Railroad promoters sometimes indulged in questionable, even fraudulent, practices. Typically, these schemes involved the construction companies that built the railroads. Here is how it worked. The railroad contracted with a construction company to build a certain number of miles of road at a specific amount per mile. The railroad then met the costs by paying cash (acquired by selling bonds to the public) or transferring common stock to the construction company. In addition, government subsidies (land grants, state and local bonds, etc.) could be transferred to the construction company. Under one complicated but widely used system, common stock was transferred to permit its sale below par value, which was prohibited by law in some states. As long as the railroad corporation originally issued the securities at par, they could be sold at a discount by a second party, the construction company, without violating the law. The contract price was set high enough to permit the construction company, when selling the stock, to offer bargains to the investing public and still earn a profit. This method of financing, although cumbersome, provided funds that might not have been obtained otherwise, given the restrictions on the railroads’ issue of common stock.
So far so good, but the system was easily abused. The owners of the construction company were often “insiders”—that is, officers and directors of the railroad corporation. The higher the price charged by the construction company, the lower the dividends paid to shareholders in the railroad and the greater the risk of bankruptcy because of the heavy indebtedness of the railroad, but greater would be the profits that the insiders made on their investment in the construction company. The officers of the railroad, in other words, had a fiduciary duty to their investors to minimize the costs of construction, but they violated this duty to enrich themselves.
Although not all railroad construction was carried out by inside construction companies, this device was common—especially during the 1860s and 1870s—and all the transcontinentals used it. The most notorious inside company was the Credit Mobilier of America, chartered under Pennsylvania statutes, which built the Union Pacific. During President Grant’s second term, this company’s operations caused a national scandal. Certain members of Congress bought stock (at favorable prices) or were given shares. It was a clear conflict of interest. By voting for grants of land and cash for the railroad, they were enriching themselves. Two congressmen were censured, and the careers of others (including outgoing Vice President Schuyler Colfax) were tarnished. Representative James A. Garfield was also implicated, but he denied all wrongdoing and was subsequently elected president. Huge profits accrued to the Credit Mobilier. A congressional committee reported in 1873 that more than $23 million in cash profits had been realized by the company on a $10 million investment—and this cash take was over and above a $50 million profit in securities. By inflating the cost of construction, the insider construction companies saddled the railroads with large debt burdens that came back to haunt them, especially in the depressed 1890s.
World History
