See what will happen through a period of depression as the percentage in the net earn ings the corporation can make on its total capitalization steadily declines from 6 per cent down.
So if the net earnings of the company should fall to three per cent oh the total capi talization, the preferred shareholders, with out the additional bonds, would still have net earnings 50 per cent in excess of the amount required to pay their dividend. With the additional $2,000,000 of bonds net earnings would be 10 per cent less thin the necessary sum.
Looking at the matter from another stand point, suppose gross earnings should decline 40 per cent, with a consequent rise in the operating ratio from 75 per cent to 80 per cent. If the company can make 6 per cent on capitalization with an operating ratio of 75 per cent, its gross earnings are : — A decline in gross of 40 per cent, accompan ied with a 5 per cent increase in operating, would reduce net to: — Or with the smaller debt such a decline in gross would leave net over 15 per cent in excess of the amount required to pay dividends on the preferred. With the larger debt it would leave net 14 per cent less than the sum needed.
If, instead of creating $2,000,000 addi tional bonds, the common shareholders had voted to increase the preferred stock by that amount, everything so far stated of the effect on the preferred of the increase in securities would still apply. They would not by this procedure, however, add to another risk of the preferred shareholders, that is to say, the risk of having their equity completely wiped out and the property pass entirely to the disposal of the bondholders. Without the additional bonds net earnings would have to decline over 80 per cent to throw the property into the hands of the bondholders. With the addi tional bonds a decline of 58 per cent in net would throw the property into the hands of the bondholders.
As a matter of fact the increase in the pre ferred would really lessen this danger. After the increase net would have to decline 86 per cent to take the property out of the control of the shareholders. The lessening of that risk would not, however, compensate for the in creased risk of a cut in dividends.
By this time the reason must have become clear for the veto power so frequently given preferred stocks, requiring the assent of pre ferred shareholders to any increase in bonds or preferred; or, generally, the purpose of the veto given any class of security on an increase in the amount of that class or any class hav ing a prior claim on earnings or assets.
It should be observed that by voting an increase of $2,000,000 in the preferred in the case we have been considering the common shareholders would have voted the balance of power out of themselves.
In the state of affairs we have been consid ering, when the amount of one class of stock is greater than the amount of another class, it has become apparent that the voting power of the minority class, though equal share for share with that of the majority, becomes valueless on any clash of interest between the two classes.
As examples of corporations issuing more than two kinds of stock we may consider the capitalizations of The Colorado & Southern Railway Common 831,000,000 (paying 2 per cent) 1st preferred 4 per cent non-cumulative 8,500,000 (paying 4 per cent) 2d preferred 4 per cent non-cumulative 8,500,000 (paying 4 per cent) Bonds 1 49,309,000 Average 4.31 per cent 1 Of this company — bonds of subsidiaries not counted.
The Erie Railroad Common 8112,378,900 (paying 0) 1st preferred 4 per cent non-cumulative 18,000,000 (paying 0) 2d preferred 4 per cent non-cumulative 47,892,400 Bonds The Reading Company Common $70,000,000 pays 8 per cent 1st preferred 4 per cent non-cumulative 28,000,000 Rel preferred 4 per cent non-cumulative 42,000,000 (Second preferred can be converted into one half 1st preferred and one halt common).
The capitalization of the Reading Com pany is the result of a reorganization. No tice that the total preferred just equals the common. So in a clash of interests between the common and both classes of preferred, the preferred stock possesses just as much con trol as the common. But suppose the com pany should not be earning enough to pay any dividends on the second preferred. Then the second preferred might cast its vote with the common in favor of a policy of returning earnings to the property until the corpora tion could earn enough to pay dividends at least on the second preferred. In the matter of the creation of indebtedness the interests of the second preferred ordinarily coincide with the interests of the first preferred.