of H. R. 3237, the part applying to railroads now in reorganization, may endanger railroad credit and thus the continued efficient operation of the railroad industry by private initiative. Such an unhappy development would, in itself, be directly disturbing to the whole economy. The destructive precedent would be even more so.

The real issues of the controversy over railroad reorganizations have often been obscured by epithets or technical detail. But they are so fundamental that they can be stated simply. And they should be.

As a faithful servant of its policyholders, Prudential feels in duty bound to submit these possibilities for the consideration of the committee in its review of H. R. 3237. Prudential speaks only in that capacity. It disclaims categorically any desire on its part, sometimes imputed by partisan argument to the life-insurance companies in general, for control of railroads or any other industry, through any means whatever. Its only interest is to provide mutual-life insurance of prime character at low cost consistent with safety. But for that purpose it must receive prompt payment of its investments so that it may make prompt payment of its obligations on its policies, and it is concerned, of course, to prevent the destruc

tion of savings in general. Only for such reasons has Prudential been active in railroad reorganizations and because the law could not work unless security holders discharged the responsibilities of their ownership by taking the initiative on_reorganization problems.

In saying this Prudential does not mean that the railroad reorganization law is ideal in its present form. On the contrary, changes, if soundly conceived, would be desirable, as the President indicated in his Memorandum of Disapproval of S. 1253, and Prudential is prepared to offer constructive suggestions to that end if they be desired. But in any such undertaking it submits that changes should be weighed from the point of view of the economy as a whole and not be made if threatening evil results in that broad perspective for the long term.

III. THE MERITS OF THE PROBLEM

1. THE PROBLEM STATED SIMPLY

Investors lend only to procure a gain by way of interest. Where there is a virtual absence of risk, as in the case of Government bonds, the rate, fixed largely by the policy of government itself, measures the current value of the use of money for the term of the particular loan. But where any element of risk enters into the assurance of the return, the rate rises to reflect the degree of risk. The risk is much higher in the case of stock and the rate of return necessary to procure funds through sale of stock is correspondingly higher.

Due to this lower rate of return on bonds, the railroads have, through all time, obtained a substantial part of their total invested capital through the sale of bonds. This was a measure of economy to the rails. The investor, for his part, was willing to accept the smaller rate of return because of the assurance that he would receive his money regularly and certainly and, in the event of disaster, would be paid in full before anything could be provided for stockholders.

Only railroads of the very highest credit, approximating Government bonds in their virtual absence of risk, could sell bonds with low interest rates were it not for the belief of the business community that, in the event of trouble, the bondholders will first be paid. From the point of view of these fundamental forces, payment means receipt of money, or the substantial equivalent of money, in the amount of the claim. It is not the same thing to receive new pieces of paper, even though expressed to be higher in rank than those given some one else, unless having this intrinsic value.

Where misfortune strikes so deeply that the whole railroad is worth less than the amount of of its debt, there is no way to preserve the old stockholder who borrowed the money if we are still to maintain the assurance that bondholders will be paid before anything is given to others, the very assurance that is the mainstay of railroad credit.

The destruction of that assurance is precisely the purpose of section 2 of H. R. 3237. It says that if a railroad borrows money and becomes unable to pay, the claim for interest may be cut down and the due date of the principal postponed, but nothing can be taken from the borrower. In such a situation, how can a fiduciary such as a mutual life insurance company, in the conscientious exercise of its responsibilities, invest in railroad bonds?

This is not a problem of particular railroads or of particular reorganization plans, but a matter of general principle, important to all the railroads in the same sense as coal and water.

2. WHAT VALUE IS

Assuming, then, that creditors must réceive money or money's worth if railroad credit is to survive, what does that mean in the situation where, as is usually true in case of trouble, there is not enough cash on hand for the purpose? Since the creditor cannot be paid in rails or ties, the only means of payment is some form of new security. So the whole question is the value it will have.

No interest in any business has any value, apart from the chance of sale for scrap, except in the expectation of future income. This is not a controversial assertion, but a truism on which all those who buy or sell unanimously agree. Judgment of future prospects controls every purchase or sale. True enough, no judgment of the future can be a certainty. It has, indeed, been referred to in the arguments on this subject as a "guess.' But an educated guess is the means by which all government and business proceed. It requires, unavoidably, an act of judgment. So if reorganizations are to deal with real value, as distinguished from paper tokens, some one must be given, and preferably a neutral agency of the government, the power to act on just such a judgment of the future.

As applied to railroad reorganizations, that means two important things: First. some one must have the power to determine the real worth of the whole railroad in terms of the total new capitalization it can reasonably support with its prospective earnings; and second, some one must also have the power to determine the classification and terms of the different kinds of new securities that can be supported by these prospective earnings. A bond, even though of distant maturity and bearing interest at a low rate, perhaps payable only if earned, may nevertheless have a real value somewhere near its face amount if the applicable earnings are so much greater than the interest as to assure regular payment year after year. But if the interest will be earned sometimes and sometimes not, it is quite a different matter. According to the balance of these chances, such a bond may really have the nature of a stock, but without the compensating privilege of a high return in prosperous years to even up for the loss of a return in poor ones. Its mere name does not give it value. Where real value is no greater than the amount of the debt, the creditor cannot be paid except by having all there is.

The public interest coincides with private right in this respect. Unless the old creditor is paid, new creditors may not be obtainable, however great the railroad's need. And unless the new capitalization is held within limits on which an adequate return can be earned and paid, the reorganized road can never be a healthy instrument of public service. Its securities become mere vehicles of speculation. Bled by excessive debt charges and suffocated by meaningless stock issues, it cannot improve its service, maintain profitable employment and yield a dependable return to investors.

By talking of the case where reorganization value is less than outstanding debt, Prudential does not mean to take a position on any of the pending reorganization cases, still less to suggest that such is the situation in any particular one of them. That is a problem to be resolved on a case-to-case basis in the light of the facts as they exist. Our suggestion is only that, for protection of the public interest, some agency, preferably the Interstate Commerce Commission, should be left with the power to make that determination on the facts, and the Congress should not undertake to lay down any fixed rule that would preclude inquiry into that vital issue.

3. WHAT THE BILL DOES

All these facts are swept out of the window by section 2 of H. R. 3237. Instead of real value, to which the businessman looks, it uses previous capitalization as the yardstick for the future. No plan can be approved under it that will in any degree reduce the old stockholder's position. Wherever real value is less than debt, this means that the creditor is not paid, but is barred from payment. It means that the dead hand of previous capitalization, however ill-conceived and for whatever purpose issued, will infect the whole future of the railroad, no matter how much the public may suffer by the inability of the road to finance improvements essential for good service.

These comments do not apply to section 1 of the bill, or to the Wolverton bill (H. R. 2298) or the White bill (S. 249). Those proposals merely afford permissive procedure for semivoluntary adjustments of debt where fair and feasible, while still leaving means for ultimate enforcement of creditor rights where necessary. But section 2 of H. R. 3237 would put all those means out of reach in the case of every road to which it applies.

We do not enter at this time on the technical details of reorganization practice. We submit that, in broad principle, H. R. 3237 misconceives the real need of the public interest, by undermining the assurance of payment that is the mainstay of railroad credit, and by harnessing sick railroads to their old owners so that funds needed for future improvements may be unobtainable. These would be misfortunes for the long future. Yet we believe the argument for them arises only out of the extraordinary and nonrecurring income of the war years, which has now evaporated. The security markets, which reflect the estimates of many people competing to make the best judgment of real worth, appraise the total capitalizations of the reorganized railroads in every instance at far less than the amount approved by the Commission, let alone the much greater amounts of previous capitalizations. In the face of that record, it is impossible for any holder of the old stock to say that the bondholders have been overpaid. If he believes that, he has only to buy some of the new stock, readily available in the market at a fraction of its face value, and thus be certain of wealth as its price skyrockets above par, as it must in time if there be anything in his contention.

Where the interests of so many are so clear, and the opposing interests are so much fewer and more doubtful, the Congress should not, we respectfully submit,

be asked to take the responsibility of enacting ill-starred legislation like section 2 of H. R. 3237.

It is on this clear field of principle that the controversy over railroad reorganizations should be resolved. But we do not wish to leave the matter in general terms. An examination of the framework of H. R. 3237 will, we respectfully believe, show its violation of these fundamental principles. The rest of this statement is given to that purpose.

IV. THE TERMS OF THE BILL

1. ITS PURPOSE

H. R. 3237 is, in its essential purposes and in most of its wording, the same as the Wheeler bill (S. 1253 of the 79th Cong., 2d sess.). The principal difference is in the roads to which it applies. That difference (see 2 below) is, in a word, that the bill, so far as relating to reorganization roads, is now confined to roads in the custody of the courts at the time of its enactment, though broadened to include all of them.

The purpose of the bill, in short, is to suspend all creditor remedies for an indefinite time as a means of forcing on them a readjustment that will preserve all the old stock interests intact. The means through which this is sought to be accomplished are, in chronological sequence, (i) a manipulation of funds by the debtor to retire debt at a discount, (ii) a write-down of interest claims and (iii) a preservation, so far as paper positions go, of all then remaining claims and all the old stock, whether or not the road is able to earn and pay a return on them. But the words of the bill fall short of disclosing such a destructive purpose. Confusion, litigation and delay are thus to be expected. But, however unwelcome these may be in the public interest, they are minor in comparison with the inevitable result. That may well be a stalemate wherever debt exceeds reorganization value and, if not, will certainly, in such cases, be a new generation of financial cripples.

The structure of the bill, like S. 1253, is in two parts. First there is a provision authorizing roads, irrespective of solvency, to modify their funded debt on prescribed findings by the Commission and the assent of a majority or more of each affected class, without a court order, but subject to judicial review. Then there is a provision suspending all proceedings on reorganization plans under section 77, substituting the debtor for the trustee and applying the new modification technique, with a cram-down power for the Commission in the absence of the stipulated assent of creditors. The bill is drawn as a separate act, the Railroad Reorganization Act of 1947, and not as an amendment to the Interstate Commerce Act. It does not explicitly invoke any power under the bankruptcy clause.

A more detailed discussion of the terms of the bill follows.

2. THE ROADS TO BE INCLUDED

The most important change in the bill, as compared with S. 1253, is the elimination of the five bracketed words in the provision that the bill shall apply to each railroad "whose properties on the effective date of this act (or at any time thereafter) are in the custody of the United States courts * *" (sec. 2 (1)).

*

As a result of this sound and beneficial change, the bill does not scrap section 77 for the future, though it does empty it for the present. The implications for railroad credit would thus seem less immediately shattering. While what is proposed is unsound, and one breach of sound principle suggests another, at least the other is not yet made and this unsound treatment may be said, especially since the bill covers only those roads that have earned their fixed charges, by the formula of the bill, in the still recent period of 1939-45, to be a legislative experiment, made wholly because of an abnormal and nonrecurring situation.

As the bill wisely omits the future, so also it wisely omits the past by omitting the provision of S. 1253 as passed by the Seventy-ninth Congress (sec. 2 (15)) for tacking on options or warrants to plans already consummated by turn-over of the properties before enactment of the bill. Moreover, by speaking only of roads in the custody of the courts at the effective date of this act, i. e., the date of its enactment, the bill excludes carriers whose plans shall have been consummated by the turn-over of properties before that time.

While thus focusing only on carriers, with a net earnings experience as aforesaid, that are in the custody of the courts at the time of enactment, the bill covers all of them by dropping out the previous limitation to carriers having total railway

operating revenues of more than $50,000,000. This extension is sure to raise administrative problems in a number of smaller situations already well advanced.

3. THE PLANS TO BE AUTHORIZED

Next to the question of what roads are included under the bill, the most important question is what can be done with them under the bill. As in the case of S. 1253, the only plan authorized by the bill is a plan to "alter or modify * * * bonds, notes, debentures, or other evidences of indebtedness issued under any mortgage, indenture, deed of trust, or any other instrument of like nature * * * hereinafter * * * sometimes called 'obligations'. * * *"" The bill, in a word, makes the funded debt the only thing that can be changed.

Stockholders may, of course, in order to procure creditor assents, voluntarily propose some cumulation of shares or other direct modification of stockholder position through such voluntary proceedings as may be permitted by the laws of the particular domiciliary State, and such action on their part may even be stimulated by creditor insistence as a condition to assent. But that remains a purely voluntary act, outside the reach of the bill and not subject to compulsion pursuant to the bill.

It may be noted that the bill, while admittedly patterned on former chapter XV of the Bankruptcy Act (authorizing semivoluntary adjustments of railroad debt, 11 U. S. C., sec. 1210 (2) (c) (i)), is, in this respect, contrary to the recommendation of one of the principal proponents of that chapter as first enacted: 11* * * the act should be so clear as to remove any doubt, that under a plan the court might order such modification in the rights or interest of stockholders as might be deemed fair and equitable, in order to compensate the creditors for the modifications made in their rights and interests. (Hearings before this committee on H. R. 6840, 77th Cong., 2d sess., April 29, 1942, p. 39.)

* * *

* *

What, then, may be done to funded debt? The basic standards are that every plan, before approval by the Commission, shall, with such amendments as the Commission may think just and reasonable, be found to be: (i) "in the public interest"; (ii) "in the best interests of the carrier, of each class of its stockholders, and of the holders of each class of its obligations affected"; and (iii) "not * * * adverse to the interests of the holders of any other class of the carrier's securities * * *(sec. 1 (2)).

The underlined words in (ii) above are new in the bill. As changes may be made only in funded debt, so also the kinds of permissible changes are limited to those that will be in the best interests of * * * each class of its stockholders.

This is a difficult standard, to be in the best interests of both debtor and creditor. But it appeared in chapter XV of the Bankruptcy Act, and has thus had some administrative and judicial history. It was never applied under chapter XV to permit any reduction in the principal amount of a debt claim (except by payment in cash), or any conversion of a part of the principal of a debt claim into equity securities. Nor was it applied to permit any reduction in a claim for interest accrued before a time substantially the same as Commission approval of the plan, or any conversion of such claim into equity securities. Historically, therefore, the standard has been used only to permit postponements of maturities, or changes in the rate and terms of interest in the future, and modifications of indenture provisions.

But chapter XV was provided only for situations of temporary distress, where the old common stock was entitled, as a matter of real value, to survive and, section 77 was left applicable to all other situations. Section 2 of H. R. 3237, on the other hand, neutralizes section 77 and thus preempts the field, including the situations where the old stock has no hope on any realistic basis as well as situations of merely temporary distress. So some departure from the historical use of this standard of chapter XV may be invited, and all the more so by the special emphasis laid in the bill on reduction of interest claims for the period since the inception of reorganization proceedings. This appears in two places. Preliminarily, the bill, in giving effect to earlier court determinations of "relative priorities," confines such respected determinations to those declaring the "priority of any claim as of the date of the filing of the petition by the affected carrier under section 77 * * *" (sec. 2 (3)).

Definitively, the bill directs that the Commission, in determining the amount of affected obligations, shall consider principal plus interest at contract rates to the