11 Going Elsewhere

Practically all of the possible abuses or frauds described in the preceding pages under the caption of stock-watering are found combined in a single instance in recent years—the reorganization of the Chicago & Alton road by the late E. H. Harriman and his associates during the eight years following 1898. The case is an illuminating one; for it shows how an unscrupulous management may, at one and the same time, enormously enrich insiders at the expense of the investing public, and prejudice the interests of shippers, both by crippling the road physically and by creating the need of high rates for service in order to support the fraudulent capitalization.

—William Z. Ripley, Railroads: Finance and Organization

When Harriman joined the Union Pacific in 1897, he was an obscure banker whose only railroad connection was the Illinois Central. Three years later he stood on the threshold of a business empire that would catapult him into being the dominant figure in the transportation industry. While his achievement with the Union Pacific would have satisfied the ambitions of most men, it was for him merely a prelude to the foundation of an empire.

Like an alert scout, Harriman had struck a promising trail through the dark and tangled forest of the modern industrial system. He already understood the symbiotic relationship between the financial and rail industries and the ways in which each enriched the other. The more he learned about the essentials of modern railroading, the more he began to probe the riddle of its larger nexus of relationships. He had the ability to examine its character with the cold eye of a clinician, unfettered by conventional wisdom and without regard for political or social obstacles. Nor did financial considerations detain him; they were simply another technical problem to be solved.

At no time did the Union Pacific occupy Harrimans full attention. He remained in charge of the Illinois Central’s finance committee and took the job seriously. Although this work took a backseat to the Union Pacific, it continued to influence his strategic thinking. Less than a year after taking charge of the Union Pacific, Harriman got involved in the reorganization of three major railroads: the Baltimore & Ohio, the Kansas City, Pittsburg & Gulf, and the Chicago & Alton. In each case he applied the formula of modernization that was already beginning to revamp the Union Pacific.

Harriman could not have moved to the national arena without vast financial resources behind him. To reorganize and overhaul rail systems required huge sums of capital, which put Harriman even closer in league with the two giants of finance who became his lifelong associates: Jacob Schiff and James Stillman. The significance of these three ventures went far beyond their effect on the railroads. Like the Union Pacific, they enhanced Harriman’s reputation and bound the bankers to him for greater things to come.

By 1900 a formidable alliance had been forged among the three men in which each played a distinctive role. Harriman managed the property, used his formula to modernize it, and arranged its new capital structure. Schiff’s firm underwrote the security offerings and handled most of the financing, while Stillman, through his National City Bank and close connections with men like William Rockefeller, mobilized capital for the venture by bringing powerful backers to it. Apart from bringing immense profits to the three allies, this division of labor also redefined the transportation map of America and ultimately provoked a political hailstorm.

The reporters covering the financial beat came early to agreement over the enigmatic James Stillman. He was, in the words of one of them, “the coldest proposition in America.” The banking brethren were notorious for being remote and aloof, but none except George F. Baker rivaled the glacial facade of Stillman. Laughter came to his lips with the frequency of leap years. He was an iceberg whose smooth, pleasant features revealed absolutely nothing of the dark complexities swimming beneath their surface.¹

A short, dark man with small, well-shaped hands and feet, Stillman dressed immaculately and wore a full mustache. His large ears and prominent nose made less impact on those around him than the piercing brown eyes and the sardonic curl of his mouth. He was, said banker Henry Morgenthau, “a perfect example of the well-built man of the world, sartorially correct, soft spoken, with a tendency toward cynical humour, and with a tongue capable of devastating sarcasms.” His tastes were urbane and cultivated. He loved the sea and the hills, admired beautiful things but lacked Morgan’s passion for buying them, and enjoyed the rituals of an ordered life.²

Two years younger than Harriman, Stillman was born in Texas but came to New York as a child. The shy young man showed a remarkable gift for ingratiating himself with older men who came to value his ability. James Woodward, his partner’s brother, headed the Hanover National Bank and made young Stillman a director. A seat on the board of the Chicago, Milwaukee & St. Paul Railroad introduced him to the road’s major stockholder, William Rockefeller, who became one of his closest friends. The alliance between them was later sealed when both of Stillmans daughters married sons of William Rockefeller.³

Silent partner: The brilliant, velvety James Stillman, who masterminded the rise of National City Bank and became one of Harriman’s closest friends and allies. (Baker Library, Harvard Business School)

At forty-one Stillman found himself head of a small, sound bank of excellent reputation. Building it up became for him a form of religion. His dream was to do for banks what Harriman was trying to do with railroads: push them into a new era by transforming what they did and how they did it. This meant moving City Bank into investment banking, the fastest growing and most profitable area of finance. The top investment houses like Morgan and Kuhn, Loeb already dominated the origination of security issues and used their extensive overseas connections to peddle them. Some large banks, allies of these firms, took large chunks of their offerings to sell to their own networks of correspondent banks.⁴

Stillman and his bank came late to both ends of the investment business-originating and marketing—but that did not deter him. Apart from being a brilliant financier, he had a gift for forging alliances with men of means. He liked the company of bright, farsighted men who could teach him things, and he filled the board of City Bank with the heads of giant enterprises. By doing this, he tapped the best business minds in America for the absurdly low fee of $400 a year.⁵

Like Harriman, Stillman rose from obscurity to titan in less than a decade, creating by 1907 the prototype of a modern big business bank. In 1895, however, he was still a banker of solid but modest reputation seeking the doorway to his destiny. His first major entry into investment turned out to be the most significant transaction of his career. It was the reorganization of the Union Pacific Railroad.⁶

The alliance with Schiff was a perfect fit for Stillman. Kuhn, Loeb, unlike Morgan, had no large commercial banking business and could not support large issues; instead, it relied on a network of other houses at home and abroad. City Bank offered the resources, Kuhn, Loeb the ability to originate, and both could place securities. Together they could underwrite huge issues not possible by either of them alone. The success of the Union Pacific reorganization demonstrated this ability and cemented their relationship.⁷

The reorganization also brought an unexpected bonus to both bankers. There were two basic sources for large security offerings: rail reorganizations and the wave of mergers that had begun to sweep all sectors of industry. To place these recapitalized ventures on a sound financial footing, the bankers needed someone capable of giving them efficient management. The Union Pacific experience introduced them to the ideal man for the rail industry. Harriman was for them the final piece in an intricate puzzle that promised enormous profits and exciting times for all of them.

Harriman did not have to seek out other projects. His growing reputation as a railroad wizard among his newfound friends brought them to him. Two distinct sets of associates looked to him for help. One revolved around Schiff and his circle; the other consisted of prominent Chicago businessmen and bankers Harriman had come to know through the Illinois Central, including meatpacker Philip D. Armour, Marshall Field, and financier Norman B. Ream. Both groups wanted Harriman in the Baltimore & Ohio Railroad.

The B&O was one of the four trunk lines that dominated traffic between Chicago and the eastern seaboard.^⋆ During the depression it too had undergone a reorganization managed in part by Kuhn, Loeb. It was probably Schiff who invited Harriman to join the B&O board. In his deft and graceful way he was looking to solve two problems at once. The B&O needed a management that would modernize the road, and, since Hill was already on the board, Schiff hoped that working with Harriman on the B&O might improve their relationship. He soon discovered that any boardroom was too small to hold both Harriman and Hill.⁸

Hill sent the B&O one of his best operating men, Frederick D. Underwood, to become its general manager. His first task was to examine the road thoroughly to see what improvements were needed. Hill cautioned him to remember that “while money can be well expended to reduce grades and increase the load on a road with a heavy traffic like that of the Baltimore and Ohio, there is of course a limit to which this should be carried.” Here was a difference that grew painfully obvious over the years: whereas Harriman never thought in terms of limits, Hill was more flexible, more attuned to political and personal influences on policy.⁹

In seeking funds from the board, Underwood found himself depending more on Harriman than on his mentor, Hill. When an expenditure for improvements was on the agenda, he would take the matter to Harriman. “Have you been over these figures personally,” Harriman would ask while giving the papers his usual quick study, “or are they the figures of some clerk?” Underwood assured him that he had gone over them with the chief engineer. Satisfied, Harriman would say when the matter came up in the meeting, “Gentlemen, I have been through these figures and I know that they are right.” Before the others could debate the question, he added, “I have an engagement and cannot stay but I move that the budget be approved.”¹⁰

This routine helped Underwood wheedle some $32 million for improvements out of the B&O board, but it did not bring Harriman and Hill together as Schiff had hoped. Hill approved the policy but grew increasingly annoyed with the tactics. By 1900 he suspected Harriman of trying to dominate in his usual manner. Fortunately, there was a solution to the conflict. To survive, the B&O had to resolve its longtime struggles with the other trunk lines. The Pennsylvania was eager to buy into the B&O and forge what became known as a “community of interest.” Harriman did not oppose this move, and by 1901 the B&O was safely tucked away under the Pennsylvania’s influence.¹¹

Later Harriman declared that he had “put in eighteen months of hard work” at the B&O, and he was not yet done with it. To make room for Pennsylvania representatives on the B&O board, Hill and some other directors resigned their seats. But Harriman’stayed on and kept his seat for the rest of his life.¹²

The other two projects that engaged Harriman’s attention were closer to home. One of them, the Kansas City, Pittsburg & Gulf, was a classic example of a good plan badly executed. A quixotic promoter named Arthur E. Stilwell had put together a 762-mile railroad from Kansas City to an outlet on the Gulf of his own creation, modestly named Port Arthur. Stilwell was not the usual entrepreneur; late in life he attributed his major decisions to the appearance of “spirits” or “brownies” in his dreams. His hunch in this case was a good one: to build a line that would haul grain to deep water cheaper than it could go to eastern ports.¹³

Through sheer drive and personal magnetism, Stilwell pushed his projects to completion despite enormous obstacles. Having scrounged money to finish the road in the throes of a depression when no one else was laying track, he seemed poised to reap the harvest of improved business conditions in 1897. In the end, however, his “brownies” betrayed him. Like most visionaries, Stilwell was neither a good manager nor a capable financier. He built an old-fashioned road the old-fashioned way. The line meandered more in search of promising town sites than the best route for cheap transportation. It lacked equipment to handle the crush of business, and the flimsy roadbed turned to goo in torrential rains.¹⁴

Stilwell tried valiantly to hold out against the Wall Street interests he later termed the “Cannibals of Finance.” By the year’s end, however, he saw no choice but to seek a reorganization. Unfortunately, refinancing the road proved as muddled as constructing it. Stilwell’s creditors included some Dutch investors and John W. Gates, the flamboyant head of Illinois Steel Company who had fed rails and money to the cash-starved Gulf road in exchange for its securities. In January 1899 a reorganization committee was formed in New York. Weeks passed without it producing the expected plan; then in March the committee added three new members, including Harriman. Later it brought in Stillman as well.¹⁵

Although Harriman later claimed that he was reluctant to get involved, he surely saw the possibilities that had beguiled Stilwell. As one of his officers stressed, “No one had a clearer idea of the strategic value of railroad properties than did Mr. Harriman.” The Gulf line occupied a territory between the two systems in which he was most interested. It was a sort of miniature Illinois Central, running north-south from a major rail center to deep water. Its northern terminus, Kansas City, had already emerged as a primary grain market. Huge shipments of grain could be funneled from the Union Pacific’s Kansas division to the Gulf at lower cost than to eastern ports.¹⁶

Once Harriman got involved, he took a radically different view of the road than Stilwell. Feeling his control of the road slipping away, Stilwell had a friend sneak into court to ask for a receivership under his own men. This shady tactic drew harsh criticism and was overturned by a federal judge, who named impartial receivers. Thwarted in his plan, Stilwell quit the committee and formed a new one with friendly Philadelphia interests. “The whole trouble,” he muttered, “is that we dared to build a railroad out west without having first consulted Wall Street.”¹⁷

Stilwell failed to grasp that he was an old-style promoter trying to play the game in a new setting that Harriman understood but he did not. Two issues were at stake in the reorganization: how much to reduce fixed charges and how much to spend on improvements. The conventional wisdom espoused by the Philadelphia committee looked to scale charges down moderately and limit spending on betterments until earnings improved enough to pay for them. Harrimans approach, which the New York committee adopted, emphasized spending money now to earn more later. He favored a steeper reduction in fixed charges and much larger outlays for improvements to put the road in shape.¹⁸

To find out how much this would cost, Harriman’sent Samuel Felton to inspect the Gulf line. Feltons report described a western railroad that could have been built thirty years earlier. He figured $1.8 million was needed at once to bring it up to standard, along with a massive infusion of new equipment. His report reinforced what the receivers had said a few weeks earlier when they warned the court that the road was in terrible shape and required $3.7 million for improvements and equipment. The court authorized them to spend only $800,000, and when the Philadelphia committee issued its plan late in August, it pronounced this sum along with net earnings “ample to place the whole system in good working order and with adequate equipment.”¹⁹

This approach suited investors who wanted to sacrifice as little as possible in the scaling down of securities and spend as little as possible out of pocket to improve the road’s earning power. Its short-term view contrasted sharply with the New York plan, but the latter was delayed by Harriman’s trip to Alaska that summer of 1899. In his absence, the situation changed drastically. The desperate Stilwell again turned for funds to Gates, who shrewdly bought more shares in the Gulf road, then demanded a place on the Philadelphia committee and soon gained control of it. Stilwell was unceremoniously shoved aside and reduced to a pawn between forces much stronger and smarter than himself.²⁰

Harriman was livid at finding the Philadelphia committee in control of the reorganization with Gates at its head. In his eyes Stilwell had broken faith by selling out to Gates. Even worse, the cautious Dutch investors had lined up behind the Philadelphia plan, which by late September won support from a majority of the outstanding securities. Otto Kahn of Kuhn, Loeb, who had played a small role in the affair, assumed Harriman had lost the fight and offered his condolences.²¹

“Hold on. Not so fast!” barked Harriman. “I am not through with this thing yet, by any means. I can’t be played fast and loose with like this. I did not care particularly to go into it, as you know; but… having done so, I am in it to stay.”

Kahn cocked an eye in surprise. “But it’s done,” he replied; “the newcomers are in rightful control, it’s no use making a fuss, and it seems to me that the best, and indeed the only thing for you to do is to look pleasant and get out.”

When Harriman repeated his determination to stay, Kahn asked what he was going to do. Harriman’shook his head. “I don’t know yet,” he admitted. “I’ll just stand pat and not budge and watch.”

So Kahn told the story two years after Harriman’s death, embellishing its details and mislaying some of the facts. As he confessed to Kennan much later, the episode lingered in his memory only as an example of “the irresistible force of Mr. Harriman’s personality and the workings of his mental processes.” What impressed him most was Harriman’s refusal to submit even though his opponents had complete control of the reorganization and could do what they pleased. His presence at a time when he ought to have retreated caused them to hesitate, to wonder if they had overlooked something.²²

Gates was an erratic figure who trampled on the sensibilities of more staid financiers, but he was a tough bargainer. An inveterate gambler, he was only months away from a trip to England, where his spectacular antics at the race tracks would earn him the sobriquet “Bet a Million.” He had come up the hard way, climbing from a village hardware store in Illinois to selling barbed wire in Texas. Twenty years of hard work and brassy maneuvers had put him atop an empire in wire and into the presidency of the Illinois Steel Company. In 1898 he took his operations to a new level by organizing the American Steel & Wire Company, a combine capitalized at a well-watered $90 million.²³

For all his success at business, Gates was at heart a plunger who liked to use the securities of his companies as ammunition for market raids. “Gates was all nerve—and no nerves,” observed Bernard Baruch. “Beneath his roughness lay a cool, bold, penetrating intelligence.” He had two things in common with Harriman: a love of horses and the enmity of J. P. Morgan, whose recent creation of a giant combine called Federal Steel had embraced Illinois Steel but pointedly left Gates off the new board. His penchant for short-term hits made him unpredictable and therefore dangerous.²⁴

The Gulf line struggle, however, was Gates’s first venture into railroads, and he was smart enough to realize that Harriman had forgotten more about railroads than he would ever know. Preoccupied with clashes in his own bailiwick of wire and steel, he offered Harriman enough concessions to bring the two committees together on a compromise plan. A new company called the Kansas City Southern was created with an executive committee consisting of Harriman, Kahn, Gates, and two Gates cronies. Stilwell was dumped altogether because, he claimed, “I had refused to surrender the road to Harriman.”²⁵

Gates agreed to sell half his interest to Harriman provided he could name two-thirds of a committee formed to control the road. This shadowy arrangement allowed Harriman to dominate even though he lacked actual control. The Union Pacific pattern repeated itself: Gates, finding Harriman’s arguments and force of will hard to oppose, made him chairman of the executive committee in June 1900. Two weeks later Harriman brought in a new president of his own choosing. No one on Wall Street knew what to make of it.²⁶

One major reason for the compromise, and for Harriman’s presence in the first place, escaped notice. Stilwell had enraged the other roads in his region by cutting rates to get business, and the receivers had followed suit. The connecting roads retaliated with a boycott against freight from the Gulf line. To Harriman and other rail managers seeking some form of stability that would prevent a recurrence of the old rate wars, Stilwell was a menace. Within days after Gates and Harriman came to terms, the dispute was patched up and the Kansas City Southern did no more rate cutting.²⁷

Harriman took charge of the Southern, and Gates sailed off to Europe. When he returned from testing the race tracks, his attention was diverted by a complex web of intrigues that led to the formation of the giant United States Steel Company. With stakes of such magnitude boiling in his brain, Gates had little time for the Southern, yet he was reluctant to let go. With control of the road locked up for five years in a voting trust he dominated, Gates realized he must either manage the road himself or let Harriman do it. The problem was that their goals were irreconcilable: Gates wanted to manipulate the road for quick market profits, while Harriman insisted on making it a first-class line.²⁸

Once again Harriman waited patiently for Gates to make the next move. In October he accepted an offer from Gates for his holdings. Two weeks later, he was summoned to another conference in which Gates, still haunted by uncertainty, did most of the talking, as if trying to thrash out the whole business for himself. By the time Gates finished, the deal was reversed. Harriman kept his shares, and Gates agreed to turn control of the voting trust and the board over to him.²⁹

Puzzled observers in both New York and Chicago assumed wrongly that Harriman had bought Gates out. “The Harriman interests and mine are working in harmony,” said Gates blandly, “and we have turned over the active management to railroad men.” Three Gates cronies were replaced by Harriman, Kahn, and George Gould, head of the Missouri Pacific. Along with Stillman and a Gould ally, the newcomers made up five of the seven trustees for the Kansas City Southern. By acting together, they could ensure harmony among a half dozen or so of the leading rail lines in the region.³⁰

During 1901 the Southerns earnings grew steadily amid constant rumors that Harriman was about to sweep it into some combination with the Alton and other roads. That January, only fifteen miles north of Port Arthur, the first gusher of the fabulous Spindletop oil field blew in, assuring Texas of a boom in oil and the Southern of a bonanza in traffic.³¹

Harriman’s involvement with the Southern had deep roots in what he was doing with the Alton. It was a road he knew from his Illinois Central days and one that for twenty years had pursued a different course than the major Chicago lines. While the others evolved into systems reaching the Missouri River and beyond, the Alton remained an overgrown local road between Chicago and St. Louis with a cutoff branch to Kansas City. Although other local roads had been swallowed up by their neighbors, the Alton survived because its tracks ran through a territory that fed it a steady traffic of coal, iron, wheat, corn, oats, flour, cattle, and hogs.

Since 1864 the Alton had been managed by the same man, a Connecticut Yankee named Timothy B. Blackstone, who kept the road on a steady, prosperous course through the wild swings of the postwar economy. The railroad was Blackstone’s baby in more ways than one; his only two children had died in infancy. He took care of both its financial and operating needs, serving a quarter-century without pay, nursing the road through rate wars and two depressions without missing a dividend. Since 1881 the Alton had paid a steady 8 percent on both its preferred and common stock. Analysts hailed the road as a model of sound, conservative management.³²

The Alton was more popular with stockholders and analysts than with other railroads. Blackstone survived by pursuing a maverick course: he refused to integrate the Alton with a rail network that was growing increasingly unified. The Alton was notorious as a disturber of stability. It cut rates, juggled schedules, ignored rate associations, and ran light, fast trains that pleased customers while driving connecting roads to despair. During the 1890s it blithely paid 8 percent dividends while larger systems sank into bankruptcy.

Although no one denied Blackstone’s impressive achievement, by 1898 some stockholders wondered if his day had not passed. The old president, nearing seventy and ill, clung fiercely to the same policies, but his tenacity could not conceal a decline in performance that traced back well before the depression of the 1890s. Both tonnage carried and freight earnings had been slipping since 1883; net earnings peaked that same year and had slumped 35 percent by 1898. Even more revealing, earnings per ton-mile slid inexorably downward from 1.24 cents in 1881 to 0.78 cents in 1898.³³

While rates were declining for every road, larger systems could compensate by carrying heavier volumes of traffic on longer hauls more efficiently than before. The Alton, however, was unprepared to embrace this credo of the new age of railroading. An expert accountant summarized its condition in unsparing language: “It had not added one mile of road in seventeen years. It had little or no reserve capacity to conduct a larger business. Its cost of operation, per unit of traffic, was very high in comparison with similar roads. Its grades were uneconomical. Its shops and equipment were uneconomical and old.”³⁴

The Alton was another example of how policy that succeeds under one set of conditions becomes a bar to success when conditions change. By standing still through two of the most tumultuous decades in railroad history, it had become an anachronism. Its dividend had been maintained by skimping on maintenance and improvements, leaving the road ill-equipped to compete in a faster game. The Alton was neither a bad nor badly managed road; it was merely an obsolete one. But as long as it paid 8 percent every year, analysts and investors praised it as a conservative, well-managed property.³⁵

During 1898 Alton common sold for nearly $167 a share. That winter, however, an analyst pinpointed its stagnation and warned that changes must be forthcoming. By the fall a fluid situation had evolved. The Gulf line and other roads showed interest in buying the Alton, and a new company threatened to build yet another line from St. Louis to Chicago. With Blackstone too ill to give more than token attention to his duties, some Alton stockholders craved new leadership. One of them, John J. Mitchell, president of a powerful Chicago bank, took his case to Harriman. Mitchell believed that the stock was undervalued, that earnings could be increased by modernizing the road, and that large profits could be made by whoever handled the refunding and improvements programs.³⁶

The main obstacle was Blackstone, who owned about a third of the Alton’s stock and opposed selling on anything less than a cash basis with all stockholders getting the same price. A cash deal would require nearly $40 million up front for the purchase. From a coldly financial point of view, the issue was clear to Harriman: could the Alton be bought for a price below the intrinsic value of the stock and earning capacity of the railroad? If it could, did he want to devote time to the deal? He was hardly looking for things to fill idle hours.³⁷

Although Harriman was always eager to make money, the crux of any deal for him was what else it had to offer. In this case Harriman’saw two other compelling factors: he could stamp his brand of progress on another archaic railroad and civilize a historic disturber of rates in a strategic region where he had large interests. With prosperity returning, this last reason may have been decisive. The bloody rate wars of a decade earlier were still vivid in every rail manager’s mind, and nobody wanted a repeat of that costly debacle. Here was an opportunity to bring warring parties together in a deal that could eliminate several threats at once.

Every account of the Alton episode describes it as the most controversial episode of Harrimans career. Most also label it his biggest mistake, a view shared by Harriman himself. The broader significance of the Alton experience, however, has gone unnoticed: it introduced Harriman to the possibilities of what became known as “community of interest.” From this first venture flowed the insights and connections on which Harriman erected an unprecedented transportation empire.

Harriman’s first step was to send Samuel Felton, who was then receiver for a midwestern road, to examine the Alton and make the first of what proved to be a string of reports on different lines. Felton hardly knew Harriman, had met him once a decade earlier and done a favor for him. “I was surprised,” he confessed, “for I thought surely he had forgotten all about me. He had not forgotten; I learned later that he never forgot anything.”³⁸

Felton went off to inspect the Alton in his usual thorough way, but Harriman couldn’t wait for him to finish. By December 1898 rumors were already circulating that a deal was near; the Wall Street Journal even listed the exact prices Mitchell had proposed. Felton was barely half done when a telegram arrived from Harriman: “Wire report on one telegraph blank.” The engineer swallowed hard. Never mind that he had not finished his work; how could he possibly cram his report about a major rail line onto one sheet?³⁹

For hours Felton wrestled fitfully with a stack of blanks, ripping up one after another until in desperation he let one go to New York. Then he hurried to complete his inspection, wrote up a lengthy report, and took it to Harriman with some trepidation. “Yes, I am very glad to have this,” breezed Harriman. “I bought the road on your wire.”⁴⁰

This was almost certainly not true, but it was vintage Harriman, a side of his personality that those close to him seldom mentioned. He loved staging brief, telling scenes to impress those around him with his boldness and decisiveness. Of course, he was bold and decisive, yet he could not resist framing a suitable vignette to emphasize the point. Harriman had already decided to tackle the Alton; Felton’s telegram merely reinforced his belief that it could be done. The timing of events is crucial here. That same December the Union Pacific board abolished the position of chairman, leaving Harriman as its de facto head. This change was a clear sign that his view of railroad policy had won over both Schiff and Stillman. George Gould had also been added to the executive committee, strengthening the ties between the Union Pacific and Gould’s Missouri Pacific system.

Felton’s report, boiled down to its essence, depicted a road that was in decent shape but required $5 million at once for improvements and equipment to modernize it. In Felton’s opinion, this outlay could improve net earnings by as much as $1 million. Aware that a large supply of cash would be needed for the deal, Harriman took Mitchell’s proposal to Schiff, Stillman, and Gould. There is little doubt that he persuaded them to join him in raising the money to buy the road, improve it, and refund its securities. The total amount needed came to about $54 million.⁴¹

A few months later Harriman outlined his reasoning in a confidential letter to Fish. “The scheme under which the purchase of the Chi & Alton was undertaken,” he explained in one his convoluted sentences, “was mainly for purpose of eliminating it as a factor, more or less, from the situation as a competitor in the South & Southwestern territory, and also through the personel [sic] of its management, to cement the various roads together & prevent to a great extent the buying of business [rebates] & stop largely the running trains at unnecessarily high speed and too many of them.”⁴²

To accomplish this, Harriman wanted the leaders of the Union Pacific, Illinois Central, Wabash, Missouri Pacific, and Katy roads on the Alton board. Harriman dominated two of these companies, Gould another two, and John D. Rockefeller the Katy. In a novel twist Harriman also wanted the other directors selected from the operating departments of the five roads. This bold departure from convention, he argued, would “tend to bring them into closer relations & enable them to adopt methods for saving much in expenses.” It was, he scribbled breathlessly, “all a very big & very important matter & can be turned to good account to bettering the whole situation. It’s a great big opportunity for us doing.” First, however, he and his friends had to get control of the Alton. Mitchell sent a circular to all stockholders offering to buy their shares at $175 for common and $200 for preferred. The ailing Blackstone could do little more than promise that if the offer was refused, he would declare a stock dividend to represent the earnings invested in improvements over the years. This point was to loom large in the later controversy; in effect, Blackstone was proposing an action similar to one that would bring severe criticism to the Harriman’syndicate. At the time it drew scant notice, however, for the stockholders ignored the plea. Early in March 1899 Blackstone conceded defeat and joined the ranks of those depositing their stock.⁴³

About 98 percent of the Alton shares came in under the offer. Harriman assumed the presidency and announced a major improvements program to put the Alton on “the same standard as the other big roads of the West.” In paying for the purchase and betterments, Harriman and his associates assumed the transaction personally. This meant they had to carry at their own risk for an indefinite time obligations totaling $63 million.^⋆ Later the Alton syndicate was expanded to a hundred individuals and firms, but most of the load fell on Harriman, Stillman, Schiff, and Gould. It was the series of transactions they devised for easing this burden that later aroused a storm of criticism—though at the time little complaint was made about them.⁴⁴

As a first step the syndicate refunded old obligations by issuing $40 million in new 3 percent bonds. About $32 million of these were taken by the stockholders; the rest were left in the treasury. Since the syndicate owned 98 percent of the stock, this amounted to selling the bonds to themselves at a price of 65, which realized about $20.8 million for the company. Kuhn, Loeb, acting for the syndicate, then sold these bonds to another firm, which later sold them to some insurance companies at a price of 96. It is not known what price Kuhn, Loeb paid for the bonds or got for them.⁴⁵

Finding a market for these bonds took some doing. Their value would be enhanced dramatically if the state of New York added them to its list of approved investments for savings banks. A bill to that effect went through the wringer at Albany and emerged in February 1900, when it was signed by Governor Theodore Roosevelt. The irony of that act would not become clear for several years. According to Melville E. Stone of the Associated Press, Harrimans role in procuring this bill was what first drew him into the orbit of New York State politics and Benjamin B. Odell, who succeeded Roosevelt as governor and became a close friend of Harriman’s.⁴⁶

The new issue of bonds was approved at a special board meeting of the Alton shortly after Harrimans return from Alaska. Felton assumed the presidency and launched the improvements program. By the years end he had whittled down the organization and spruced up its physical plant. “This road,” marveled one observer, “is undergoing a metamorphosis under its new management.” That fall the board also declared dividends on both the preferred and common stock.⁴⁷

To eliminate the threat of a new Chicago-St. Louis line, the syndicate bought the small St. Louis, Peoria & Northern and sold part of it to the Illinois Central. Since the Alton’s charter did not permit it to absorb the new road, a holding company called the Chicago & Alton Railway was created and made into a vehicle for more creative financing. It acquired the Peoria line outright and leased the Alton Railroad for a long term. To pay for them, it issued $19.5 million in preferred stock, a like amount of common, and $22 million of collateral trust bonds. For this $61 million in securities the holding company gained control of both roads.⁴⁸

At the same time (May 1900), the syndicate carried out a version of the transaction promised by Blackstone if the Alton remained in his hands. Shortly after taking charge, it had credited to the Alton’s surplus account the sum of $12.4 million representing the amount invested over the years in improvements and paid for out of earnings. Instead of the stock dividend Blackstone proposed, however, the syndicate declared a 30 percent cash dividend on both classes of stock, paying it with proceeds from the earlier bond sale. Most of this $6.7 million went to the syndicate.⁴⁹

These transactions recapitalized the Alton at a much higher level. Harriman figured the interest on its bonds and a 4 percent dividend on both classes of stock at $3.5 million. During the lean depression years the Alton’s net earnings had averaged $2.7 million annually. Felton estimated that $5 million worth of improvements and more efficient management would boost the net at least $1 million a year on existing traffic. The new Peoria line and $5 million more in betterments, Harriman thought, would add another $1 million, making $4.7 million in all. This would be more than ample to support the enlarged capital structure.⁵⁰

If all went well.

At the time, these transactions aroused much interest but little criticism. Seven years later, however, they became the target of an ICC investigation that condemned nearly every aspect of Harriman’s management. In 1915 the righteous Professor Ripley used this ICC report as the basis for his own attack, adding little more than a generous garnish of moral indignation. Both the commission and later critics such as Ripley were guilty of the same fallacy: they wrenched the issues out of their historical context.⁵¹

The primary charges leveled at Harriman and the syndicate were that they impaired the Alton’s credit by giving it a bloated capital structure; they aggravated this problem by paying themselves the 30 percent dividend and taking the new bonds at prices well below their market value; they deceived those who bought Alton securities by concealing the true nature of these transactions; and they skimmed exorbitant profits while the overcapitalized Alton ultimately sank.

Although the charges contain elements of truth, they were not probed deeply because the ICC and later critics were less interested in what actually happened than in using Harriman as a whipping post for their own agendas. The ICC wished to show the perils of allowing men like Harriman to wield such power over the rail system, while Ripley and others used the Alton to illustrate unsavory financial practices a later era had disowned. Kennan, who defended Harriman vigorously, was of course no more impartial on the subject than the critics and borrowed most of his argument from Harriman’s own statement.⁵²

No one has bothered to look at some basic questions that got buried in the mud-slinging. What did Harriman try to do? Why did he do it? In what ways did his handling of the Alton differ from his treatment of other roads?

The letter to Fish cited earlier reveals clearly what Harriman had in mind with both the Alton and the Gulf line. Already the vision of imposing order on the region between the Mississippi and Missouri Rivers had seized him; soon it would be extended to the Pacific coast. With prosperity returning, it was imperative that the earnings bonanza not be dissipated by rate wars. As Schiff explained to George Gould, “If all interests involved combine to clear up the railroad situation in the Middle West, great results can … be accomplished, which will be of lasting benefit… to all the different railroads which divide this territory.”⁵³

Again the timing is crucial. Convinced that he had the correct formula for whipping any road into shape to make money, Harriman had applied it first to the Union Pacific. By late 1898, when he went into the Alton, the results of that experiment were promising but by no means certain. Having sunk huge sums into the Union Pacific, the syndicate members then shouldered the Alton (and later the Gulf line) before the outcome of their venture was clear. The high degree of risk made them anxious to hedge their investment, especially since the money was going to be tied up for a while.

This sense of caution applied more to the bankers than to Harriman. Even at this embryonic stage of their partnership can be seen its later pattern of Harriman rushing headlong into new projects while the bankers struggled to assimilate the last one. But how free a hand did he have at this early stage? How much of the Alton’s financial scheme was devised by Harriman and how much by the bankers? Melville Stone, who grew close to Harriman in later years, said that one day, while the two of them were chatting under the pagoda at Arden House, Harriman told him that Schiff had arranged the recapitalization of the Alton while Harriman was away in Alaska. After his return Harriman found much in the scheme that he did not like, but he acquiesced and never tried to duck his share of responsibility for the results.⁵⁴

While this might explain why Schiff defended the deal so vigorously, it does not clarify Harriman’s role. He was not yet a prominent financier; indeed, many writers argue that it was the Alton transaction and not the Union Pacific that first thrust Harriman into the limelight on Wall Street. How, then, did the Alton deal differ from the Union Pacific and the group’s later investments?⁵⁵

At first glance, Harriman’seemed to follow his familiar formula with the Alton. He recapitalized the road at a much larger figure just as he did the Union Pacific and later enterprises, sank huge sums into modernizing the road and its equipment, streamlined its management, got it to hustle harder for business, and tried to arrange favorable interchanges of traffic with connecting lines.

But there were differences, some of them subtle at first but looming larger over time. Harrimans formula enlarged the capital structure to raise the funds for upgrading a road so that increased business could carry its greater financial burden with ease. This approach worked best for the larger transcontinental systems with long hauls and untapped resources to exploit. The Alton was an intermediate road through well-developed country, which meant that the bulk of any new business had to come from connecting roads rather than its own territory. This proved far more difficult to do than Harriman anticipated.

The Alton’s earnings did in fact increase as Harriman projected, jumping 32 percent by 1904. Net earnings rose only 17 percent during those years but averaged $3.5 million between 1900 and 1904. Although earnings continued to rise for the next few years, expenses soared even faster. Harriman’s plan for the Alton was scuttled by twin economic forces that also hurt his other roads less severely: steadily rising costs and flat or declining rates. Harriman insisted that these factors were decisive; his critics discounted their influence. On this point Harriman was more right.⁵⁶

The whole point to taming maverick roads was to stabilize rates in two ways: keep them level or rising slowly and develop new sources of traffic paying higher rates than bulk products like coal and lumber that required huge volumes at low rates to break even. To run economically, the Alton needed not only more traffic but better traffic and more tonnage in every car. A key to accomplishing this, argued Felton, was “removing the present disabilities of the property in securing traffic from connections.”⁵⁷

Felton understood these factors and analyzed them in his reports on both the Alton and the Gulf lines. His conclusion for the latter fit the former equally well. “Unless the average rate per ton per mile can be raised materially without seriously curtailing the traffic movement,” he wrote, “future results probably will justify but a small fixed charge.” Unfortunately, neither road did well in comparison with rival roads in their territory.⁵⁸

Two forces that could not have been anticipated combined to frustrate this objective. For more than thirty years after the Civil War prices fell in the longest period of deflation in American history. After 1897, however, the trend reversed as the cost of labor and materials climbed steadily. Railroads, like other businesses, found themselves needing higher rates just to keep pace with inflation, but political pressures at both the state and federal levels kept rates down, thereby squeezing strong and weak carriers alike. On the Alton the earnings per ton-mile declined steadily from ninety-two cents in 1894 to sixty cents in 1907. Harriman estimated that the fall in rates between 1898 and 1907 alone cost the Alton nearly $19 million, or $2 million a year, in income.⁵⁹

As a result, net income chased gross earnings in an upward spiral, but the gap between them widened steadily. The Alton could not stand this squeeze as well as larger systems; nor did Harriman manage to integrate it with neighboring roads. Since the concept of real or adjusted prices had not yet entered the economists’ repertory, critics paid little attention to Harriman’s argument on this point. He could hardly be held responsible for the broader trends of the economy or for a political mood that let its hostility to giant enterprises in general blind it to the railroads’ situation in particular.⁶⁰

These factors guaranteed a decline in the Alton’s performance, yet they are not the whole story. Harriman’s critics were right on one point: he weakened the Alton by deviating from his formula in ways that aggravated these external problems. On his other roads he used earnings to pay for improvements and resolutely held off paying dividends in order to divert as much money as possible to the work. The object was always to increase earning power enough to justify the larger capitalization he imposed on the road. In nearly every case this was exactly what happened.⁶¹

But not with the Alton. Here the syndicate resorted to old-style financial tactics for taking back some of their investment early. In addition to the special 30 percent dividend, it started paying regular dividends at once. The reason for this deviation lay in the fact that the Alton had to be a cash deal requiring greater risks and more money up front, and it came at a time when the syndicate’s leading members were already carrying heavy financial loads.

From several angles, then, the Alton was an exception to the norm of Harriman’s policies. Most of his critics attacked the episode for the wrong reasons and committed the fallacy of applying the prevailing standards of their era to an earlier time in which those standards did not apply. On the surface there appeared to be reasonable counterarguments to the charges, their force heightened by the absurdity of some of Ripley’s accusations. The charge that the transactions were concealed to deceive investors, for example, simply is not true. They received full coverage in every major financial organ, often in more detail than other transactions, precisely because they were so complex.⁶²

Yet the doubts and ambiguities lingered. Harriman’s rebuttal never went public because in this one case he could not persuade himself to believe in the deal. Years later he talked about the transaction with Clarence W. Barron of the Wall Street Journal and asked him to write up something on it. Barron was willing because personally he believed the refinancing of the Alton had “not a financial or moral error in the whole transaction.” But when he produced a draft statement, Harriman told him that someone wiser than both of them had advised him to say nothing on the subject. Barron thought the advice had come from Harriman’s lawyers and that they were wrong.⁶³

So Barron confided in May 1915, six years after Harriman’s death. A week later he dropped by the office of Judge Robert S. Lovett, who had been Harriman’s most trusted adviser. What Barron heard during the next hour gave him an entirely different slant on the transaction, one that remained confidential until two years after his death in 1928.

Shaking his head sorrowfully, the judge admitted that the critics had been right on one main point. “The crime of the Alton,” he said, “was that instead of the Alton credit being improved the Alton credit was destroyed and the benefit of that credit transferred from the company to the syndicate.” The syndicate had put only about $1.3 million of its own money into improvements, and it created the holding company just to get the profits from the bonds it sold itself at a bargain price. In doing this, the syndicate had not increased the Alton’s fixed charges, but it had skimmed for itself profits that ought to have gone to the railroad.

“We tried many times to explain the Alton matter,” sighed Lovett, “but we never could reach any satisfactory explanation. When we thought we had something I would show Harriman how from the facts it could be picked to pieces. He would lose patience and throw it up. There never was any explanation made and I do not think there could be any explanation made. Harriman declared it was the one blot on his record.”⁶⁴

⋆ The four eastern trunk lines were the Pennsylvania, New York Central, Erie, and Baltimore & Ohio railroads.

⋆ This sum included $38.8 million for the stock, $20.8 million for the 3 percent bonds mentioned below, $3 million for the purchase of the St. Louis, Peoria & Northern line, and $500,000 for commissions and other expenses.