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.
Usually the most urgent problem in a reorganization is to bring in fresh capital, either for the purpose of making additions and betterments in the fixed assets, or more commonly for the purpose of providing adequate working capital. In either case it is necessary, in almost every reorganization, to secure a considerable amount of cash. If the company had been well supplied with cash it would not presumably have become insolvent. But the fact that a company is in receivers' hands is naturally no recommendation to prospective purchasers of its securities, and the problem of raising cash is therefore not only urgent but often extremely difficult It can be solved only by enforcing drastic sacrifices on security holders. There are three possible methods of raising new capital or of securing an equivalent reduction in current liabilities:
2. By levying assessments on bond or share holders.
3. By inducing the current creditors, or some of them, to accept funded obligations in payment of the amounts due them.
In case the insolvent company's credit has not already been used to the limit, it may be possible to bring about some rearrangement of claims upon assets and earnings which will leave room for the issuance of new securities. These securities may then be sold at a heavy discount and thus the cash most urgently needed may be obtained.
The second method of raising cash is through assessment. In nearly every reorganization the common shareholders are requested to pay some assessment in order to secure any holdings in the reorganized company. The same requirement is frequently imposed upon the preferred shareholders and is sometimes imposed even upon the junior bondholders. It may seem strange that a bondholder or even a preferred shareholder should be compelled to pay out fresh money in order to hold an interest in the company; but the truth is that any security holder who is not amply protected by marketable assets is likely to face this experience. If he resists the proposal a new company is organized which, at the judicial sale, will turn in the prior lien securities in payment for all the property of the company. This automatically wipes out the junior bondholders - unless they choose to raise the capital with which to pay off the prior lien holders, in which case they will hold the whip-hand. The junior bondholders or shareholders are thus left with the clear alternative of either giving up their previous investment without any further effort to protect and redeem it, or of paying the assessment.
The question as to whether a shareholder should or should not pay his assessment is always one to be studied with much care. Naturally the reorganization managers will endeavor to make terms that will be at least fairly attractive in order to insure that the money which is required shall be forthcoming. For this reason it is usually profitable for shareholders to pay up their assessment. Daggett states that in almost all cases of railroad reorganization the price of the securities obtained by the assessment payer was within six months nearly equal to the previous market quotation plus the assessment. In practically every case later quotations have gone much higher. The increase in value "has abundantly justified the payments which stockholders were asked to make.,, Probably the most drastic assessment on record is that of the Houston and Texas Central Railroad Company in 1897, which amounted to 73% on the common shares.
The third method of increasing cash resources - that of inducing the current creditors to accept long-term securities in settlement of their claims - is practicable only when the insolvent company is fundamentally prosperous and has been brought into difficulties merely through a temporary shortage in working capital. In both the Westinghouse reorganizations the holders of floating debt were easily persuaded to take long-term notes and bonds in payment, for they were convinced of the company's inherent soundness. In the first reorganization of 1891 the company's $3,000,000 in floating debts were replaced largely by stock issues.