six other operating companies in Illinois between 1925 and 1931. This price was $21,411,672.28. Of this, $14,863,881.41 was paid for the common stock of the seven companies. This stock at the time of this purchase had a book value on the books of the seven companies which issued it, of $5,314,012.26. This figure presumably reflected no less than actual cost of constructing those companies' properties. But the holding company paid $14,863,881.41 for these stocks or $9,549,869.15 more than their value on the books of the companies issuing them. These prices were paid by a holding company which proved unsuccessful and which had to undergo reorganization with consequent heavy losses to its own security holders." They were paid during the period when the competition among holding companies to acquire operating companies was at its frenzied worst and when prices were strongly influenced by schemes to generate profits through commissions and spreads on distributing the senior securities of the companies acquired, through fees for management, engineering, legal and other "services," from sales of material or properties to controlled subsidiaries and from other forms of patronage then inherent in control. The holding company paying these prices and the prices themselves were not subject to the approval or jurisdiction of any regulatory body. The prices were fought out between strangers in interest it is true, but they were not subject to any type of governmental supervision, state or federal. The importance of that fact lies in the further fact that a large portion of those prices so paid have now become transmogrified into book values of the properties of the operating company, the applicant.

How did that come about? By the following steps: The applicant, controlled by the holding company, in 1931 bought the properties of the six other companies, also controlled by the holding company. The buyers and the sellers being subject to common control were mere pawns of the holding company. The properties sold were on the books of the selling companies at $13,027,619.57. They were sold for $3,079,694.26 more than that sum or $16,107,313.83. However, the applicant did not record them at $16,107,313.83 but at $19,709,136.62 or an additional mark-up of $3,601,822.79 making a total markup of $6,681,517.05. By these steps the holding company worked into the property account of the operating company roughly twothirds of the excess of the price which it had paid for control, over the underlying book values of the companies whose control had

7 See Vol. 52, pp. 202; 309-334 Federal Trade Commission Reports-Utility Corporations. This sum might have been a credit to the surplus of the selling companies. However, the profit actually so credited was $1,867,784.26, which is the above $3,079,694.26 reduced by the discount ($1,211,910) on bonds taken by said selling companies as described in the succeeding note.

9

been bought. After the six selling companies sold their properties and received their pay from the applicant, in the form of applicant's securities, the six selling companies were dissolved and the applicant's securities which they had received, as stated, were passed on to the holding company.

As already pointed out, up to this point about two-thirds of the amount by which the price paid by the holding company to obtain control of the operating companies exceeded the value of the control stock as shown by the operating companies' books, had been amortized into the property account of the applicant. To complete the process a further increase in the applicant's property account of about $3,000,000 was required. This was accomplished in the following manner: The applicant wrote up its own property account (i. e., property which it owned before the six selling companies made their conveyances to it) by $2,807,928.73. There were subsequent writedowns on applicant's books of $2,261,251, leaving a net write-up in the property account at April 30, 1939, of $7,228,195.10 So I repeat that the property account of the applicant is based upon the price which a holding company was willing to pay to obtain control of the voting stock of the applicant and its predecessors, and I have pointed out how the metamorphosis was accomplished. On these facts I challenge the propriety and wisdom of property accounts being made up in the fashion described, and I especially challenge the propriety of such figures being used to balance security issues put out to the public by operating companies. I cannot see why holding company costs should be reflected in the operating company's balance sheet, especially since these costs so often include excesses which the state (and the federal government before the passage of the Public Utility Holding Company Act) was powerless to prevent. The great significance of these observations to the present case lies in the fact that if we deduct from the net property account of the applicant the write-up of $7,228,195, we find that the net outstanding funded debt exceeds what remains as of April 30, 1939. The debt is about 101.2 percent of the net property account minus mark-ups.

'Part of the so-called purchase price paid by the applicant was paid in bonds of the applicant. The order of the then Illinois Commission required that these bonds "should be delivered on the basis of par." The applicant set them up at par on its books in arriving at the mark-up of $6,861.517.05. The six selling companies, however, took them

on their books at 89% percent of par and passed them on to the holding company at the same price. They were sold to the public at 94%. (The bankers' spread was 5 points. The record does not show whether the bankers were those who controlled the holding company.) This method resulted in effect in capitalizing $1,211,910 of debt discount in the property account of the applicant and also reduced the credit for profit on the sale credited to the earned surplus of the six selling companies.

10 The aggregate write-ups amounted to $9,489,445.78. After deducting the subsequent write-downs of $2,261,251, there remained $7,228,195.

Bonds and debentures are being issued and sold to the public in an amount $1,282,060 in excess of the net property account, if we disregard the sums which the holding company by the means described succeeded in injecting into the applicant's property account. In other words for every $1,000 of the net property account, minus mark-ups, the applicant is issuing and selling $1,078 of mortgage bonds and debentures.

The authorization of the state commission, dated February 4, 1931, dealing with the events I have discussed, and described in the majority opinion, was based, at least in part, so that opinion states, upon a reproduction cost appraisal of the physical properties of the applicant and the six selling companies.

Reproduction cost first achieved prominence in 1898, when the Supreme Court decided that a Nebraska statute which fixed the maximum rates to be charged for the transportation of freight upon railroads in the State of Nebraska, prohibited those railroads from earning a reasonable return on the fair value of their property and therefore violated the due process and equal protection clauses of the Fourteenth Amendment.11 The Court held that the determination of fair value of railroad properties for rate-making purposes must be predicated upon a consideration of the following factors:

We hold, however, that the basis of all calculations as to the reasonableness of rates to be charged by a corporation maintaining a highway under legislative sanction must be the fair value of the property being used by it for the convenience of the public. And in order to ascertain that value the original cost of construction, the amount expended in permanent improvements, the amount and market value of its bonds and stock, the present as compared with the original cost of construction, the probable earning capacity of the property under particular rates prescribed by statute, and the sum required to meet operating expenses, are all matters for consideration, and are to be given such weight as may be just and right in each case. We do not say that there may not be other matters to be regarded in estimating the value of the property. What the company is entitled to ask is a fair return upon the value of that which it employs for the public convenience.12

And from one clause in the Court's dictum-"the present as compared with the original cost of construction"-has sprung the "reproduction cost new minus depreciation" theory of fair value. That one short phrase has profoundly influenced the economic life, perhaps, the history, of this nation.

For present purposes it is unnecessary to elaborate the arguments against this method of valuation; it is sufficient to point out that the Court was seeking only to ascertain fair value for rate-making

11 Smyth v. Ames, 169 U. S. 466 (1898).

12 Ibid, 546-47.

purposes and that even for those limited purposes reproduction cost was identified as but one of several elements to be considered.

The present case is not a rate case. The issue is not whether the applicant's property is being confiscated because it is not permitted to make a fair return upon the present value of its property. We are dealing with the recording of property on books of account to balance the issue and sale of securities to the public. I know of nothing in law or accounting that justifies the recording of estimates of reproducing property new on books of account. Smyth v. Ames does not justify it; first because that case dealt only with rate making and the confiscation issue, and second because even under that decision an estimate of reproduction cost was only one of several elements to be considered. Note the following from "A Statement of Accounting Principles":

The experience of the last twenty years indicates that such revaluations inject a disturbing element into accounts; they destroy comparisons and tend to reduce the acceptability of the balance sheet generally. For the most part accountants have opposed them, and should continue to do so."

A rate base, under certain decisions of the Supreme Court, is required to reflect the present fair value of public utility properties for rate-making purposes. And since such value has no immutable character, these decisions also recognize that altered circumstances, such as a change in the general price level of commodities, may necessitate a change in the base. The rate base and consequently the rates can be adjusted to changing conditions. But once securities are issued and sold on the basis of an estimate of the cost of reproducing it (especially if as here the estimate is made in a time of high prices) the loss must be absorbed by the investors, and the loss cannot be avoided merely by restating the value of the properties. Such a restatement is usually made in the process of a painful reorganization and in the meantime many of the investors have been compelled to dispose of their securities and suffer severe losses.

The view that Smyth v. Ames in some way justifies the recording of reproduction estimates on books of account and the issuance of securities of an equivalent amount is based upon a distortion and misapplication of that famous decision and has done incalculable injury both to the public and to the utility industry. I can find but one case in our Supreme Court where this subject is dealt with.

On January 1, 1927, Atlanta, Birmingham & Atlantic Railroad Company filed with the Interstate Commerce Commission a balance

13 "A Statement of Accounting Principles," Sanders, Hatfield, and Moore (1938) p. 63; see also "A Tentative Statement of Accounting Principles Affecting Corporate Reports," 11 Accounting Review 187-189 (1936).

5 S. E. C.

sheet which reflected the value of its assets ascertained by means of a reproduction cost appraisal; certain comments of the Commission in rejecting the balance sheet are pertinent to this case:

In considering the propriety of the accounting rule which has been applied in this case, it is to be borne in mind that the "comparative general balance sheet" prescribed by us, considered in connection with the instructions for its use, does not purport to contain a correct statement of the current cash value of capital assets. Such value is variable, depending upon a multitude of circumstances which change from day to day. It is possible, however, to state with entire or approximate accuracy the cash or equivalent investment at the time it is made; and it is this amount which our accounting rules require to be recorded in the balance sheet. If a carrier, for example, purchases land for $200,000 which is actually worth considerably more or considerably less than this amount, nevertheless it is $200,000 which must be recorded in the investment account, and the accounts of all carriers which we supervise are kept uniformly on this basis *** the mere fact that the investment stated in the balance sheet does not correspond with value for rate-making purposes in no way pre vents the carrier from earning a fair return on that value."

Thereafter, on March 26, 1932, the Commission instituted, of its own motion, a broader inquiry into methods of accounting for capital items and for liability for capital stock. In its report the Commission adhered to its original view, but undertook to find and did find the market or fair cash value of the properties.15 This determination was subsequently assailed in a District Court on the ground that the valuation thus made was unreasonable, arbitrary, and void because the Commission ignored reproduction cost as well as other elements of value significant in rate making. The district court dismissed the bill but failed to pass upon the ground originally taken by the Commission. On appeal to the Supreme Court the dismissal was affirmed.16 It is significant that Mr. Justice Brandeis quoted with approval the following statement from the opinion of the Commission:

Clearly, the only pertinent value is that for purposes of sale or exchange. Cost of reproduction is to be given little, if any weight in determining such value in the absence of evidence that a reasonably prudent man would purchase or undertake the construction of the properties at such a figure."

So far as I am aware, there is no decision of the Supreme Court which sanctions the use of reproduction cost appraisals for balance sheet purposes, and the Atlanta, Birmingham & Coast Railroad Company case seems to disapprove the practice.

14 Reorganization and Control of Atlanta, Birmingham & Atlantic Railway Company, 158 I. C. C. 6, 12-13 (1929). See also United States v. Atlanta, Birmingham & Coast R. Co., 282 U. S. 522 (1931).

15 Accounting for Capital Items (In re Atlantic Coastline Railroad Company and Atlanta, Birmingham & Coast Railroad Company), 201 I. C. C. 645.

16 Atlanta, B. & C. R. Co. v. United States, 296 U. S. 33 (1935).

17 Ibid., at p. 39 (201 I. C. C. 670).