01_Baltimore and Ohio Railroad

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1 Case Studies in Auditing HS09

Baltimore and Ohio Railroad Corporate Governance and External and Internal Controls

It is November 1831. You are Joshua Bates, one of the powerful London investment banking

partners of Baring Brothers & Co. You are meeting with an enthusiastic American, George Peabody,

who wants your firm to invest $3 million in securities with the Baltimore and Ohio Railroad (B&O),

the company he represents. Other Americans have been through your office trying to raise capital for

their ventures; canals, toll roads, and states have all come to 8 Bishopgate, Threadneedle Street,

London. Barings is regarded as “the American House” ever since it financed the Louisiana Purchase.

Ironically, the B&O’s chief rival, the Chesapeake and Ohio Canal, has just been rejected for a loan by

your firm, but the B&O situation seems interesting, yet risky.1

As you listen to George Peabody talk, you realize he is a true salesman, a classic optimist, and

the embodiment of the American story with its leap-forwards and set-backs. George Peabody was

born poor, served as a shopkeeper's apprentice starting at age 11 after only a little education,

worked for his uncle selling goods peddled by horseback, served two weeks as a soldier defending

Washington against the British in 1814, and became a partner with a dry goods merchant he met

there in the army. The firm relocated to Baltimore, and moved from dry goods to international

finance. Clearly, you see greatness in Peabody.2

Peabody argues that the land of the American interior is a wilderness and will remain so until

a transportation system makes the land valuable. The rich interior land of the Ohio and Mississippi

River Valleys will never be developed until farmers can get their goods to market and merchants can

ship goods from the East Coast ports to the interior. The cost of moving goods by wagon only a few

miles can easily be several fold more than the value of the goods being shipped, due to poor road

conditions. If a cheaper way could be found to move goods within the U.S., then land will become

valuable. Profits to be made from shipping are immense. Canals - such as the Erie - reflect some of

the economic potential of an efficient transportation system. However, a "railed-road" represents a

huge incremental step beyond the canal.

What you learn from Peabody this November morning is that the B&O has built 13 miles of

railed-road from Baltimore and is in the process of completing the road into Frederick, Maryland.

From there, the construction will go to the Potomac River and follow the river through Harpers Ferry,

then in Virginia. However, construction is becoming difficult as the railroad approaches the rough

terrain of the Allegheny Mountains - which it must traverse - to reach the Ohio River. The risks are

high as construction costs are unknown. Indeed, the B&O has run out of the capital it had initially

raised from its 1827 offering of stock. Only if the construction can be completed will the railroad idea

succeed! The risk is not only the uncertainty of construction costs and the ability of the B&O to raise

enough capital, but there is also risk in this unproven technology, for the engineering of a railed-road

is just now being developed. Mountains are to be crossed, rivers and gorges need bridges, and

excavation and tunnels need digging. Moreover, the steam-powered locomotive has yet to be

developed into a reliable technology.

George Peabody describes last fall's race between Tom Thumb, a steam-powered train, and

the horse-drawn trains on the 13-mile track into Baltimore. While the horse-powered train won the

1 The estimates of the 21st century equivalent of the 1830 amount of $3 million ranges widely depending on which index is used.

Economics History’s EHNET gives four historical indices that range from 20 to 400 times the 1830 numbers. This leads to a range of $60

million to $1.2 billion. A narrower, realistic estimate of the 1830 amount probably is between $500 million and $1 billion today. Because it

took ten times as much ($30 million) to build the line to the Ohio River, the total amount in 2005 dollars would be $5 billion to $10 billion.

Baring Brothers evolved into Baring Bank, which survived into the late 20th

century until it was brought down by an employee, Nick Leeson,

who traded on behalf of the bank. His excessive trades, which resulted in huge losses, occurred because of the Bank’s control weaknesses. 2 Peabody's firm, George Peabody and Company, evolved into America's famous banking institution: the House of Morgan. Peabody

eventually became exceedingly wealthy and a great (America's first) philanthropist establishing the Peabody Institute and other

educational institutions and programs.

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race due to a mechanical problem on the Tom Thumb, steam-powered locomotion is dearly the

technology of the future to take the B&O to the Ohio River. You are already familiar with a similar

race five years earlier between the Rocket, a steam-powered locomotive-drawn train, and a horse-

drawn train on the Stockton and Darlington Railway near Manchester, England. In this race, the

steam-powered train won - a victory for British technology, you recall.

You listen intently to Peabody's fascinating information, yet you try not to let your

imagination go too far. The former U.S. colonies have always been enticing - a land of opportunity -

as embodied by Mr. Peabody standing before you. You ask about Peabody's personal commitment to

the B&O venture; you learn that he was among the founders. In fact, he subscribed to 122 shares of

stock in 1827 for a total investment of $12,200. Peabody's initial interest in the "railroad" idea had

arisen from his perspective as a dry goods merchant in Baltimore. Specifically, Baltimore needed to

preserve its competitive advantage in trading with the Ohio Valley, because the Erie Canal had just

opened. The canal had made New York City a much more viable port city for trade with farmers in

the interior. Now Peabody is explaining the economic benefits that will flow as development will

occur in regions connected to the railroad. If it can just be built!

Other leaders of Baltimore were as involved in the railroad enterprise as George Peabody.

The list of directors that Peabody gives you (see Exhibit 1) reads Iike a modern Who's Who of

American businessmen. The name that immediately catches your eye is Alexander Brown, America's

preeminent investment banker. In fact, his firm, Alex Brown & Co. Inc., has opened branches in

England, and you have traded with it. The commitment to the B&O by these gentlemen is impressive.

Indeed, the citizens of Baltimore and Maryland were also eager to invest in the stock (as

Exhibit 2 demonstrates). Peabody may be exaggerating a bit, you think, when he says that every

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citizen had bought shares. Yet you are surprised that of the 30,000 shares of B&O stock issued,

10,000 are owned by the state of Maryland and 5,000 are owned by the city of Baltimore. So half of

the stock is owned directly by the government, making the citizens truly owners, directly or

indirectly. Peabody had said that this unique enterprise is a "public-private" partnership with a public

purpose: the economic development of the region. Peabody had also told you that the state of

Maryland retained the right to set rates for passengers and cargo and, in exchange, promised not to

tax the railroad. Other unusual aspects of this enterprise that Peabody mentioned were the

requirement in the state incorporation charter that the president issue an annual "statement of

affairs" letter to the shareholders, and that the Board of Directors, in its initial 1827 meeting, had set

a requirement for a committee of directors to audit the financial records on a quarterly basis.

Peabody leaves you various financial documents, including annual report information,

corporate minutes of the Board of Directors, and newspaper accounts. You pass the papers to your

clerk, Richard Jones, a hard-working fellow, to examine and analyze. He writes a summary of the

financial and operating activities of the B&O during its first four years as part of your initial screening

of this investment. (Clerk Jones' report summarizing the content of the minutes, "statement of

affairs" [annual reports], report of B&O engineers, and Baltimore newspaper stories is contained in

the next section.) You now must conduct a preliminary analysis of the B&O as an investment

opportunity. A satisfactory outcome of your analysis will lead you and the other Baring partners to

more closely examine the risk and rewards of this investment.

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REPORT OF THE B&O'S FINANCIAL

AND OPERATING ACTIVITIES

Submitted by

Richard Jones, Clerk

Baring Brothers & Company

Baltimore, Maryland has enjoyed the geographical advantage of being a natural harbor at the

northern end of the Chesapeake Bay. As a seaport, it further gained an advantage as being in the

middle of the eastern seaboard of the U.S. and the closest port to the Ohio and Mississippi River

Valley. The shipment of goods across America's only east-west road ("the National Road") further

magnified the importance of Baltimore as a port that linked with the American interior. In 1825,

Baltimore's advantage weakened with the opening of the Erie Canal on the Hudson River Valley,

linking the Mississippi River and Ohio River Valleys via the Great Lakes to the Erie Canal to New York

City. The cost of shipping goods via water-borne transportation fell significantly as compared to

costly ox-drawn shipments on the National Road. Further, other eastern U.S. cities started

constructing canals to compete with New York for trade.

Baltimore merchants fear the end to their prosperity and are worried not only about the Erie

Canal, but also about the Chesapeake and Ohio Canal, recently started along the Potomac near the

Capital in Washington. Willing to consider almost any idea in efforts to preserve Baltimore, these

merchants are desperate for an alternate shipping route because Baltimore does not have river

access to the West.

At the same time that the Erie Canal was completed, Great Britain was developing steam-

powered locomotive railroads in the areas of Liverpool and Manchester. Philip E. Thomas and George

Brown, two Baltimore bankers, have received letters from England about the new railroad

technology. The two wealthy bankers concluded that this new "railed-road" might be Baltimore's

answer for competing against the canals in transporting goods and people over mountains to the

Ohio River.

Thomas and Brown gathered 25 Baltimore merchants in an evening meeting and drew up

plans to form a company that would build a "railed-road" from Baltimore over the Allegheny

Mountains to the Ohio River. The power source for pulling wheeled carts that would ride on rails (at

a large mechanical advantage over wagons on the road) was left unspecified; horse-drawn trains or

the new steam-powered and even wind-powered "sail" locomotives were discussed.

By a special act, Maryland's state legislature incorporated the company in February 1827.

Because the railroad would cross state lines, state legislatures incorporated similar acts in Virginia

and Pennsylvania that same year. Following these incorporations, stock was issued to Baltimore's

excited citizens, who quickly subscribed to all the offered shares. A total of 30,000 shares of $100 par

value stock were issued; 10,000 of the shares were bought by the state of Maryland, 5,000 by the

city of Baltimore, and the other 15,000 shares going to individuals.

The formation of the B&O does not seem to be motivated by profits, per se, but rather to

save the city of Baltimore's position as a seaport. This motivation is further indicated by the large

government ownership of the company and the incorporation provision in Maryland's legislative act

that specifies Maryland would set freight and passenger rates. In turn, however, the B&O would not

have to pay state taxes.

Given the large number of B&O investors, outside the business and same outside the region,

issues of communication and control over management seem to have been worked out reasonably

well from the onset. First, the B&O, by its charter, has to issue an annual "statement of affairs."

While the form and content have not been specified, the statement of affairs had developed into the

following format:

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1. President's letter to the shareholders,

2. Management reports on construction progress and on operations, and

3. Treasurer's report.

Second, from its inception, the company had established a committee of directors to serve as

a "routine" audit committee. The "Code of By(e) Laws," adopted April 9, 1827, states:

A Committee shall be appointed at least once in three months to inspect the accounts

and funds of the Company and to examine the vouchers far all monies expended and

shall report the same.

After the adoption of the corporate "Code of Bye Laws" at the April 9, 1827 meeting, the

Board of Directors met on September 8, 1827 and appointed two of the directors, John B. Morris and

William Stewart, to examine the "Treasurer's accounts" and to report their findings to the Board at

the next meeting. The committee's report is reproduced here as Exhibit 3. The statement reflecting

the account balance actually showed 19/100, even though the audit report stated "9/100." It is

indeed significant to find vouchers being used to support the company's disbursements and that all

of these payments had been authorized by the Board of Directors. Certainly, these internal controls,

along with the audit committee's examination, are techniques to assure that assets are safeguarded.

For the end of the June 1828 quarter, an audit committee comprised of John B. Morris and

Patrick Macaulay - and excluding William Stewart - was appointed to examine the Treasurer's

accounts. The committee's report is provided in Exhibit 4 (emphasis has been added).

As in the previous exhibit, minor errors are noted: the date "June 31st” was meant to be

"June 30th." Two other matters of interest were mentioned in the report. First, some engineers had

been charging the B&O a 2.5 percent fee for processing payments under their control. This practice,

apparently, was customary during their federal government service. The audit committee reported

that the practice met with acceptance by Philip E. Thomas, B&O's president. Second, the federal

government was to provide the receivable of $6,345.55 for costs that the B&O paid. This charge for

surveying would appear on several quarterly audit reports before it was eventually collected.

The audit committee rendered a "two paragraph" report to the Board of Directors of the next

quarter. It is reproduced in Exhibit 5.

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At the December 28, 1828 meeting of the Board of Directors, as the last item of business, the

"Committee to Examine & Report upon the Treasurer's accounts" (according to the provisions of the

3rd article of the "Bye Laws") was appointed. Both John B. Morris and Patrick Macaulay continued in

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their memberships on this committee; and William Stewart, who had served previously, was

reappointed to the committee. This expansion to three members reflected the agreement that the

Company would appoint two directors and the city of Baltimore (a major holder of stock) would

appoint one director to this committee. Given the financial backing by the city of the B&O enterprise,

this appointment power over the audit committee reflects how important this committee was in the

financial administration of this venture.

In Exhibit 6, a letter from the President transmitting the accounts and vouchers to the audit

committee indicates that he has taken responsibility for the numbers being presented for audit. The

rest of the exhibit is the committee's audit report that found the account balances correct and

supported by documentation. The report does reference exhibits not included in previous reports,

including a balance sheet that accompanied the committee's report. Interestingly, the annual report

to the stockholders did not include a balance sheet.

In the audit report, the accounting for the discount on notes is questioned as an audit

"exception."

In the reports in Exhibit 7, the audit committee pointed to two cash expenditures that it felt

were incorrectly paid. Apparently, laborers had been overpaid $1.86 by the B&O. While this oversight

may seem minor, the detail reflects the care with which the committee undertook its work. The

second expenditure - postage of $54.49 - must have been for employees' personal mail, which the

B&O paid for. The audit committee recommended a voucher system to ensure that only company

postage was paid for by the railroad.

Exhibit 8 shows a summary of the audit committee activities with regard to the three-month

examination of the treasury's accounts. The remainder of this report shows the special "operational"

audit activity by the B&O audit committees.

The financial difficulty in which the B&O finds itself in 1831 stems from the gross

underestimation of railroad construction costs. This underestimation, in hindsight, is not surprising

given that no similar building project had been attempted before; costs including excavation, filling in

ravines, bridging over gorges and streams, tunneling, and laying track across mountains are all

unknowns. Organizational learning has taken place as the construction has become organized, but

the first miles - "flat," easy miles out of Baltimore - have been expensive to build. Further, the B&O's

problems have been exacerbated by control issues. Casper W. Wever, the superintendent of

construction, insisted on making changes to the route as well as making design changes to the

bridges, despite the fact that these changes were costly and required work to be redone.

Furthermore, he has been in constant conflict with the surveyors ("Board of Engineers"), who take

issue with his attitude toward details such as vouchers, contracts, regulations, and communications

with them and other B&O officials (Long and McNeill 1830).

The construction problems began almost from the "laying of the first stone" ceremony on

July 4, 1828. The costs per mile of construction were estimated then at $3,500 by President Thomas

and $7,000 by the Board of Engineers. A year later it became apparent that something was amiss

with construction. Wever had requested amounts be paid to contractors without documentation to

support the payments. Wever justified the incomplete state of the vouchers, the lack of work

measurement to support payment, the payment to contractors exceeding contractual amounts, and

his practice of making advances to contractors as "being necessary," given the labor shortage that

had occurred with the competition from the nearby Chesapeake and Ohio Canal. Wever felt that he

could not let contractors be penalized for higher labor costs or unexpectedly difficult rock or mud

formations; otherwise he would lose the contractor. So at the behest of Wever, the B&O was

disbursing funds freely.

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The Board of Engineers brought the problem of Wever's spending and lack of financial

control to the Board of Directors, who, in turn, sent an audit committee of directors to examine the

construction spending practices. On April 27, 1829, the Audit Committee issued its report that

absolved Superintendent Wever of blame, and gave him a free hand to continue, However, Wever

had to return to the Board of Directors to ask for $20,000 - $30,000 more per month. Additionally, he

requested $45,000 to pay contractors. This one request caused the Board of Directors particular

problems because the B&O did not have the funds in the fall of 1829 to cover the additional cash

outflow. The cash flow crisis arose, in part, because shares of stock had been issued on a subscription

basis, with only a fraction of the equity capital being received in cash. To raise the funds, the

directors called on shareholders to pay $5 on each share of stock that was subscribed. This

unanticipated call surprised shareholders and also caused the president to reassess construction

costs and revise the cost estimates for building the railroad. With only 13 miles of line actually

constructed, the costs accumulated were a staggering $37,500 per mile, far more than the $3,500

and $7,000 estimates of the year before. The difficult Alleghenies are not yet in sight, so the Ohio

River seems very distant.

Again, in September 1829, Wever surprised the Board of Directors when he announced that

he would have to pay out $180,000 to contractors during the next 90 days. The B&O was short

$160,000. This shortfall was covered by William Patterson, Robert Oliver, Alexander Brown, and

President Philip E. Thomas, who all used their banking connections to solve the short-term liquidity

crisis. Eight directors signed promissory notes of $12,500 each, which the B&O then discounted to

raise cash. Shareholders were then called on at the end of 1829 to make another subscription

payment beyond that $5.00 on their shares of stock. It does speak well that the founders are

committed to advancing the B&O more money to see the venture through, suggesting the

confidence of key insiders in this venture.

The Board of Engineers accused Wever of withholding true costs of construction, as the cost

overruns had been apparent to him for months. With Wever's requests to the Board of Engineers

and the Board of Directors, the problem with construction costs was now obvious to both Boards.

Wever acknowledged that he had deceived them by not being forthcoming about the problem

sooner. However, President Thomas prevented any sanctions against Wever for fear that the cost

overrun problem would be revealed publicly. He argued that punishing Wever could cause the B&O

stock price to fall further, as shareholders already had reacted negatively to the surprise call for the

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stock subscription payment. Low stock price was the last thing the B&O needed when it had to raise

capital.

The audit committee of the Board of Directors met in early January 1830 to again go over the

construction superintendent's handling of the contractors and the construction expenditures. Again

the audit committee absolved Wever. In a second report, the audit committee rebuked the Board of

Engineers, which had been the source of complaint against Wever. The audit committee

recommended that the Board of Engineers be abolished, which was done by a vote of the Board of

Directors.

The financial crisis of the B&O abated slightly in the spring of 1830 as the 13 miles of track

opened and citizens found a new source of amusement from horse-drawn coaches that were strung

in a series and mounted on the rails. The excursions were the hit of the season.

The noteworthy outcome of the internal crises within the B&O and its cash problem is that

the audit committee followed up with its examination of Wever's handling of construction

disbursements and, on its recommendation to dismiss the Board of Engineers, restructured the B&O

organization. This February 8, 1830 report examined the operations and sought to streamline the

duties, responsibilities, and reporting authority. Especially removing overlapping authority and

conflicts of responsibilities and duties. The structure placed the "chief engineer" - second in position

to the president - in charge of the operations of the railroad activities.

The next position designated is the Superintendent of Construction, the officer responsible to

the chief engineer for building the roadway, bridges, viaduct, and masonry. He is responsible for

making cost estimates, reporting these estimates to the president and directors, and dealing with

contractors. The audit committee also recommended a third operating officer: an auditor to keep the

books of the company and "examine and certify all claims or accounts against the company." The

fourth officer in the audit report is the treasurer, the handler of the money who is to make payment

only if the voucher is complete to support the claims. The voucher must be approved by the auditor

before the treasurer pays it.

The audit committee's reorganization report was approved by the Board of Directors. The

new auditor position has been filled by William Woodville, a particularly talented individual whose

duties expanded quickly. He is now the "Auditor & Superintendent of Transportation." Revenues

from running horse-drawn trains of coaches as excursions on the 13 miles of track are now being

received. Woodville is in charge of not only making sure that the cash is being correctly received,

deposited, and recorded, but that the trains of coaches also run safely and on time. Undoubtedly,

overseeing train operations will become more important and time-consuming in the near future.

Noteworthy is the criticism last year by some shareholders, upset at being assessed to pay

for the stock subscription because of B&O's financial difficulties. These shareholders contend that

B&O President Thomas is overpaid, that his salary is greater than the governor of Maryland, and that

he is one of the highest paid people in the former colonies.

Report respectfully submitted by Richard Jones, Clerk, Baring Brothers & Company

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QUESTIONS FOR JOSHUA BATES TO CONSIDER IN PRELIMINARY

ANALYSIS OF INVESTING IN B&O

1. In current research literature, the problem between external investors and corporate

managers is known as the "agency issue." Give a brief overview over the "agency theory" and

its application to Corporate Governance issues. What early steps were taken at B&O to

reduce the "agency" problem? What was the impact of large investment from multiple

external sources on B&O, its operations, and its governance?

2. In Joshua's initial assessment of the B&O investment, what factors should he consider in

evaluating the B&O Board of Directors'?' Which factors of a "good" Board are present, which

are absent, and which factors can not be assessed because insufficient information is

available? Why is evaluating the B&O Board of Directors an important first step for Joshua in

his evaluation and investment decision?

3. Describe the importance of the audit committee's role in B&O's survival. What essential

functions did these committees perform for the B&O? How are these functions carried out

today?

4. What problems did the audit committee find and report?

5. Describe specific instances of internal control weaknesses at the B&O. What were the

consequences? What steps were taken to strengthen the internal controls?

6. What was the purpose of the voucher system? What information would be necessary in the

voucher for a contractor to be paid? Why did the B&O use the voucher system, adopted from

the federal government, at a time when businesses typically did not have such a formal

system?

7. How did the reorganization improve the B&O's chances of survival?

8. What corporate title would the "auditor" job created after the B&O 1830 reorganization

carry today?

9. Describe why an external investor such as the House of Barings might focus on the make-up

of the Board of Directors and the role it plays in governing the corporation. Why should the

audit committee's activities also be of particular interest to an external investor such as

Barings?

10. Describe the purpose of an external audit. In today's business environment, who is the

"client" that the auditor represents and protects in the audit examination? Why is this

important issue?

11. Comment on management's integrity as demonstrated by the B&O's President and by the

Superintendent of Construction. Why should Barings be concerned about such management

integrity issues?

12. The "statement of affairs" was required by the B&O charter to be issued annually by the

President to the shareholders. This practice evolved quickly into the forerunner of modern

corporate annual reports, complete with financial statements. Explain how the "statement of

affairs" /annual report/financial statement are important corporate governance and external

control mechanisms.

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POSTSCRIPT

Baring Brothers did invest in B&O securities, opening the door to other British investors

investing in the B&O as well. Other U.S. railroad executives followed the B&O to London, and the way

to securing financing, particularly debt financing, of U.S. railroads evolved. However, the B&O

placement of securities with Barings happened in 1839, not 1831; also, the placement happened

after the railroad had been built to Harpers Ferry, with a branch to Washington. Also noteworthy,

Philip Thomas was replaced in 1836 by Louis McLane, who had served 12 years as Congressman,

Ambassador to England, Secretary of Treasury, and Secretary of State. While McLane was considered

a statesman rather than a politician, his connection to Great Britain must have been a boost for the

investment by the British in the B&O securities, for the B&O was still far short of its goal of reaching

the Ohio River. After 12 years of construction, the railroad was still on the eastern side of the

Allegheny Mountains, with rugged mountains to cross, and progress periodically stymied by the lack

of funds.

It would be 1852 before the B&O reached Wheeling, Virginia (now West Virginia) on the Ohio

River, 379 miles from Baltimore. Thus it took 25 years (1827-1852) and $30 million of capital to

realize the goal of Philip Thomas and George Brown for a railed-road to connect Baltimore to the

Ohio River. Over 100 years later, in the early I960s, the B&O merged with the Chesapeake and Ohio

Railroad. Its operations continue today as part of the Chessie System.

01_Baltimore and Ohio Railroad

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