APPENDIX 
MILKING THE INSULL STRUCTURE
THE LEVERAGE GAME
In general, the larger an electrical utility’s service area, the more efficient its operations, since there were very large operating economies of scale. This conflicted with state-based regulatory regimes, which limited a utility to service a particular state. The holding company was a practical solution. A utility holding company could create a power complex to serve regions of different states, as dictated by geography, and then sell power to local state-based subsidiaries. While that made excellent economic sense, the holding company model opened the door to highly leveraged, abusive, pyramid structures.
Assume a local operating company, AZ Power, with a capitalization of $12.5 million, earning a net of $1 million for an 8 percent return on capital. Half of the capitalization is funded by long-term 5 percent bonds, a quarter by 6 percent nonvoting preferred stock, and the rest by a single class of voting common. The investor positions, at standard rates, are represented in Figure A.1.
The bondholders are first in the queue to get paid, followed by the 6 percent preferred shareholders. The 5 percent interest coupon on the $6.25 million in bonds and the 6 percent dividend on the $3.125 million equals $500,000 altogether. With net operating income of $1,000,000, the common shareholders will have increased their wealth by $500,000—a nice, and fairly safe, 16 percent return. Insull’s flagship companies, like Commonwealth Edison, often did better than that. Note that the common holders have taken most of the risk, so they deserve higher returns.
Repeat that step four more times: HC2 buys HC1’s common equity, funding half the purchase with new 7 percent preferred, and the rest in cash, then HC3 buys out HC2’s common, with the same financing method, and so on (see Figure A.2). The company at top of the pyramid, HC5, will make $296,875 on just $97,656 equity, a 304 percent return. Most importantly, although HC5’s $97,656 in equity is only 0.8 percent of the operating company’s total capitalization (97,656/$12.5 million), it owns all the voting stock. The chain of holding companies not only can create outsize profits on minimal equity positions, but also can lock in control for a very small group of investors, with them putting up only a minimum of cash.1
Of course, squeezing down the common equity greatly increases the risk. Assume that same structure but, due to some misfortune, a 5 percent equity return at the operating company, which is hardly inconceivable. The available cash would cover the amounts due to the bondholders, the senior preferred, and HC1 preferred, leaving only a 1 percent dividend for the common. If there were an HC2 layer, holders would get a sliver of their dividend, leaving nothing for the common nor for any of the additional layers of preferred.
Note that in the Insull conglomerates, the successive holding companies were almost always formed by insiders. The directing boards were typically the same as in all the other Insull properties. The advantages of the pyramid structure were, among other things, that the additional 7 percent preferred was good collateral for more lending, as financing standards got easier (and sloppier) through the 1920s. The extremely high profits to common also made great window dressing for subsequent flotations. Congressional hearings on the Insull structures suggested that MWU’s actual leverage was 2000:1—$1 in common stock controlled $2,000 in assets.*
As the Eaton deal squeezed the Insull cash flow, the conglomerate raised cash by selling, or using as collateral, great volumes of securities in highly leveraged entities. When the bankers finally put a stop to that, the pyramids collapsed, and the company was insolvent.
VALUATION AND DEPRECIATION SCAMS
As the Insull holding companies’ layers proliferated, it opened opportunities for intra-company stock trading at inflated prices. Let’s say that the fourth holding company in the structure laid out in Figure A.4 chose to sell some of its stock to another Insull company. Since almost none of the intermediate holding company stocks traded on exchanges, the managers had considerable freedom in assigning values—possibly the original share price, or its book value based on a multiple of its most recent earnings, or the management’s judgment of its intrinsic worth. It was common for one side of the transaction to book the sale at the highest plausible price while the other side used the lowest price to manufacture profits from the air.
The Insull companies also had a poor record in maintaining depreciation reserves, thus overstating operating income and net worth. The Internal Revenue Service (IRS) rules and best accounting practice for long-term assets, like power plants, were to take a 3 percent charge on original costs to reflect the diminished value of the asset. Many utilities, however, following Thomas Edison’s lead, made best-estimate reserve decisions each year, which predictably tended to mirror their available cash. An analysis of Middle West Utilities (MWU)’s earnings in 1928 disclosed that it was reserving only 1.02 percent of the plant book values, compared to an average of 1.99 percent for three other major utilities. One major subsidiary of MWU, for instance, Central and South West Utilities (CSWU), reserved $4.5 million for depreciation between 1927 and 1931, when the IRS standard would have called for $21.4 million.* In those same years, CSWU claimed to have a $6.9 million net earned surplus, when proper depreciation accounting would have shown that the company not only did not earn a surplus, but also funded $10 million of the dividend payout from its capital (see Figure A.4). Such accounting dodges could not be hidden forever. In this case, the bill came due in 1932, when MWU’s receivers in bankruptcy wrote off mountains of obsolete capital assets.2
