In the majority of cases of insolvency the trouble has arisen primarily because the company had a larger load of fixed charges than its income would permit it to carry. That being the case, the only safe and correct course in reorganization is to cut down these charges. It is useless to continue them unless the company's difficulties are partly temporary; for to do so would be simply to invite a new insolvency.

One of the simplest and most severe cases of cutting down fixed charges is that of the reorganization of the Northern Pacific Railroad Company in 1875. The company's line was at that time still under construction and its earnings were less than 1/2 of 1% on its funded debt. There seemed to be no immediate prospect of increasing the earnings and it was therefore determined that all fixed charges should be eliminated. All outstanding bonds were replaced by preferred shares; floating debt was also exchanged for preferred shares; and old common shares were replaced by new common shares.

Daggett points out that out of seven railroad reorganizations in the period from 1893 to 1898, every one showed a decrease in fixed charges averaging 31%. He suggests that experience shows the advisability of keeping in view, in the rearrangement of fixed charges, the five following principles:

1. The maximum fixed charges after the reorganization is completed should not exceed the absolute minimum of net earnings.

2. As large a proportion as possible of the charges should consist of interest on bonds, avoiding sinking funds, guaranteed dividends, rentals, and the like.

3. The losses should fall most heavily on the junior security holders generally, leaving the first lien securities - unless the reorganization is exceedingly drastic - practically untouched.

4. While fixed charges should be cut, the nominal value of the new securities received by security holders in the old company should be reduced as little as possible.

5. Bondholders whose claims are scaled down should be given a corresponding chance to participate in future increases of earnings.*

* Daggett's "Railroad Reorganization," pp. 357-362.

If the junior bondholder who is asked to accept a reduction in the principal and possibly in the rate of interest of his holdings, is at the same time given preferred and common shares up to the full par value of his former bondholdings, or perhaps a little above, he is inclined to accept the reduction much more readily. He may feel, quite properly, that there is at least a chance of his recovering in future all the capital that he has lost.

As to industrial reorganizations, Dewing has averaged the results of 27 companies, and finds that fixed charges were reduced on the average about 25%. This percentage probably measures fairly well the excessive amounts of bonded and other obligations which were issued above the limits of prudence under the old financial plan.

The tendency on the whole has been more and more strongly toward avoiding half-way measures in reorganizations and toward putting the corporation on its feet financially so that it will not within a short time come back into the hands of the financial surgeons. To illustrate this tendency, an interesting parallel may be drawn between the first reorganization of the Erie Railroad in 1859 and its reorganization in 1895 by which time the present-day methods and principles of reorganization had become well recognized. In the first reorganization fixed charges were not reduced, preferred shares were given in exchange for the unsecured indebtedness, the second mortgage which was about to fall due was extended, and an assessment of 2 1/2 % was levied on both preferred and common shares. The position of the road was not much stronger after the reorganization than it had been before, and the money paid in by the shareholders was dissipated without permanent benefit either to the corporation or to themselves. The reorganization of 1895, on the other hand, lowered fixed charges, procured ample cash by assessments on the shareholders, and gave shares rather than bonds in exchange for the new cash raised.