This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
It has already been noted that it is customary in this country for merchandising firms to take advantage of cash discounts in paying for their purchases and to secure the funds with which to make immediate payments by borrowing from their own banks. • This practice spread throughout the country beginning in the 8o's, but it originated in New York several years before. Shortly after the crisis of 1873, the late president of the Importers and Traders National Bank in New York City, Mr. Buell, rapidly built up the business of his institution by showing his customers how, by borrowing from his bank on their own single-name paper, they could obtain cash prices or cash discounts and thus show a substantial profit on their interest and discount accounts for the year. The custom is now so firmly established that practically every business concern in good standing counts on establishing a line of credit with its bank which will enable it to borrow simply by drawing its own notes and depositing them with the bank.
A variation in this custom exists among large manufacturing and commercial corporations which often find it advantageous to turn over their own notes to brokers who for a small commission sell them to any bank that may happen to have idle funds available. The note brokers sell the paper of large concerns throughout the country. At the time of the failure of the Booth Fisheries Company some years ago, and at the time of the more recent failure of the H. B. Claflfn Company and associated concerns, it was found that the notes of these companies were scattered among banks throughout the United States. The banker who buys a single-name note from a broker, very often has no knowledge whatever of the financial affairs of the company which issues the note. He may have heard the name of the company frequently and he probably considers the note broker a good fellow in whose honesty and judgment he has confidence, and that is the extent of the actual information before him when he makes his purchase. This loose method of doing business has brought some protest and is likely to be improved in part during the next few years.
A few large concerns which sell their short-term notes in the open market on a large scale, headed by the International Paper Company, have instituted the custom of having all their notes registered by a trust company, just as bonds are registered. This has at least the advantage of making it easy to ascertain how many notes a company has outstanding at any one time, thus avoiding gross overissues. A second important improvement is to be made a feature of the Federal Reserve banking system. It 'is the intention to place a complete record of the note obligations of all important concerns in the hands of members of the system. This record will, of course, include references to any defaults of bills in payment. In the course of a few years it will become a highly valuable aid to bank examiners and to the Federal Reserve officers in checking up the credit standing of borrowing companies.
One accepted rule which should be observed by corporations that sell their notes through brokers, is that they should not at the same time be discounting any large quantity of notes with their own banks. If they are using both banks and note brokers, they have no quick method of raising funds open to them in an emergency. If they are using either their own banks alone or note brokers alone, then they can turn, if it should become necessary, to the method that has not previously been utilized.
The abuse of bank credit has long been a weak feature in modern business life, and will not quickly be eliminated. It may arise in two ways: either by making a wrong application of the funds secured from the bank, or by obtaining the funds on the strength of false or questionable claims. There are three legitimate reasons for making bank loans: first, to finance a temporary shortage of funds; second; to increase the stock of salable goods on hand; third, to extend additional credit to customers. The first reason may be quite acceptable, but only under exceptional circumstances. A firm, for instance, may have suffered a loss by fire and have insurance payments shortly due, in anticipation of which it may properly borrow from its bank; or it may have funds shortly coming in from its stockholders or from other sources. Each case of this kind must be decided on its own merits. The second reason is the one that is customary and that is generally considered soundest. It is, of course, necessary for both the borrower and the bank to be reasonably certain that the goods being purchased are salable, so that there may be no question as to meeting the note out of the proceeds of the sale. The third reason is also concerned with the sale of goods, but this time from the standpoint of the seller. It is necessary here for both the borrower and the bank to make sure that the credit which is being extended to customers, is well placed and sound.
If the borrower, instead of using the funds he receives from the bank for one of the three purposes above mentioned, utilizes it in extending his plant in the purchase of non-salable goods, in general advertising, or puts it into any other property or expenditure that is not readily convertible into cash, he may properly be said to be abusing the trust of his banker. More than that, he is seriously jeopardizing his own financial safety. "What difference does it make to the banker whether I use his money in one way or another?" is the answer of some business men, "sooner or later he will get his money back with interest, and that's all he needs to fret about" Yes, but the banker is not in the business of making long-term loans or loans that may be sound enough but cannot be paid back on the dot. The only safe banking is short-term banking, and he is absolutely right when he insists that his loans be used only in quick turns and not for permanent or uncertain investments.
The other abuse of bank credit is best illustrated by the great Claflin failure in New York in the summer of 1914. On account of the high standing of the Claflin firm for generations, and its unquestioned credit, it was permitted to discount many millions of dollars of paper issued by its subsidiary corporations. It was learned after the failure, that much of this paper did not represent actual commercial transactions. It was simply put out more or less at random when the firm needed money. The H. B. Claflin Company's contingent liabilities were never reported; in fact, no complete financial statements were given to bankers. In the absence of financial statements and of any definite form of assurance that single-name notes or notes issued by one subsidiary company to another subsidiary company in the same organization are representative of commercial transactions, there is really no method of telling whether a corporation is borrowing beyond the limits of safety or not.
As is pointed out more fully on page 124, most banks are now beginning to insist quite properly on receiving financial statements. A committee of the New York Clearing House has suggested that a form of promissory note be devised, the signature to which certifies that the document is the product of a commercial transaction. The suggestion has merit, and with the strong backing of important banks behind it, might eventually be adopted. In this connection it might be well to say a word as to "accommodation" indorsements of commercial paper. This practice, which was formerly so prevalent among individuals, is gradually dying away. There have been many instances of indorsers having suffered heavy losses simply because they were weak enough, or good-natured enough, to lend their credit to their acquaintances. Sometimes a corporation is guilty of lending its name in the same way, and with even less excuse. In fact, an indorsement by a corporation for accommodation is probably illegal, and would not be held good in most jurisdictions. A corporation is organized to carry on a certain line of business, for which it is granted definite powers under its charter. It is probably not within the legal power of any corporation to assume the responsibility which goes with an indorsement given without consideration.