Business Failure, Judicial Intervention, and Financial Innovation: Restructuring U.S. Railroads in the Nineteenth Century

Abstract

This article describes the problems faced by reorganizers of distressed railroads in the late nineteenth century and how they were addressed by a combination of judicial intervention and financial innovations. In particular, the judicial innovations of supersenior financing, the equity receivership process, and the setting of upset values permitted firms to raise funds. The private financial innovations of deferred coupon debt, contingent charge securities, and voting trusts made subsequent default less likely. The private innovations can be interpreted as responses to both the distress of the railroads as well as the intervention by the courts that emasculated prior debt contracts.

Accounting and Regulation

“…However, we might note that such interplay, at least in its most narrow economic sense, is likely to provide only a partial explanation. Tufano (1997) has observed that in addition to the economic explanation for changes in practice in finance there are other perspectives to consider, in particular the legal perspective capturing the legislative context and decisions of courts which frame practice, and a business history perspective which examines the behaviour of particular business actors at particular times. Bringing these various perspectives together suggests that it is necessary to consider innovation in finance as a process which is broader than the economic and the same argument may be applied to debt covenants as a sub-set of finance practice.…”

“…The influence of these innovation determinants is well illustrated in several research studies. Tufano (1997) reports the impact of widespread financial distress in US railway companies, a financial crisis given the importance of that economic sector at that time, on debt contracting. He cites a range of sources who noted that these railway reorganisations led to the emergence of new covenants in securities contracts (see Dewing 1911;Draper 1930;Rodgers 1965;Stetson 1917).…”

“…Whilst these new contracting devices were responses to crisis and enhanced agency costs, they also appear to have been reactions to legal changes which weakened ex post the position of secured creditors. Tufano (1997) records a succession of legal judgements in the US where the rights of secured creditors were superseded by the redefinition of existing securities contracts. 18 Thus, new contracting practices responded to legal change by introducing enhanced monitoring to avoid ex post judicial intervention.…”

“…Covenants also have a long history as control restrictions applied within business relationships within firms, as indicated for example in Hejeebu's (2005) work on covenants in employment contracts issued by the English East India Company in the seventeenth century. In relation to corporate debt, covenants and other restrictions on management of indebted companies emerged during the railway reorganisations in the US in the 1890s (see Rodgers 1965;Tufano 1997). Restrictive covenants and accounting-based covenants in particular have for many years been included in debt contracts written under arrangements typical of US (Smith and Warner 1979) and UK (Day and Taylor 1995) institutional conditions.…”

Companies' insolvency and ‘the nature of the firm’ in Italy, 1920s–70s1

“…24 24 For example, the mechanism called ‘upset price’ invented by American courts to involve reluctant creditors in the relaunch of insolvent railway companies. For details, see Tufano, ‘Business failure’. …”