From Insull to Injury: A Study in Financial Jugglery
THE following analysis of the Insull collapse is written for the use and contemplation of those who are interested in the causes, methods, and results of business decadence; in those factors which have shaken the very foundations upon which the continuity of modern industry hinges — namely, accumulation of savings applied to large industry and directed by individual initiative, judgment, and, we hoped until recently, integrity. The complete breakdown of faith in this system, unfortunately justified, as expressed in lack of confidence, the fruits of which all markets, banks, and business in general are reaping at present, may spread untold ruin among the most cherished and essential institutions of security and stability — banks, insurance companies, private property, in fact the whole industrial and credit structure of production and distribution.
Unless we are ready to try new principles and ideas according to which the sins of the few will not necessitate repentance by society as a whole, remedies will have to be found; ways must be devised to check individual tendencies to digress from methods that ensure the preservation of industry and to eliminate those elements of instability which are due, not to faults of the system, but to the weaknesses in the mental fibre of individuals in positions of leadership. However, a pious desire to do something constructive is not sufficient; we must know the nature of the germs which have weakened the system. The Insull incident is a case study; perhaps it does not represent the general or average; on the other hand, the financial practices which it reveals are by no means rare occurrences.
I
‘All the important properties in the Insull group of public utilities,’ proclaimed Samuel Insull in a pamphlet dated October 31, 1930, ‘. . . have the advantage of Insull policies and management. Thus, there has grown up an institution — based upon the experience and upon the financial, engineering, organization, and executive ability of its personnel — which has made a notable success in utility management.’ The pamphlet went on to explain the increasing complications of the corporate structure: ‘To maintain this institution and to perpetuate it in behalf of the public served by the various operating companies of the Insull group of utilities, in behalf of the hundreds of thousands of investors in those companies, and in behalf of the men and women who make up the various organizations, there were organized two investment companies — Insull Utility Investments (Inc.), incorporated in December 1928, and Corporation Securities Co. of Chicago, incorporated in October 1929.’
The results of this solicitude for the public weal are expressed in the auditors’ or receivers’ reports as of the day receivers were appointed in April 1932: —
1. Insull Utility Investments (Inc.): Total liabilities, $253,984,341.61; total assets, $27,473,364.80, most of which is pledged or loaned, leaving unpledged securities with a market value (April 16, 1932) of $1,646,580.84, which have now proved absolutely worthless, as against funded debt of $58,645,028.77 and capital stock of $148,036,572.93. In other words, there is nothing for total investors’ book equity of $206,681,601.70.
2. Corporation Securities Co. of Chicago: Total liabilities, $142,374,979.58; total assets, $13,146,482.66; assets pledged to secure notes payable, $12,041,017.51; leaving $112,768.12 for liabilities of all kinds, excepting secured notes, of $126,966,716.35. The receivers could not even afford to hire the services of accountants to audit the books.
3. Middle West Utilities Company: No assets to cover preferred and common stocks carried at a book value of $220,924,641; furthermore, the equity available behind the outstanding gold notes to the amount of $40,000,000 has declined in value to a point where it is doubtful whether they will realize much in liquidation.
The above indicated deficits are not the measure of investors’ losses in these three companies. The actual loss cannot be calculated accurately for two reasons: in the deficits given there is duplication on account of inter-company holdings of stock; and again, the stated value of capital on the books of the companies does not correspond to the price paid by a great many investors who bought the securities on the exchanges at inflated quotations, the inflation being effected, as will be shown later, by the accounting methods of the companies.
The total loss involved in the Insull debacle goes beyond the annihilation of the assets of the three largest and topmost holding companies. Though the most important of Insull’s corporate progeny, they are not the only ones to come under the care of receivers. There are a dozen or more others just as emaciated which have staggered their way into the hands of courts of equity, and many of them probably will not survive the operations administered by courts, counsel, and committees. In view of the total amount of Insull holding-company securities outstanding in the hands of the public, the realized loss resulting from the collapse will be in the vicinity of $700,000,000.
We need not consider separately every one of the companies now in receivership, because they are, almost without exception, wholly owned subsidiaries of the three parent companies mentioned above, and their degeneracy is reflected in their parents. The same disease afflicts the whole clan of Insull holding companies, and a diagnosis of the illness of the parents will explain the decadence of the family.
At the time they went into receivership, the major Insull holding companies were completely empty — mere corporate skeletons. This condition cannot be explained by a casual reference to the general decline in security values. Though this decline in the last three years has been great, values have by no means reached the zero level. The earnings of operating companies have fallen 10 to 20 per cent from their high points of three years ago, but they still show substantial net incomes, they still pay dividends, and their stocks, correspondingly, possess real value. In view of this, how does it happen that the Insull holding companies, which were supposed to have their foundation on the sound basis of utility properties, show an absolute wastage of assets? The discrepancy shown by the complete annihilation of holding-company equity in face of the comparative soundness of operating utilities must be explained by conditions other than the decline in market values.
II
The portfolio of the three largest Insull holding companies consisted of three types of investments: securities of operating companies, securities of subholding companies, and each other’s stocks. The first still have value, but are pledged to banks, or lent to affiliates, which have in turn pledged them to cover short-term debts. Therefore they are not available as a part of investors’ equity. The sub-holding-company securities and the investments in each other’s stocks, the greater part of which is also pledged, are absolutely worthless.
This condition is strikingly illustrated by the difference between book values and market values of operatingcompany and holding-company securities in the portfolio of Insull Utility Investments (Inc.). On April 16, 1932, of the total book value of investments stated at $237,892,050.00, operatingcompany securities accounted for $119,003,904.92 and holding-company securities stood at $118,888,145.08. And yet the market value of the former was $25,613,731.00 and that of the latter only $4,788,536.47. Therefore, at that time, the market value of operatingutility securities had declined to a little less than one fourth of their book value, while the holding-company investments had declined to approximately one twenty-fourth of their book value. Since April 1932, conditions have so changed that the operating-company securities are worth more and the holding-company securities are worth nothing.
Why this striking contrast? After all, were not the sub-holding-company securities ultimately based also on operating properties which still possess value? The solution of this anomaly will be found in the multifarious financial practices in which Samuel Insull indulged for many years prior to the panic of 1929. The germs of decay had been implanted during the period of prosperity; but they remained undetected as long as the Bacchanalia lasted.
The dissipation during the years of speculative revelry will be described subsequently. Here we must indicate the disposition made of the assets which still possessed value in spite of the market decline since 1929. These were pledged with banks and others against substantial loans. During two years of depression, 1930 and 1931, Insull Utility Investments (Inc.) alone obtained net capital funds from loans (still outstanding in April 1932) of $41,585,020.53. Corporation Securities Co. of Chicago and Middle West Utilities Company also had loans outstanding of $15,408,263.23 and $33,304,906.82 respectively, making a total of more than $90,000,000 for the three companies. Since 1929 the whole Insull holding-company system is estimated to have obtained nearly $130,000,000 in loans by pawning away most of the investors’ possessions. Of all this money, only an infinitesimal amount is left.
This enormous sum, in addition to considerable amounts of capital receipts from stock subscriptions, was dissipated in two years of depression. It would tax the ingenuity of a master magician to spring a disappearing act of such dimensions. But Insull managed it. In fact, the only reason why the amount was not much more is that he could not obtain any more loans.
III
The Insulls have shown a discreet disinclination to explain this situation. The auditors and the receivers of the companies in bankruptcy have presented a mass of facts without attempting to analyze and interpret them. From close scrutiny one can detect in them clear evidence of certain recurrent practices which explain the dissipation of these huge sums.
In the first place, large amounts of cash dividends were paid out, even though the companies possessed no net cash income after interest charges and expenses had been defrayed. In fact, since the cash dividends received on securities owned were mostly from subholding companies which had not actually earned them in operation, but had declared them out of capital after making proper accounting entries, lnsull Utility Investments (Inc.) and Corporation Securities Co. hardly covered their operating expenses during their existence. Yet they paid over $16,000,000 in interest and over $12,000,000 in cash dividends, most of which came out of capital receipts. This condition was hidden from the public by the introduction of non-cash and unrealizable items into the income account.
Commissions to outsiders and advances to officers of the different companies, made either directly or through subsidiaries, to carry on speculation in stocks, also consumed a part of the proceeds from loans. The good faith of some of these transactions has been questioned by a Cook County grand jury. Payment of contractual obligations arising out of property acquisitions, usually at exorbitant prices, as will be shown later, accounts for an additional part of the cash outlays during 1930 and 1931.
Quantitatively the most important, and the least comprehensible, method of wastage consisted of pegging transactions by the companies of their own or each other’s securities on the stock exchanges. In 1930 alone, lnsull, Son & Co. (Inc.), a wholly owned subsidiary of lnsull Utility Investments (Inc.), bought 1,193,590 shares of the latter’s stock — nearly one third of the total outstanding — at a cost of $66,421,769.88, most of these funds being obtained through advances from the parent and affiliated companies. Approximately $50,000,000 was realized by reselling some of the stocks to the public at prices lower than cost. The rest was transferred to lnsull Utility Investments or Corporation Securities Co. of Chicago at cost or higher than cost. lnsull, Son & Co. thus registered a ‘profit,’ though at the time of transfer the stocks were worth little more than half the price paid.
These onerous transactions are inexplicable. The details of the situation add to their mystification. The average consideration received for all issues of lnsull Utility Investments common stock, excepting stock dividends but including those issued in exchange for sundry investments, was about $28.85. And yet the company bought large blocks of its own stock for the treasury at prices varying between $55 and $65 a share. The funds used were the proceeds of the bank loans obtained by the pledge of all the valuable assets. Thus the company had been emptied of all good assets in order to buy its own stocks which were worthless at prices which were twice what they realized at the time of original issue.
One wonders what the motive of the management could have been. It must be remembered that Samuel lnsull and associates received large blocks of this stock from the company at prices ranging from $5.00 to $15. Thanks to their accounting methods, they saw it go up to $160 — the figure quoted in Fitch’s Manual of 1931. Then it slipped back. Insull pledged most of the assets of the company for loans with which to peg the exchanges. As already stated, Insull Utility Investments (Inc.) bought through subsidiaries approximately one third of its total outstanding common stock in 1930 alone. Though a part of this was resold at a loss, Insull, Son & Co. kept on buying the stock of its parent company all through 1931. During the same period other constituent holding companies in the Insull group indulged in similar pegging operations. It would be interesting to know whether the holdings of the Insull family diminished during the period from 1929 to 1932 at the expense of the public and the companies.
Thus the funds received from loans were wasted away in quixotic activities.
‘The failure of Corporation Securities Co. of Chicago,’ write the receivers, ‘is easily understood when consideration is given to the last audit of the Corporation, prepared as of December 31, 1931, which discloses holdings in the Corporation’s portfolio of Insull Utility Investments, Inc. stocks which are given a book value as of that date of $58,756,208.42, and stock of the Middle West Utilities Company which has a book value as of that date of $42,829,772.73, the total of these two items being $101,585,981.15. Practically all of these securities were owned by the Corporation on April 16, 1932, and on that date had only a nominal value.’
IV
The Insull holding-company structure was a skyscraper of many stories. The income-producing properties rested in the cellar, and the floors above were occupied by various gradations of holding companies up to the top, where Insull Utility Investments and Corporation Securities Co. held sway. It has now been revealed that not only was the top floor vacant, but all the others, occupied by similar fictitious legal personalities, as well. When creditors forced their way into Insult’s labyrinthine corporate structure, they found literally nothing more than empty desks and stacks of account books. Whatever there had been was pawned away; everything else was worthless paper, the product of a printing press owned and operated by the vanished truant.
The success with which this condition was hidden from the outside world was a tribute to financial impressionism. The faithful public was deceived by glittering signs periodically flashed in the form of annual reports and gratuitous statistics. Like a Moslem minaret during Bairam, the turret was lighted up with colorful lanterns, and occasionally a fanatical high priest of finance proclaimed from the top the glory of Allah and the virtues of the prophet Insull. Having risen from a clerkship into his grand-opera manner, Samuel was the symbol of an era.
It appears now that the superficial glitter of his faith did not touch the essence. His temple, in its various incorporated forms, was in fact a veritable mystery chamber, a maze where the treasures of lifelong thrift offered by his faithful followers swiftly disappeared.
The management of the vast Insull holding-company structure has been characterized, since the organization of the Middle West Utilities Company in 1912, by an utter disregard for the interest of investors. Even as it wasted the enormous funds borrowed from the banks in 1930 and 1931, so it squandered the savings of hundreds of thousands of investors for many years before that. By shuffling of investments and juggling of accounts, it managed to show profits and growing assets though no funds entered the establishment, and any actual accretion of capital value had been discounted several times over by payments of excessive prices for acquisitions and by the resultant overcapitalization.
The wisdom of an investment depends upon the nature of the business which is purchased, the management under which it is to run, and the price at which the acquisition is made. On the score of operating management, as distinguished from financial management, there is no indictment to be presented. Most of the operating properties which the Insull holding companies acquired were well managed before their entrance into the Insull domain, and still better run when they became a part of it. However, this could not be said of some of the holding-company groups which were absorbed into the system during the boom period. The National Electric Power Company, the control of which was acquired in 1925, and the National Public Service Corporation, acquired in 1927, indulged, even before their introduction into the Middle West System, in many practices similar to those described above. ‘Birds of a feather flock together.’
V
In the choice of investments, and in the prices paid for them, Insull was indiscriminate, even extravagant. In the summer of 1931 when I was making a field survey of the power industry, I had a conversation with the president of an electric light company who had sold out to Insull in 1925. He was an engineer who had nursed his company from a small water-power plant to one doing over 80 per cent of the power business in his state, and who up to that time had prided himself upon the fact that since his early youth he had always been his own master. I asked this portly man in shirt sleeves and suspenders why he sold out to Insull. He retorted: ‘What in hell would you do if someone came along and offered you three times as much as your company was ever worth?’
As late as June 1930, Samuel Insull bought from Cyrus Eaton, of Continental Shares, Inc., common stock of operating companies around Chicago for $350 a share, considerably above the market price at the time, for a total consideration of $56,000,000. He turned one half over to Insull Utility Investments (Inc.) and the other half to Corporation Securities Co. of Chicago. On the basis of $8.00 of dividends per share, these stocks yielded a shade over 2 per cent on the investment.
Insull was still less careful in other transactions. His investment in National Electric Power Company, for instance, yielded him little real income. In 1928, Middle West Utilities Company had an equity of $21,234,263 in the class B stock of National Electric Power. The latter indicated earnings of $3,266,758 on the investment, which gives an income of 15 per cent. But $3,587,431.33 of the total income in that year, or more than the equity of class B stock, was fictitious. Instead of an apparent 15 per cent return on an investment of $21,000,000, there was an actual deficit after the payment of class A dividends.
The grandiose munificence with which Samuel Insull bestowed pecuniary benefits upon owners of public utilities which he wished to acquire is matched only by the paternal solicitude he showed for the furtherance of speculative undertakings with enormous subsidies. Some of the funds obtained from the investors by pointing out to them the well-advertised qualities of public-utility properties, — their importance in the national economy, their illimitable expansibility in the future, and the proved stability of their income, — the capital attracted under such disguise was partly used in subsidizing, either directly by the Middle West Utilities Company or indirectly through subsidiaries, all kinds of competitive and speculative undertakings: bankrupt textile mills, paper manufacturing plants, real-estate promotional schemes, and so forth. In the portfolio of Mississippi Valley Utilities Investment Company, a wholly owned subsidiary of Middle West Utilities, we find holdings of stock in American Cirrus Engines, Inc., Business Research Corporation, Continental Shares, Inc. (an investment trust), Intercolonial Exploration, Inc., Niles Hotel Co., and other gimcracks of the sort.
The Quivira Development Company, owned by Mississippi Valley Utilities, and in receivership since April 18, 1932, was engaged, according to the report of the latter’s receivers, ‘in the development of an exclusive residential townsite about twelve miles from Kansas City. The venture, in addition to the townsite, included the formation of an artificial lake, the building of a golf course and clubhouse, and other facilities for amusement.’ Similarly, the Port Isabel Corporation (Delaware), also owned by Mississippi Valley, through certain subsidiaries had undertaken ‘the development of a port and townsite at Port Isabel, Texas, the development of citrous fruit lands in the Rio Grande Valley, not far from Port Isabel, the operation of a railroad approximately twenty-three miles long, the operation of irrigation facilities,’ and so forth. A Texan characterized Port Isabel as a ‘hot hole, a mangy harbor,’ which they tried to make ‘the Venus of the South.’ Little did the investors suspect that they were contributing, through Insull’s munificence, to the beautification of the countryside!
VI
As if it were not sufficient to have bought mere gold bricks on behalf of investors, Insull proceeded to shine them up before presenting them to security holders in the top holding companies. Having paid high prices, having invested in questionable enterprises, the master manager proceeded to give decorative touches to total assets — the ‘investment’ account was inflated in order to present soothing figures to the gaze of any curious investors who might peruse the annual reports. This was done by several artful methods. Often investments were simply revaluated at a higher figure, or, what amounts to the same thing, they were shuffled back and forth between sub-holding companies at continually rising values, resulting in an increasing asset value of the top holding company’s investments. Sometimes the operating-company properties were evaluated at a price higher than that which state regulatory commissions would allow, and the difference was nevertheless taken up by the holding company as an enhancement in the value of its investment. As if high heels make a real addition to stature!
Most curious of all. Middle West Utilities Company, National Electric Power Company, and National Public Service Corporation, mentioned in the order of lineal descent, had the happy thought of considering expenses as assets. Expenses of organization, reorganization, and financing, after staggering in different asset accounts, finally found a comfortable resting place in the investment account, thus apparently enhancing what they actually depleted. By the same reasoning one would be entitled to consider the expense of moving from one house to another as an addition to the value of the furniture. There would be obvious difficulties, however, in convincing the creditors or the auctioneer of the validity of such imaginative accounting. As long as no questions were asked, this device enabled the Insull companies to protect their income or surplus against necessary amortization charges, and at the same time to inflate the assets. The art of accounting is indeed a rare profession in that it allows two such beautiful effects with one stroke of the brush.
In October 1929, Corporation Securities Co. of Chicago purchased from Halsey, Stuart & Co. preferred stocks of Middle West at prices fourteen to twenty dollars higher than the market quotations on the same day. It then had them redeemed by the Middle West at the purchase price. The latter charged the excessive premiums paid to cost of common stock. In other words, an obvious, one might say an unjustified, profit to Halsey, Stuart & Co., an outside interest, was used to inflate the value of investments, instead of charging off against surplus.
The resultant overvaluation of assets and the overcapitalization of the Middle West System were such that there is legitimate doubt whether the common stocks of the top companies had any real assets behind them even at the peak of the market boom in 1929. In each successive holdingcompany stage from the operating companies to the top (and there were as many as eight such stages in the pyramid) the common-stock equity had been attenuated.
The Middle West Utilities Company itself was overcapitalized right from the beginning. In 1912, Insull obtained $5,000,000 par value preferred stock and $7,000,000 par value common stock from the company in exchange for assets that were worth hardly the face value of the preferred. The common stock represented nothing but ‘water.’ Thus the system had an unorthodox baptism. This policy of literally ‘floating’ a holding company was pursued all through the history of the Middle West System. The parent company would acquire some properties, or options, and then sell them to a subsidiary holding company at a price in excess of its commitment. The latter would issue preferred and common stocks in return. The proceeds of the preferred stocks, sold to the public, would be sufficient to pay for the properties. The common stock, representing, again, nothing but water, would be retained by the parent company as investment at some book value. Occasionally it would exchange, at a still higher figure, some of these investment stocks with another subholding company, standing higher than the first, at an increased valuation, obtaining in exchange either the subholding company’s common stock or some of its investments at correspondingly enhanced valuation.
For example, in 1925, Middle West Utilities Company organized the New England Public Service Company, and turned over to it some properties in New England. Middle West obtained in exchange preferred and common stocks of New England Public Service whose book value was higher than the indicated book cost of the properties by $2,413,119. The preferred stock was sold to the public. Three years later the common stock of the New England Company was ‘sold’ to National Electric Power, a subsidiary, at a ‘profit’ of $5,825,518. Thus the asset value of the New England properties was gradually being increased on the books of the holding companies.
In this way the asset value of investments increased to figures higher than could be accounted for by new accessions of real property. It made a good show with the public; Insull could begin selling some of his Middle West Utilities common stock, and make neat capital gains.
VII
It was not sufficient merely to inflate the assets of the holding-company system. Once Insull’s Gargantuan progeny came into existence, it had to be fed. But where were earnings to come from? Exorbitant prices had been paid for acquisitions. Large sums had been invested in unprofitable undertakings. The capitalization of the system was overextended. Consequently there was not sufficient income to feed the lusty child. Parental pride in its growth and the anticipation of pleasure and profit which Insull expected to derive from the activities of his corporate monstrosity led him to resort to a variety of unorthodox ways of showing income in order to support it.
In buying stock of a holding company, investors sought to obtain two things — an income, and an accretion of capital value. The appearance of the second was generously provided by Insull through inflat ion of assets. But, in the last analysis, increasing capital value in the market depends upon growth of income. To increase the value of watered stock, Insull had to show earnings. Under the circumstances this required the drawing of blood out of a turnip. For a while he seemed to succeed.
In sixteen out of the twenty years of its existence from 1912 to 1932, the Middle West Utilities Company did not have enough real income to justify the payment of the dividends which it actually paid in cash. Such was the case in 1913, 1915 to 1918, and 1922 to 1932. But such realities did not daunt Insull. He proceeded to show, through his accounting methods, ‘profits’ when there were none, and to pay dividends, which actually came out of capital, and to build up a large ‘ earned ’ surplus, which was fictitious. In certain years these illusory items amounted to more than 50 per cent of the indicated net income.
From 1912 to September 30, 1930, the Middle West Utilities Company indicated a total net income, after all expenses, taxes, and interest payments, of $81,876,640.73. Of this, $40,909,004.77 was paid in preferred dividends, $14,296,757.75 in cash, and $9,555,770.62 in stock dividends on the common, and $17,115,107.59 rested in earned surplus on September 30, 1930. And yet over $40,000,000 of the net income was unearned, fictitious, or unrealized. In other words, the common stock of Middle West Utilities Company which went up to $570 (old stock) in 1929 had little, if any, real earnings throughout the history of the company.
The window dressing of the income account by which this condition was hidden from the outside world was achieved in several ways. In the first place, and this is the most elementary of all, insufficient provision was made for depreciation of operating-company properties wherever this could get by the state public service commissions. In this way the high cost of acquisition could be justified, and there would be more income to ‘work’ through the successive stages of holding companies toward the top. But this was not enough. To depend on it would be like putting an olive under the grinder and expecting it to fill a large empty barrel with olive oil. Other and larger resources had to be tapped. The greatest source of cash for the holding-company system was in capital receipts — that is, the proceeds of sales of stocks and bonds; and, when it was difficult to sell securities to the public, bank loans were obtained by the pledge of assets. This was a veritable gold mine, if only a way could be found of paying back to the investors a part of their own funds as dividends without letting them know about it.
Devious methods of accounting provided a way of keeping investors ignorant and contented while diverting capital receipts to income and dividends. The Middle West Utilities Company entered as ‘income’ profits made on the sale of its own securities. This is a capital receipt and should be considered, not income, but capital surplus. Then again, the company periodically revaluated batches of stocks in its investment account at higher figures and entered as ‘income’ the difference between previous ledger value and the inflated figures. This was a beautiful discovery. It had the magic of producing greater assets and income by a mere touch of the pen on the books.
VIII
There was still another arbitrary way of boosting the income account which was more complicated and had in it the semblance of reality. The several holding companies within the Insull group, affiliated to each other through complete control by the Middle West Utilities Company or through partial or complete ownership by Insull Utility Investment and Corporation Securities Co. of Chicago — the several companies in this cozy group shuffled investment securities to and fro among themselves, continually increasing the values assigned to them. These transactions were considered bona fide ‘sales,’ regardless of the complete ownership of one corporation by the other.
The difference between the ledger value on the books of the ‘selling’ company and the ‘sale’ price paid by an affiliated or subsidiary company was entered as income and made available for dividend disbursements. Naturally no money was coming into the system through such transactions. Any payments made from such ‘income’ came out of capital.
In one transaction, consummated in January 1928, between the Middle West Utilities Company and its subsidiary, the National Electric Power Company (now also in receivership), the two companies together, and therefore the parent company in its own right, showed a total ‘profit’of $6,030,950.69, and an increase in consolidated assets of $8,839,753.73, without the accession of an additional cent into the system. The Middle West Utilities ‘sold’ to its subsidiary, the National Electric Power, certain shares of common stock of New England Public Service at an aggregate figure of $12,438,900.00. The ledger value of these shares on the books of the Middle West was $6,613,381.91. The company, therefore, made a gross profit of $5,825,518.09; certain items were charged against this, so that the net ‘profit’ recorded was $3,016,715.05.
At the same time, and by the same agreement (dated January 5, 1928), National Electric Power in turn ‘sold’ to Middle West a batch of securities for a total consideration of $12,218,518.54. The ledger value of these stocks on the books of National Electrical Power was $9,204,282.90. Thus this company also made a ‘profit’ of $3,014,235.64. (This is the item which accounted for the apparent return of 15 per cent on Middle West’s investment on the class B common stock of National Electric Power in 1928.)
Hardly any funds passed from one company to the other, and obviously no actual income came from the outside. With one coördinated transaction, consolidated earnings were arbitrarily increased by over $6,000,000, and consolidated assets were boosted by over $8,000,000. The grave significance of this one transaction from the investors’ point of view becomes apparent if it is remembered that in 1928-1929 the market was addicted to anticipating increase in earnings, and such ‘income’ gave justification for ever-increasing market inflation. On a conservative basis of capitalization at 6 per cent, the fictitious income resulting from the above transaction alone caused or, if it came after the fact, ‘justified,’ an increase in the market value of Middle West stocks by $100,000,000. Actually the ratio of capitalization of earnings during the ‘new era’ was much more optimistic, and the resultant influence of such fictitious income on market values much more extravagant.
Finally, stock dividends by subsidiaries, which were often declared with little justification in actual earnings, were taken up by the higher holding companies into their income accounts at market value, and were made the basis of cash dividend payments. During the entire period of its existence, Insull Utility Investments would have shown, after payment of interest, a net deficit of $2,736,307. And yet it paid preferred dividends in cash of $7,180,105, and added insult to injury by declaring a 10 per cent stock dividend on the common. Stock dividends received from Middle West Utilities Company and others, which had not earned enough to justify their declaration, and the other methods described above were used to clothe the nakedness of Insull Utility Investments.
The effectiveness of these methods could last only so long as the entertainment provided by such acrobatics of accounting caused the investors to unloosen their purse strings and buy more securities. But when the pyrotechnics of the ‘new era’ were at last exhausted, and the public would not buy any more of the paper wares manufactured by Insull’s Lincoln Printing Company of Chicago, there was no more cash to back the show. Failure was a natural consequence. With the use of bank loans, a last stand was made by keeping up dividend payments as well as by pegging the exchanges. This action was probably not as altruistic as people suppose, since the Insull family held a goodly portion of the outstanding stock of Insull Utility Investments (Inc.) and Corporation Securities Co. of Chicago.
IX
We hear the question asked, ‘Why did Insull fail? In fact, how could he fail?’ The explanation here given has resolved itself into showing, not so much why he failed, as how he kept himself from failing long before he did. Essentially there was no failure, because there was no success in his holding-company venture. Insull only failed in hiding any longer the lack of success in his financiering activities. The appearance of success could be kept up only so long as he could get funds from investors and banks to make good on the liabilities created by his tortuous accounting methods.
Samuel Insull and some of his followers still insist that they were defeated by the unconquerable forces of the depression. He was, it is maintained, a defenseless victim of the Bears. The Christians in the Near East have a quaint explanation of why Mohammedans hate pigs. It is related that Mohammed, in order to prove his claim to prophetic rank, had the inspiration of imitating Moses in drawing water by a mere tap of his wand. Not oblivious of the realities of nature, and inwardly modest about his own powers, Mohammed thought he would make success assured by secretly burying bags of sheepskin full of water underground at the spot where he proposed to perform his miracle. It worked on several occasions to the reverential awe of the faithful. He thrust his staff into the ground, and a jet of water issued forth. On one particular occasion, before a throng of his followers, he again finished his exhortations by requesting Allah to quench the thirst of his servants with Heaven-sent water — and struck his wand on the carefully selected spot. But, alas, there was no water forthcoming. During the night a pig had nicked the bag. Then and there Mohammed cursed the pig. Insull, too, tried a similar miracle, with his inflated holding companies filled with ‘water.’ When it did not work, he held the Bears responsible, and cursed them.
It is a sad commentary on our corporation laws and on our accounting and auditing methods that we had to wait until a major depression descended upon us to wake us up to see the real secrets of financial miraclemaking. For years the rules of conservative corporate practices were disregarded; careful accounting methods were forgotten; the canons of business ethics and moral precepts were trampled upon; and sometimes even the broad boundaries of legal tolerance were overstepped. This, however, was sheer carelessness. Insull committed his gravest mistakes within the limits allowed, or, more accurately, undefined, by law. Hidden behind a mystic maze of corporate personalities, strengthened by the accepted sanctity of contracts even though some of the parties thereto were nothing but paper dummies, he manipulated accounts to the detriment of investors.
This could be done without breaking any laws because there are none to deal with such practices; and without apparently deviating from codes of accounting, because there is no standardization of accounting practice. Public auditors have failed to recognize their responsibility to the public. The law courts have been slow to disregard the interested logic of lawyers, and to penetrate beyond the veil of legal personalities into the economic realities of the situation. Legislators seem to have lacked the necessary knowledge or courage, or both, to control the vagaries of self-interest, and to grapple with the complexities of anarchic corporate practices. Consequently, Samuel and Martin Insull have been indicted by a grand jury, not for gross misrepresentation, not for questionable dealings with their corporations in their dual capacity as officers and private individuals, and not for having misappropriated tens of millions of capital funds to pay dividends and peg the stock market, but for having been careless enough to take from the companies only a few hundred thousand dollars! And this in spite of the fact that the total loss to the investors, all of which cannot be accredited to mere mistakes, will reach the staggering sum of nearly $700,000,000.