cumstances which subjected the declarant to the burden of supporting an over-capitalized structure and it has supported it. The $20,800,000 of common stock of declarant cost the Cities Service Company nothing; indeed, it cost it minus $4,993,254.59, or less than nothing. There has been a complete absence of arm's length bargaining between the Cities Service Company and the declarant-the transactions were subjected to no independent scrutiny or supervision.

The Cities Service Company has been in control of the declarant and its predecessors and has used that control to the benefit of Cities Service Company and the detriment of the declarant. As a result thereof the declarant has paid Cities Service Company enormous profits on property bought with funds provided by the declarant.

Cities Service has controlled the policies of the declarant presumably with respect to such matters as accounting, dividends, depreciations, transfers of depreciation reserves to the surplus of the company in which surplus Cities Service or its subsidiary Cities Service Power & Light owned an equity; presumably, also as to the matter of the declarant entering into a gas purchase contract with the Colorado Interstate Gas Company. Cities Service has controlled the declarant not through a "disproportionately small investment," as the statute says, but with no investment whatever.21

When Section 7 (d) (1) is read in light of the enumerations of policy in Section 1 (b), it is clear that it was intended to outlaw securities issued against write-ups and intrasystem profits. Section 7 (d) (1) does not necessarily embody a prudent investment or original cost standard, but I do believe that it includes the standard of "actual investment." Actual investment excludes self-serving declarations of value and arbitrary appraisals. Actual investment is a matter of history, not of speculation. And it is to be added that in disregarding prices paid in sales growing out of an intimate alliance between buyer and seller, the "actual investment" standard disregards an item which offers no guide to value. Where the transactions are unaccompanied by the independent scrutiny of a public agency or other independent check, intrasystem transactions often engender obscurity and confusion to the detriment of honest determinations; and so the prices paid in such deals have a delusive appearance of exactness whereas they are actually unreliable criteria of value.22

As I have said, the declaration of policy found in Section 1 of the Act and the direction there given as to how the provisions of the Act

"It is no answer to say that Cities Service Power & Light, and not Cities Service, now owns the control of the declarant because Cities Service Power & Light is controlled by Cities Service, and the transactions involving transfer of control from the latter to the former were not conducted at arm's length. See supra, footnote 17.

2 Cf. Dayton Power & Light Co. v. Public Service Commission, 292 U. S. 290, 295 (1934); American Telephone and Telegraph Company et al. v. United States et al., 299 U. S. 232, 239 (1936).

shall be construed, make it plain that Congress did not intend that securities should be issued against write-ups and intrasystem profits. That is what is being done in this case. I find the bonds and debentures are 90.50 percent of the adjusted net assets (hereinbefore explained). If to the bonds and debentures is added the preferred stock in the hands of the public, the result is 101.22 percent. It is not too much to say that write-ups and intercompany profits of the kind here described were among the chief reasons for the passage of this Act. It seems to me that if we approve this issue we are in effect approving practices that the Act emphatically condemns.

Is no meaning whatever to be given to Sections 7 (d) (1) and 7 (d) (6) of the Act? To answer "yes" is to amend the statute, a power only Congress possesses. If not now, when, if ever, will a security be found not to be reasonably adapted to the security structure of the declarant? Could anything be more unreasonable than raising all the actual capital for an enterprise through bonds and preferred stock, and then permitting the common to take the lion's share of the earnings?

In deciding whether a bond or debenture is reasonably adapted to the security structure of the declarant, is no attention to be paid to the ratio of such bonds or debentures to the net assets or total capitalization? Would it not be generally agreed that a capital structure consisting say of 85 percent bonds, 10 percent nonvoting preferred and 5 percent common was an unbalanced structure; that the leverage given the common was unfair; that the senior securities were in reality asked to take the risk attendant upon equity securities without the compensating chance of an opportunity to realize something beyond a low fixed return? Would not the common stock be in control of the whole enterprise with a disproportionately low investment? Nearly all authorities will answer in the affirmative.23

Keeping bonds in a reasonable relationship to net property and total capitalization is recognized as desirable by many authorities on security analysis.24 For example, very recently a series of conferences on bank investment has been conducted by the Committee on Bond Portfolios of the New York State Bankers Association with the cooperation of the Federal Reserve Bank of New York. A set of "yardsticks" was set up for the guidance of bank executives. The second item reads: "Funded debt, ratio to net property should be less than

23 The importance of common stock money in a security structure was succinctly explained by C. W. Kellogg, president of the Edison Electric Institute, in his article, "An Audit of 1937 Electric Utility Business" (Electrical World, January 15, 1938), when he the common stock money is the one final and necessary foundation that makes the whole structure stand up • *."

wrote:

"Even the indenture proposed to be executed by the declarant in connection with the proposed issuance of the bonds provides that new property additions may not be bonded beyond 70 percent of the cost or fair value (whichever is less) thereof.

60 percent." 25 The statutes of New York and Massachusetts defining bonds which are legal investments for savings banks and trustees fix the ratio of debt to net property at 60 percent.26 There are states in which it is still unlawful to incur debt in excess of capital stock."

I recognize that many good authorities regard earnings as the one realistic standard for judging investment values. But as I have shown there are authorities who have different views and the statute makes earnings but one of six tests. However, we are not here to merely pass on the attractiveness of securities from the investor's point of view or convert ourselves into another rating or statistical service. We are to regulate the issuance of securities according to the terms of the Act.

I recognize that to the objections which I have registered it will be answered that these issues are refunding issues, that by taking advantage of present low interest rates the condition of the company will be improved; that a debt due the parent is converted into an investment in the form of common stock 28 and that savings and interest are tied up and cannot be paid out in dividends.

Though under the Act the same standards are applicable to refunding issues as to new issues, I know that as a practical matter the standards are often relaxed in favor of refunding. But here the total funded debt in the hands of the public is being increased $4,860,601; the capital representing the greater part of the only actual money invested in this company is to receive a reduced return; the so-called improvement in the condition of the company simply means

26 See P. U. Fortnightly for June 22, 1939, p. 856. See Ostrolenk & Massie's "How to Buy Bonds" (1932): "To be conservative, bonds should not be outstanding against either of these properties (i. e. electric and gas) at a rate much higher than 50 percent of net property values."

26 N. Y. Banking Law § 235; General Laws of Massachusetts (Tercentenary Edition) (1932) Ch. 168 § 54. See also Waltersdorf, State Control of Utility Capitalization (1928)

37 Yale L. J. 337.

27 E. g. Wyoming Revised Statutes, secs. 28-132, as amended by Spec. Sess. L. 1933, c. 52; Revised Code of Arizona Supp. of 1934, sec. 587; South Dakota Revised Code of 1919, sec. 544.

28 The majority opinion disposes of the intercompany debt by merely saying that the open account between the parent company and declarant was substantially in balance on July 1, 1935. As to the claim of the parent accumulated since that date, a portion represents funds which the parent loaned the declarant to enable the latter to pay dividends on its common stock which was held by the parent. In other words, the parent company in effect charged the dividends against the subsidiary plus interest at the rate of 6 percent per annum.

The record does not contain any information regarding the intercompany account prior to 1935. It may not be an unfair assumption that the debits and credits ran into millions of dollars. If during that period there were any substantial overcharges by the parent to the declarant, the account might not only have not been in balance but the parent might well be indebted to the declarant. Moreover, while the majority opinion treats the parent's acceptance of common stock for this indebtedness as a conversion of a debt into a common stock investment, it is not clear that this $2,190,000 debt would not be subject to certain offsets as a result of profits made by the parent at the declarant's expense. Compare, Taylor et al. v. Standard Gas & Electric Company et al., 306 U. S. 618 (1939).

that a larger portion of the earnings will be available for the common stock which represents no actual investments; freezing of the savings due to refunding merely postpones the date when Cities Service Power & Light can take them over. The greatest benefit from the refunding goes to Cities Service Company and Cities Service Power & Light,29 who have already received disproportionate benefits to which they were not fairly entitled.

The advantages accorded to the common stock through this refunding can be demonstrated by using consolidated book figures without adjustment. The debt represents 61.38 percent of book capital and receives 45.86 percent of the income. The preferred represents 12.38 percent of book capital and receives 10.44 percent of the income. The common stock and surplus represents 26.24 percent of the book capital and receives 43.70 percent of the income. The refunding changes these proportions (still using consolidated book figures without adjustment for intercompany profits) as follows: The debt becomes 60.45 percent of the book capital, its share of the income 35.81 percent (as against 45.86 percent before refunding); the preferred stock will represent 11.80 percent on book capital and will receive 10.85 percent of income; the common becomes 27.75 percent of book capital (as against 26.24 percent before refunding) and receives 53.34 percent of income as against 43.70 percent of income before refunding. If the book capital were adjusted to eliminate intercompany profits, the common stock would represent no contribution to the company's capital except the accumulated consolidated surplus. This surplus as of February 28, 1939, was $644,133.32. This sum, however, cannot be computed as a contribution to the company's capital because the common stock contribution was a minus sum and the surplus does not equal it. Therefore the earnings accruing to the common stock cannot be related to the adjusted actual contribution in common capital. To put it more simply the common stock represents no actual contribution of capital, yet for the year ended February 28, 1939, there had been earned thereon $2,801,850. If the present refunding had been in effect throughout the same period this sum would have been $3,290,102.

Applying the tests of Section 7 (d) (1) the securities are not in my judgment reasonably adapted to the security structure of the declarant, Cities Service Power & Light Company and Cities Service Company for the following reasons:

The bonds and debentures constitute too high a percentage of the actual capital of the company and of the net property account minus

I would not urge these objections if the common stock of this company represented an actual investment.

intercompany profits. The bonds, debentures, and publicly held preferred are in excess of the sums actually invested in this company and of the net property account minus intercompany profit. Said securities financed the enterprise and the result is that Cities Service is permitted through its control of Cities Service Power & Light to control the declarant with a disproportionately low investment. In fact when Cities Service turned over the declarant's common stock to Cities Service Power & Light it had no investment in said common.

The majority opinion directs that the declarant's balance sheets shall contain an appropriate footnote reference to the intercompany appreciation. I think this requirement wholly inadequate. It is a requirement which proper accounting would impose irrespective of any order of this Commission. This requirement in no way satisfies the applicable standards of the Act for the adaptability of the securities proposed to be issued to declarant's security structure is not improved by the addition of a footnote to a balance sheet.

It is significant that not only are the book figures not sustained by the cost of the properties to Cities Service Company or by the actual investment therein but there has been no independent authentic appraisal of the properties by anyone. We have not attempted to value them, nor do we have the right to do so in these proceedings. And I have already stated in my opinion in In the matter of Central Illinois Electric and Gas Company, 5 S. E. C. 115 (1939), that I believe there is nothing in law or accounting which justifies the use of reproduction cost determinations to balance security issues.

Stript of legal and accounting verbiage, I think my position reduces itself to this: that I cannot approve a scheme which calls for pouring into this corporation another $5,000,000 of the public's money, with but one effect, not of adding anything to the corporation's properties or facilities, but only of making further earnings for the benefit of the common stock, which represents no contribution to the corporation's capital and which in a period of about 141⁄2 years has already received nearly $27,000,000 in cash dividends.

5 S. E. C.