Is This Any Way to Run a Railroad?
from July/August 2002
Bad business models have a storied place in American history, stretching back to another economy-altering industry that predated dot-coms by more than a century. As with high-tech start-ups in the 1990s, the biggest drain on railroads in the 1870s was their own dizzying expansion. Competition prompted rival lines to lay hundreds of miles of new track (and with it, to take on steep fixed maintenance costs) even as they were slashing fares (and revenues) in a desperate attempt to lure passengers. Things got so bad in the last quarter of the 1800s that approximately one-third of all railroads were forced to pull the plug.In 1867, Congress passed the first bankruptcy bill to contain provisions for corporations. But the act stopped short of allowing a company to retool its operations, so it didn’t do much for the creditors of sputtering railroads. Liquidation was an option ill suited for them. As David A. Skeel Jr., a law professor at the University of Pennsylvania and the author of Debt’s Dominion: A History of Bankruptcy in America , points out: “A thousand miles of railroad track, divided up among 100 creditors, was not going to be worth anything to anybody.”
Congress pushed through another set of bankruptcy guidelines in 1898, but those too failed to establish a system for reorganizing medium-sized or large corporations. And so, as they often did in the course of building their empires, the “robber barons” who controlled the railroads made the rules themselves.
Bonds underwritten by J. P. Morgan and his peers were the primary source of capital for the railroads. As one line after another began missing payments, the bankers worked with their lawyers to control the receiverships that assumed control of an insolvent corporation’s
assets. This allowed them to selectively sell assets but keep a railroad intact. “Wall Street bankers and lawyers were the guiding influences on the equity receivership process, and its most obvious beneficiaries,” Skeel writes in Debt’s Dominion. Other creditors and shareholders, who might have benefited from a different form of governance—little as it might have produced for them—were left out.
That began to change with the Chandler Act of 1938. Responding to the anti-Wall Street sentiment brought on by the Great Depression, the federal government created Chapter X, which required that trustees be called in during bankruptcy to take control away from current management. Not surprisingly, top executives didn’t like that so-called mandatory-trustee provision. Over the next four decades, large corporations increasingly found a way around the clause by sneaking into bankruptcy under Chapter XI of the Chandler Act, which was intended for mom-and-pop businesses and did not dictate a change in governance. With Chapter XI, current management could retain control of a company under what bankruptcy lawyers call debtor-in-possession status.
More than once the Supreme Court declined to close that loophole. The next major bankruptcy reforms, adopted in 1978, codified it, explicitly making debtor-in-possession available to even the biggest corporations. Arabic replaced Roman, and Chapter 11 reorganizations were born. In the U.S., bankruptcy—a term that originated with the medieval Italian practice of breaking the trading benches of deadbeat merchants (banca rotta: broken bench)—was on its way to becoming just another business strategy.
