Building the First Systems in the 1880s

No man had a greater impact on the strategy of American railroads than Jay Gould, the most formidable and best known of the late nineteenth- century speculators. It was Gould who forced the Pennsylvania to abandon its long-held territorial strategy and to build the nation’s first interterritorial railroad empire. And it was Gould who finally convinced William Vanderbilt to transform the New York Central into a similar giant system. Then, a decade later, it was the same “Mephistopheles of Wall Street” who pushed the top managers of the Burlington, the Chicago and Northwestern, and other western lines into a strategy of expansion and consolidation. A review of Gould’s actions thus provides a useful focus for describing and analyzing system- building in American transportation.

Gould first acquired national notoriety when he joined Daniel Drew and Jim Fiske early in 1868 to prevent Cornelius Vanderbilt from taking over the Erie.3 Vanderbilt, who had obtained full control of the New York Central only a year earlier, had moved quickly to acquire his nearby weak, and therefore, in his opinion, dangerous competitor. The three speculators were able to successfully stave off Vanderbilt’s attack by the ingenious illegal and extralegal tactics that Henry and Charles Francis Adams dramatized in Chapters of Erie. After the battle, Drew and Fiske sold out. Gould became the road’s largest stockholder and its president.

Gould needed traffic if the securities of the Erie were to have any value. One way to obtain this traffic was to obtain full control of roads to the west. Except for the financially shaky and poorly managed Atlantic and Great Western, the Erie had no alliances with western connections. By capturing those of either the Pennsylvania or the New York Central he could both assure traffic for his road and at the same time weaken a major competitor.

What precisely Gould’s long-term goals were cannot be documented. He may have been planning to integrate the roads he acquired into a consolidated system. On the other hand, given the pattern of his whole career, it is much more likely that he expected these purchases to raise the price of Erie stock, which he could then dispose of at a high profit. Or possibly he merely planned to sell these lines back to the Pennsylvania or the New York Central at a comparable gain.

In any case, late in 1868 Gould, after he had leased the Atlantic and Great Western, began his campaign to obtain control of the Pennsylvania’s western allies.4 He started by negotiating with the Indiana Central, which would have connected the Atlantic and Great Western with St. Louis. Thomas A. Scott, the Pennsylvania’s vice president in charge of external affairs, was able to parry Gould’s try for the Indiana Central by offering a higher price to lease it. Gould’s attempts to win control of both the Cleveland & Pittsburgh and the Pittsburgh, Ft. Wayne & Chicago were more novel. He purchased proxies to be voted at the roads’ annual meeting. With these proxies in hand he could appoint the roads’ directors and then arrange for their sale to the Erie. Scott prevented Gould from controlling the meeting of the Cleveland & Pittsburgh by challenging the legality of the proxies in the Ohio courts. He turned aside the threat to the Ft. Wayne by proposing that the Pennsylvania legislature alter the road’s charter so that only one quarter of the directors could be appointed at each annual meeting. A sympathetic legislature quickly approved. Its members fully realized that Gould’s control of the Ft. Wayne could divert much of the western traffic from Philadelphia to New York City.

Gould’s swift and unexpected attack forced the Pennsylvania to adopt a new strategy.5 “In view of these extraordinary movements, it became evident to your Board,” its president, J. Edgar Thomson, reported to the stockholders, “that this Company must depart from the policy that had heretofore governed it, and obtain direct control of its western connec- tions.” By July 1, 1869, the Pennsylvania had leased the Ft. Wayne and then the Cleveland & Pittsburgh and the Indiana Central on reasonable terms. Their directors preferred Thomson and Scott as associates to Jay Gould.

Blocked by the Pennsylvania, the Erie’s president immediately turned his attention to obtaining the lines running along the southern shores of Lake Erie.6 Early in April he renewed an agreement with the Michigan Southern to obtain access to Chicago. By summer Gould had merged that line with others along the shore of Lake Erie between Toledo, Ohio, and Erie, Pennsylvania, into the Lake Shore and Michigan Southern. Here he had the help of Legrand Lockwood, a Wall Street speculator who had earlier tried to prevent Vanderbilt from obtaining the New York Central. At the same time, Gould began to buy stock in the Toledo, Wabash, and Western, a through road connecting Toledo to St. Louis. In August, he was elected to its board. Vanderbilt, who had been echoing the views of the Pennsylvania’s executives by saying he had no interest in controlling or managing lines to the west, suddenly realized these vital western connections were about to fall into the hands of his arch rival, Jay Gould.

It was only Jay Gould’s other speculations that permitted Vanderbilt to save the situation by reversing his earlier policies and obtaining control of the Lake Shore. In October 1869, Gould joined Jim Fiske for their most daring speculative coup, the attempt to comer the gold market. In the resulting stock market shakeup that followed the failure of the corner, Lockwood was forced to sell his shares in the Lake Shore. And, as Gould’s biographer has pointed out, “It was Vanderbilt, the businessman with funds, and not Gould, the speculator without funds, who bought the distressed stock.” Besides obtaining control of the Lake Shore, Vanderbilt picked up blocks of Wabash stock and soon had his representatives on its board, including his son-in-law, Horace F. Clark.

For all his energy and unscrupulousness, Gould lost the Erie’s campaign for western connections. He failed to put together a railroad system. His strategic actions, however, had a lasting impact on two of three major east-west competitors. The responses of the presidents of these roads is revealing. J. Edgar Thomson, the professional engineer who built and then managed the Pennsylvania, immediately decided to build a self- contained system. In the words of a later stockholders’ report, he and his senior managers “with grand ideas, formed a plan or policy to reach all important points in the West with their lines.”7 Robert W. Garrett of the Baltimore & Ohio, an experienced manager who was also a major stockholder, began to construct a smaller, less ambitious system. Cornelius Vanderbilt, the capitalist par excellence, merely made his son-in-law president of the lines Gould had forced him to buy.

The career managers of the Pennsylvania planned their strategy with care and carried it out with speed. Significantly by the 1860s these man- agers, who owned relatively little stock in their company, completely dominated its board. The board which in the early years of the company had met almost weekly now convened less than twice a month. Thomson was board chairman as well as company president. The four other top managers sat on the board with him. The remaining members, according to the findings of a stockholders’ investigation, “are virtual appointees of the president.”8 Not surprisingly, the directors approved almost without discussion the plans for expansion.

These plans called for obtaining access to the major commercial centers and the natural resources—coal, oil, and lumber—in the nation’s heartland between New York and Philadelphia and Chicago and St. Louis.9 The Pennsylvania leased or purchased control of roads into Columbus, Cin- cinnati, Indianapolis, Louisville, Maysville, and Cairo. Simultaneously it purchased control of lines to the lake ports and the lumber region of Michigan. Then in 1871 it leased for 999 years the “Joint Companies” in New Jersey in order to insure absolute control of the routes from Philadelphia and other Pennsylvania rail centers into New York City.10 It soon had its own lines into Buffalo and Toledo, as well as Detroit and Chicago, and its connections to Washington and Baltimore. In less than five years the Pennsylvania had grown from a line of 491 miles of track to one of just under 6,000 miles, or 8 percent of the total mileage of railroads operated in the United States. Its capitalization stood at just under $400,000,000, a fraction less than 13 percent of the total capital invested in American railroads. By 1874 the total mileage it directly administered equaled that of the railroad network of Prussia. Only two nations in the world, Great Britain and France, had more miles of railroad than the Pennsylvania system.

As they built their self-contained system, Thomson and his associates let their enthusiasm for empire-building get somewhat out of hand. In 1871 they organized the American Steamship Company to run from Philadelphia to Liverpool, as a way of lessening their road’s obvious dependence on the New York City outlet, and then invested over a million dollars in the International Navigation Company which ran ships to Antwerp and other continental ports.11 In the following year its managers obtained full control of the fast freight lines they had earlier sponsored: the Union Railroad and Transportation Company and the Empire Transportation Company.12 During the same period, the Pennsylvania entered mining and manufacturing. In 1872 and 1873 it bought large mining properties in the state’s anthracite region. Again the managers stressed that its motives were defensive. Since the Reading and other carriers of anthracite coal had begun to obtain coal mines and lands, Thomson therefore felt obliged to do the same.13 “To retain some of this traffic for its railroads, the Pennsylvania Railroad Company was compelled,” read his annual report for 1873, “to follow the example of the other railroad companies by securing, in the vicinity of its lines, the control of coal lands that would continue to supply transportation for them.”14 The book cost of carrying out this defensive plan came close to $4 million. Shortly thereafter the road spent three quarters of a million dollars to finance the Pennsylvania Steel Works Company to assure it of a steady supply of steel rails produced by the recently invented Bessemer process.15 Finally, to encourage the cooperation of the supplier of the nation’s sleeping and parlor cars, it invested still another million in the Pullman Palace Car Company. Even so, the Pennsylvania’s holdings in nontransportation enterprises were only a small part of its total $400 million worth of assets.

Despite pronouncements to the contrary, the Pennsylvania in these same years looked to its connections beyond the Mississippi and south of the Ohio.16 But outside of “the country which your Company thought belonged to them geographically,” the executives relied more on the older policy of alliances than of the newer one of direct legal and administrative control.17 In 1871, the company formed a holding company to purchase securities of railroad corporations connecting Cairo, Illinois, with New Orleans, and of roads south of Washington connecting Richmond, Danville, Charlotte, Raleigh, and Atlanta. To the west, the Pennsylvania’s interest was more personal than corporate. Tom Scott (and probably other senior executives) invested his own funds in the Kansas Pacific and in the Union Pacific. For a brief period during 1871-1872, Scott was the president of the latter.18 After retiring from the Union Pacific, he became president of the still-to-be constructed Texas and Pacific.

The coming of the depression of 1873 dampened the expansive mood of the Pennsylvania and its senior executives. In the interest of long-term stability, they decided to sell the corporation’s interest in the roads to the south of the Ohio and west of the Mississippi, and to concentrate instead on the more efficient management of the system they directly controlled. The annual report for the year 1874 announced that the company had completed its expansion—an expansion that conformed to the basic strategy decided upon in 1869:

Your company, having secured lines and extensive terminal facilities at Philadelphia and New York and, through roads controlled by it, at Baltimore and Washington, in the east; the control of roads to Erie, Ashtabula and Toledo, on Lake Erie, with good connecting roads working in harmony to Buffalo; and the control of lines through the lumber region of Michigan; and in the west having terminals at Chicago, St. Louis, Louisville, Cincinnati, Wheeling and other important commercial centers, with good connections beyond those points; and having also perfected communications with the entire oil region of Pennsylvania, the Connellsville [sic] coke region, the city of Cumberland and the Cumberland coal region; and with Frederick and Hagerstown in Maryland, and Martinsburg in West Virginia—your Board have concluded to adopt as general policy that no further extension of lines should be made or obligations be assumed by your Company, either by lease or otherwise, except to complete the several small branches and extensions now in progress in Pennsylvania and New Jersey. The best energies of your Board and its officers will hereafter be devoted to the development of the resources of the lines now controlled. They believe these lines have a great future for the shareholders.19

The directors and managers of the Pennsylvania also began to draw back from their steamship, coal, and steel ventures. They had decided that the operation of a self-contained railroad system joining the midwest with the seaboard and reaching the major areas of natural resources was the maximum size enterprise they could profitably administer. The peripheral activities had not paid off. Through perfecting their administrative structure, they hoped to manage efficiently a single, unified transportation system.

The creation of the nation’s first interterritorial railroad system—its first megacorp—required significant financial, legal, and administrative innovations. These innovations would be taken over by other railroads when they, a decade later, turned to building their systems, and still later by giant industrial enterprises when they grew large by integrating mass production with mass distribution.

The Pennsylvania’s completed system was a huge business enterprise. In a period when very few industrials had assets of over $ 1 million, the Pennsylvania’s were valued at $400 million. The actual cost of obtaining the system was much less than the value of its assets because many of the properties were leased rather than purchased. Also, when a company was purchased, only 51 percent of the stock was needed to assure certain control. Leases normally guaranteed the bonds of the road being leased and the payment of a rental to its stockholders equal to its current dividends. These charges the Pennsylvania’s managers expected to pay from the current income of the leased roads.

Nevertheless, the cost of building the system was unprecedented. In the five years from 1869 through 1873, the Pennsylvania sold or otherwise disposed of $87 million worth of securities.20 No other private enterprise in the United States had ever raised so much capital so quickly. Of the securities, $41.1 million were shares of stock. Their disposition increased the par value of stock outstanding from $27.0 million to $68.1 million. A sizable share of the new issues was sold to existing stockholders and nearly all the rest to other American investors. By May 1871 only 7.3 percent of the stock was owned by foreigners. A much larger share of the $26.3 million worth of bonds was sold abroad.

In marketing these bonds, and to a lesser extent the new stock, the Pennsylvania’s managers relied on the services of the nation’s foremost investment bankers. In 1870 Jay Cooke, who had made his reputation by mass marketing government bonds during the Civil War, formed the first modern underwriting syndicate in the United States to sell the Pennsyl- vania’s bonds. He arranged for eight financial houses to guarantee the sale of a block of bonds, with each member of the syndicate accepting respon- sibility to sell an agreed upon amount. The syndicate paid all the costs of distribution, including advertising. The Pennsylvania received “90 flat” for the bonds for a total of $1.8 million.21 And it agreed not to offer any bonds on its own account until the syndicate had completely disposed of the issue. After 1870 Thomson turned from Cooke to Drexel and Company to assist in marketing the road’s securities.22 Obtaining the Pennsylvania’s account, the largest in the country, may have been the reason Anthony Drexel was able to persuade the young and financially well- connected J. Pierpont Morgan to become his New York agent. In 1871 Drexel, Morgan & Company opened its doors at 2 3 Wall Street. In any case, the Pennsylvania’s career managers were allied with the leading investment bankers from the very beginning of their system-building.

Legal innovation accompanied financial innovation. To assure legal control of their many properties, the Pennsylvania perfected the modern holding company. In 1870 it obtained from the Pennsylvania legislature a charter for the Pennsylvania Company and in the next year one for the Southern Railway and Security Company.23 The managers planned to use the Southern Railway to hold the securities of its southern allies. They wanted the Pennsylvania Company to control its unified system between the Atlantic coast, the Great Lakes, and the Mississippi River. Thomson had the Pennsylvania Company acquire from the Pennsylvania Railroad Company the leases and securities of the Ft. Wayne, the Cleveland & Pittsburgh, and other lines northwest of Pittsburgh and the Indiana Central, the Pittsburgh, Cincinnati & St. Louis (the latter was known as the Panhandle line), and other lines running southwest from Pittsburgh. In return for these leases and securities, the Pennsylvania Company paid the Pennsylvania Railroad Company $8.0 million of its total preferred stock issue of $11,360,900. The rest of that issue went to the Union fast- freight line to pay for its rolling stock, warehouses, depots, and other facilities. The Pennsylvania Railroad Company continued to hold the securities of the lines running east of Pittsburgh as well as those of its coal, shipping, and steel subsidiaries and those of the other fast-freight line, the Empire Transportation Company. On the basis of three large regional legal units (the Panhandle to the southwest, the Pennsylvania Company to the northwest, and the Pennsylvania Railroad Company to the east of Pittsburgh) Thomson and his associates then fashioned a carefully defined decentralized management structure through which over 1,000 managers supervised the work of at least 50,000 to 55,000 employees.24 This administrative innovation is described later in this chapter when the development of the structures to manage the great systems is considered.

John Work Garrett, the president of the Baltimore & Ohio since 1858, followed the moves of Gould at the Erie and then Thomson at the Pennsylvania with keen interest.25 A strong advocate of alliances, Garrett had been willing to obtain control of a connection if it was necessary to maintain his territorial strategy. He built a feeder into Pittsburgh and in 1866 leased the Ohio Central in order to connect Wheeling with Columbus. Early in 1869, as Gould began to negotiate with the Ohio roads, Garrett moved quickly to purchase full control of a line north to Lake Erie at Sandusky. At the same time, the Baltimore road substantially increased its stockholdings in the Cincinnati and Marietta (connecting Wheeling to Cincinnati), and made its vice president, John King, the Marrietta’s president.

Then Garrett stopped. He and other investors on the board were becoming troubled by the cost of expansion. The road continued to be financed largely by the family mercantile and banking firm of Robert Garrett and Sons which had, since the 1840s, close connections with the two leading American financiers in Britain: George Peabody and Junius S. Morgan, J. Pierpont’s father. These and other investors were represented on the board.

Nevertheless, the defensive need for assured connections to major com- mercial centers overcame the reluctance of president and board to expand. In 1874 the board agreed that the company could no longer rely on the Pennsylvania or other roads for entry into Chicago and authorized the construction of a 2 63-mile line connecting that city with the Sandusky road. Garrett also incorporated the Cincinnati and Marietta into the Baltimore & Ohio’s management structure. Then in 1878 he obtained full control of and began to operate the old but often obstreperous ally, the Ohio & Mississippi, when that road went into receivership. Garrett’s growing system now had direct connections with St. Louis, Louisville, and Chicago and with roads west of Chicago at Peoria. After the Pennsylvania purchased the Philadelphia, Wilmington and Baltimore in the early 1880s, the Baltimore & Ohio responded and built its own road into Philadelphia. Even then it continued for several years to rely on the Reading and the Central to carry its traffic into the New York area.

The Baltimore & Ohio moved, as had the Pennsylvania, into nonrailroad enterprises.26 The road purchased coal properties and in 1872 built and operated a steel rolling mill. It had close ties with coastal steamer lines to Philadelphia and New York. After an unsuccessful venture with its own steamship line to continental ports, Garrett turned to an alliance with the powerful North German Lloyd Steamship Company to provide shipping to Britain and the Continent. He also built a chain of hotels along the line of the road. Moreover, Garrett insisted on manufacturing his own sleeping and parlor cars, even at the cost of a lengthy patent dispute with Pullman and others. As the road’s historian has emphasized, by the late 1870s Garrett “very much preferred to run the company in every way as a self- contained and highly independent unit.”27 Nevertheless, strong investor influence on the board had slowed and limited expansion. The system always remained much smaller than that of the Pennsylvania.

The Vanderbilts, owners of the third great trunk line, were even more cautious than Garrett and his associates. After Gould forced Vanderbilt to take over the Lake Shore, the Commodore did little to integrate the operations of that road with those of the New York Central.28 When Clark, his son-in-law, died unexpectedly in 1873, Vanderbilt sold the family holdings in the Wabash and in other mid western roads in which Clark had purchased stock, turned over the operation of the Lake Shore to a professional manager, James H. Devereaux, and made it clear that he had no intention of enlarging his railroad properties.29 William H. Vanderbilt, who took charge of the family interests after his father’s death in January 1877, was even more conservative.

William Vanderbilt was an administrator, not an empire-builder.30 He hired first-rate managers and installed advanced procedures and tech- nology. But he had no enthusiasm for expanding his holdings. What purchases he did make were instigated by the speculative schemes of Jay Gould. In the summer of 1878, as part of a deal with Gould, Vanderbilt obtained the controlling shares of the Michigan Central.31 Gould had organized a telegraph company to compete with Western Union, and Vanderbilt was one of the largest investors in the established telegraph enterprise. Gould was able to have Vanderbilt persuade the Western Union board to pay the price Gould wanted for his company by promising to provide Vanderbilt enough shares in the Michigan Central to control that road, which was the Lake Shore’s foremost competitor. Then in the next year the Canadian Southern, the road connecting the Michigan Central to the New York Central, went bankrupt. Vanderbilt picked up this key connecting line at a small price. Almost in spite of himself, Vanderbilt was beginning to build a system.32

Bargains though the purchases were, they did require funds, particularly as the facilities on both roads had deteriorated. These expenses plus the cost of improving the roadbed and equipment of the New York Central itself, and the further stock purchases needed to maintain the alliances with the Central’s eastern connections—the Boston & Albany and the Boston, Hoosac Tunnel and Western—helped to convince Vanderbilt of the futility of trying to maintain personal control over a major railroad. So in 1879 he arranged with the junior partner of Drexel, Morgan and Company to sell off a sizable portion (225,000 shares) of his New York Central stock.38 J. p. Morgan formed a syndicate to sell these securities in London, then became an active member of the Central’s board of directors.

One reason Vanderbilt had so little taste for system-building was his faith in the alternative strategy to assure the continuing flow of traffic across his properties. He believed that the cartels would work. He remained one of Albert Fink’s strongest supporters. In this view he was supported by the presidents and directors of many other American roads. The leading capitalists and investors of the lines running west from Chicago, including John Murray Forbes of the Burlington, William Osborn of the Illinois Central, David Dows and Peter Geddes of the Northwestern, backed the regional associations that imitated and worked closely with the Eastern Trunk Line Association.

Although the large investors continued to believe that cartels provided a less expensive alternative to system-building, a number of younger managers, particularly in the west, were beginning in the late 1870s to speak out against the conservative policies of their boards.34 Both Charles E. Perkins of the Burlington and Ransom R. Cable of the Rock Island maintained that the current economic depression of the 1870s was pro- viding an opportunity for their roads to build their “defenses” by obtaining lines into key cities at low prices. In 1878, in a number of detailed reports, Perkins outlined an explicit strategy. He urged that the Burlington take over its ally in Nebraska, the Burlington and Missouri, and that it purchase adjoining roads, some of which were still unfinished, in order to assure it of its own entrance into Kansas City and St. Joseph. “If we do take them now, when they are bankrupt,” Perkins wrote Forbes, “and before others awake to the value of that region, we control that country and can extend the roads at our leisure.”36 Perkins planned to round out this network by obtaining the Hannibal and St. Joseph. As he told Peter Geddes:

I have long been of the opinion that sooner or later the railroads of the country would group themselves into systems and that each system would be self-sustaining or in other words that any system not self-sustaining would cease to exist and be absorbed by those systems near at hand and strong enough to live alone . . . Each line must own its feeders.37

But Forbes, Geddes, and other directors continued to maintain that such a consolidated system would become too large for effective internal manage- ment, and too expensive for its stockholders. By the early 1880s, however, these investors both in the east and in the west were beginning to change their minds. The great cartels were clearly becoming inadequate. Again Gould was the catalyst.

Source: Chandler Alfred D. Jr. (1977), The Visible Hand: The Managerial Revolution in American Business, Harvard University Press.

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