When the speeches ended, the eyes of the nation, or more properly, its ears, focused on the distinguished ex-governor. A telegrapher stood nearby, hyper-alert and ready to tap out the celebratory message. As the Central Pacific railroad representative, Leland Stanford’s job was simple: drive home the Golden Spike. He swung the sledgehammer…and missed. Confused accounts say “Doc” Durant, head of the Union Pacific tried his hand next but also bungled the moment. It didn’t matter; the operator closed the circuit and broadcast the word “Done” to the world. Fastened by workers’ muscle and rails of iron, the nation was joined, coast-to-coast.
Construction of the Transcontinental Railroad may have been a singular engineering feat, but as a hallmark of transcendent, awe-inspiring American capitalism, it left a lot to be desired. Indeed, the venture would prove a disheartening prelude to a new era of business enterprise—a period when unrestrained corruption and outsized egos despoiled an entire industry. The result was not just a series of spectacular business failures it also contributed to political turmoil and the near ruin of the American economy. The Age of Railway Pirates taught the investing public important lessons about business diligence, personal accountability, and fiscal transparency.
Scandal in the Heartland
There were signs of trouble even before the 1869 ceremony at Promontory Point. The Transcontinental Railroad was a massive project which meant, by default, it would be a joint public-private enterprise. Fortunately, the U.S. Treasury made it hard to fail, subsidizing the two corporate builders with exorbitant land grants and a sweetheart debt arrangement (simple interest only, due in 30 years). We can find interesting modern-day analogues in the government’s support for critical semiconductor and renewable energy infrastructure projects. But for Stanford, Durant, and their partners, it was not enough.
The spike had been in place for three years by the time the scandalous “King of Frauds” broke. The Union Pacific outsourced its construction to a shadowy company few people seemed to know much about, Crédit Mobilier. As the miles progressed, costs escalated. The Union Pacific paid its bills, sometimes with checks that, oddly, were never deposited. Instead, they were exchanged for Union Pacific stock and other securities. By the time they completed the railroad, dividends paid to Credit Mobilier shareholders ranged from 50% to 100% annually.
It turned out the lucky investors were “Doc” Durant and his Union Pacific partners, along with a few well-connected politicians, including the Vice President, who received discounted stock that looked suspiciously like bribes. Durant’s self-dealing was so egregious, the crooked politicians eventually forced him out of Crédit Mobilier! In the end, American taxpayers and bondholders got their railroad but at a tremendous monetary cost and an even greater impairment to public trust.
The Fall of the House of Cooke
By that point, the rush was on to expand the nation’s railroad infrastructure. With the war over, Jay Cooke needed a new outlet for his investment bank, and the money-hungry trans continentals seemed to be the answer. Planning to replicate his prior success during the war and sell Northern Pacific Railway bonds guaranteed by the federal government, Cooke hadn’t counted on the Crédit Mobilier fiasco. The perfect storm hit in 1873. Railway construction required huge advances from Cooke just as European investors lost interest and stopped purchasing bonds. At the same time, the government sought to retire the war debt, reducing circulating currency. As bond sales fell to a trickle, the famous House of Cooke was unable to pay creditors and finally had to shut its doors in September. The failure of one of the nation’s premier investment banks shook the economy, leading to a prolonged recession.
Roads to Nowhere
When conditions improved in the late 1870s, railway construction reached its zenith. The would-be industry reformer, Charles Francis Adams, watched in dismay as new lines spread randomly across the western United States—railroads in search of customers. It was, he proclaimed, a “period of madness.” In 1890, the state of Kansas had four times the per-capital rail of all of New England. Intense competition for transporting farm commodities led to price fixing and the formation of collusive “pools” among operators desperate to raise prices.
Railroad economics would ruin honest men, so the industry drew unprincipled swindlers like Jay Gould instead. Best known for his 1869 attempt to corner the gold market, the “Mephistopheles of Wall Street” dreamed of establishing the nation’s preeminent railroad empire. In the early 1870s, he invested heavily in the troubled Union Pacific. The Union Pacific’s fortunes improved for a while, and the tycoon ratcheted up dividends paid mostly to himself. As the company’s fortunes declined again, Gould used insider information to unload his stock. Finally, in a feat that was unusually shameful even for this period of financial buccaneering, Gould forced the Union Pacific to merge with two insolvent railroads he happened to own. By 1883 Gould was gone, having milked the railroad, as one writer put it, for “all that he thought possible.”
Cooking the Books
Gould and other railroad magnates could get away with their frauds and incompetence because no one was watching. The SEC was decades away and accounting rules were mere textbook suggestions that few took seriously. Owners manipulated the annual reports they used to attract investors with a variety of deceits including inflated valuations, fictitious accounts, and hidden interest charges. The only time a railroad’s true financial picture came into focus was when the bankruptcy receiver ordered a forensic audit.
American society was not completely oblivious to the uninhibited capitalist tendencies of the post-Civil War railroad boom. Throughout the Gilded Age, a countercurrent of public opinion urged some means of controlling the Robber Barons’ grasping excesses. Much of it was purely economic—farmers tired of arbitrary freight costs, workers demanding better wages, bankers seeking fiscal responsibility. The periodic slumps and market crashes got the attention of politicians and by 1900, regulations and industry consolidation made it much tougher to find new areas to exploit. The ignoble, wild west period of railroad banditry finally came to an end.
What This Means for Owners & Advisors
Gilded Age investment bankers contributed to the undisciplined business practices of the railroad tycoons. They failed to see or understand basic financial and operational principles that govern rational expansion planning. Bankers assisting clients in today’s complex business environment adhere to a much greater standard of care.
- Business owners must guard against expansionary plans that lack sound motivations and rationalization. Aggressive tactics often lead to poor execution and suboptimal outcomes.
- Industry expertise and knowledge of market conditions are indispensable for bankers advising business owners concerning transactions or other growth strategies.
- True and accurate financial reporting lies at the heart of investing. It is the banker’s responsibility to gather, analyze and translate data into meaningful investment advice.
PCE’s advisors know the challenges business owners face and the decisions you need to make. As our client, you’ll benefit from our proprietary market research and insight drawn from decades of experience. It’s our responsibility and privilege to deliver the support you need.
Steven G. Krug, PhD, CFA, is a Director in PCE’s Valuation Group, specializing in valuations for financial reporting, transactions, tax and estate planning, ESOPs, and litigation support. His PhD in history informs his perspective on the evolution of American finance and capital markets.
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