Trustees Under Indentures

SECURITIES AND EXCHANGE COMMISSION

REPORTON THE

STUDY AND INVESTIGATION

OF THE WORK, ACTIVITIES, PERSONNEL

AND FUNCTIONS OF PROTECTIVE

AND REORGANIZATION

COMMITTEES

PURSUANT TO SECTION 211 OF THE

SECURITIES EXCHANGE ACT OF 1934

PART VI

TRUSTEES UNDER INDENTURES

WASHINGTON, D. C.

June 18, 1936

UNITED STATES

GOVERNMENT PRINTING OFFICE

WASHINGTON : 1936

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COMMISSIONERS

JAMEs M. LANDIS, ChairmanGEORGE C. MATHEWS

ROBERT E. HEALYJ. D. RossWiI&m 0. DouGLAS

FRANCIS P. BRASSOR, Secretary(HI)

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LETTER OF TRANSMITTAL

SECU RITIES AND EXCHANGE COMMISSION,

Washington, D. C., June 18, 1936.

SIR: I have the honor to transmit herewith another part of theCommission's study and investigation of the work, activities, per-sonnel, and functions of protective and reorganization committees.This report was prepared and is submitted in pursuance of Section211 of the Securities Exchange Act of 1934.

This study and investigation was headed by Commissioner William0. Douglas who was then Director of the Protective CommitteeStudy. Collaborating with him on this part of the report wereSamuel 0. Clark, Jr., Abe Fortas, and Martin Riger, together withSamuel H. Levy, all of the Protective Committee Study.

The part which is transmitted herewith deals with Trustees UnderIndentures. Under dates of May 2, 1936 and June 3, 1936, we trans-mitted parts of this Commission's report which dealt with Com-mittees for Municipal and Quasi-Municipal Obligations and Com-mittees for the Holders of Real Estate Bonds. There are in prepa-ration other parts which deal with (1) committees and other agenciesfor holders of foreign governmental issues; (2) general problemsof all reorganization and protective committees; and (3) the varioustechniques for effecting reorganizations, further recommendationsof this Commission for appropriate legislation in the light of thesituation which this study and investigation have revealed, and aconsideration of the necessary machinery to effectuate these recom-mendations. These additional parts will be submitted in the nearfuture.

The part of the report which is transmitted herewith containsspecific recommendations as to the scope and nature of the legisla-tion which is deemed necessary. As we have stated in the report,this legislation should be part of an integrated legislative programdealing with all phases of the reorganization problem. Additionalparts of such an integrated legislative program will be submitted inconjunction with subsequent parts of the report.

By direction of the Commission:J. M. LANDIS,

The PRESIDENT OF THE SENAT, Chairman.The SPEAKER OF THE HOUSE OF REPRESENTATIVES,

'Washington, D. C.

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CONTENTS

SECTION I Page

Introduction ----------------------------------------------------- 1

SECTION II

Protection of the investors' position --------------------------------- 7

A. Acceptance of the trust ------------------------------------- 7

1. Negative pledge clauses -------------------------------- 10

2. Release and substitution of collateral ---------------------- 16

B. Recordation and certification ------------------------------- 23

C. Application of proceeds ------------------------------------- 29

D. Payment of taxes and maintenance of capital ratio ------------- 31

E. Notice of default ----------------------------------------- 37

F. Conditions precedent to action ------------------------------ 42G. Protection of minorities ----------------------------------- 61H. Fees and exculpatory clauses ------------------------------- 67

SECTION III

Conflicts and protection of trustees --------------------------------- 71A. Affiliations with committees -------------------------------- 71B. Affiliations with junior interests, short-teum creditors, manage-

ment and underwriters ---------------------------------- 80

SECTION IV

Conclusions and recommendations --------------------------------- 110

APPENDIX A

Corporate trustee questionnaire and tabulation of data ---------------- 115

APPENDIX B

Representative fees of corporate trustees ---------------------------- 132

APPENDIX C

Bondholders' meetings ------------------------------------------ 135A. Provisions in trust indentures ------------------------------ 135

B. Reorganization by contract -------------------------------- 143

C. Selection of members of protective committees at bondholders'meetings ----------------------------------------------- 151

APPENDIX D

Active participation of indenture trustee in reorganization -------------- 178A. External bonds--City of Barranquilla ------------------------ 178

B. Trusteeship of guaranteed mortgage issues in New York -------- 185C. Standards for indentures and indenture trustees enacted in 1936

by the New York State Legislature ------------------------ 191

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vI

APPENDIX EPage

The indenture trustee and the non-depositor ------------------------- 205

APPENDIX F

Proposed rules under Section 17 (c) of the Public Utility Holding CompanyAct of 1935 ------------------------------------------------ 215

APPENDIX G

Selected bibliography of materials on trustees under indentures --------- 225

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REPORT ON THE STUDY AND INVESTIGATION OF THE WORK,ACTIVITIES, PERSONNEL, AND FUNCTIONS OF PROTECTIVE

AND REORGANIZATION COMMITTEES

TRUSTEES UNDER INDENTURES

SECTION I

INTRODUCTION

We have included the indenture trustee in our study and investiga-tion of the work, activities, personnel and functions of protectiveand reorganization committees pursuant to Section 211 of the Securi-ties Exchange Act of 1934, for several reasons. In the first place, thetrustee (which normally is a commercial bank) 1 holds title to theproperty which is conveyed by the issuer as security for its bonds,debentures or notes. The indenture under which the security is heldand pursuant to which the bonds, debentures or notes are issuedcommonly vests in the trustee broad discretionary powers which itmay exercise for the protection of the Lneficiaries of this trust.Throughout the life of the trust many occasions will arise for exer-cise of these powers. Commonly these occasions will increase in fre-quency as the period of reorganization draws near or arrives. Inconsidering, then, the problem of designing a reorganization systemwhich will afford to investors maximum protection against exploi-tation at the hands of the reorganizing group, a study of the func-tions which the trustee in the past has performed and of the func-tions which it might properly perform becomes of paramountimportance.

In the second place, the trustee has a direct and intimate bearingon the functioning of and occasion for protective committees. Aswe develop herein, trust indentures almost universally provide that

"Generally, the earliest mortgages ran to a single Individual as trustee, although inthe case of the New York and Erie Railroad Company from the beginning there weretwo or more individual trustees. Subsequently it became the general practice to nametwo or three individuals as trustees. Still later, the individual trustee was supersededcustomarily by a corporate trustee, and in recent years, to meet the requirements ofState statutes calling for a resident trustee, a natural person and citizen of the Stateoftentimes Is joined with a corporate trustee to which, however, is assigned exclusivelyall active duties prior to default." Stetson et al., Some Legal Phases of CorporateFinance, Reorganization and Regulation (1927), at 11. The use of individual trustees(usually employees, officers, or directors of the houses of Issue) in the real estate bondfield Is described in our report on Committees for the Holders of Real Estate Bonds(1936), Sec. II at 12-13. The extent to which commercial banks act as trustee Is

described intra, at 99.

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the security holders can force the trustee to take specified action, suchas foreclosure, only if a designated percefttage of them makes demandon the trustee (with adequate tender of funds to indemnify the trus-tee) and the trustee refuses to act. Furthermore, these indenturesfrequently provide that the security holders themselves can take cer-tain action, such as suing on the securities, only if a designated per-centage makes demand on the trustee (with similar tender of in-demnity) and the trustee refuses to act. Hence in case of bonds,debentures, notes or similar securities, formation of a protective com-mittee may be necessary in order to obtain the necessary amount ofthe securities to make such demands on the trustee and thus maturethe right of these security holders themselves to proceed or to forcethe trustee to do so. The relevancy of a study of the trustee to astudy of protective and reorganization committees is thus apparent.

Our study of the trustee paralleled our study of protective and re-organization committees. In the reorganizations which we investi-gated and presented at public hearings the activities of the trusteewere explored. Trust officers and their counsel were examined, bothas respects their relation to the various committees and as regardstheir action or non-action prior to and after default. A question-naire was prepared and sent to 53 leading corporate trustees through-out the country, these being chosen at random with due regard togeographical distribution. This questionnaire is included as Ap-pendix A to this report. 424 returns from this questionnaire werereceived. The results have been incorporated in this report. Fur-thermore, we have drawn to some extent from reports and investiga-tions of other governmental agencies, from decisions of the courts,and from other sources' for illustrative material bearing on theproblem of the necessary and proper functions of the trustee bothbefore and after default.

The current interest in this field is attested by the fact that spe-cial committees of the American Bankers Association and of the In-vestment Bankers Association have recently been appointed to studythe problems of the trustees and investors under these indentures.

Under modern trust indentures securing issues of corporate bonds,debentures and notes, important powers are vested in the trustee.The security holders themselves are generally widely scattered andtheir individual interest in the issue is likely to be small. The trus-tee, on the other hand, is usually a single bank. By virtue of thebroad discretionary powers vested in it under the typical trust in-denture it is in a position to take immediate action in a variety ofways to protect or enforce the security underlying the bonds, de-

s A selected bibliography of such sources is set forth in Appendix G to this report.


bentures and notes. But the security holders are rarely given any

voice in formulation of policies which the trustee pursues; the trust

indenture ordinarily does not require that they be consulted before

the trustee acts. Hence the trustee generally need not be delayed

or embarrassed by the necessity of consulting the security holders

or of reconciling their divergent opinions and policies. Theoreti-

cally, the result should be beneficial to all concerned: to the security

holder because of increased efficiency, expedition and economy; to the

issuer because a trustee is a convenient legal device for conveying

title, and because the presence of the trustee relieves the issuer of pos-

sible suits and supervision by many individual security holders.But as a matter of fact, this arrangement has resulted in injury

to thousands of investors. They have bought securities and haveretained no effective control over the issuer's performance of itsobligations in respect of them. Such control has been surrenderedto or assumed by the trustee. It has been invested with power tocertify securities; to supervise the deposit and the withdrawal ofcollateral and application of funds; to take action upon default;and, in short, to do everything upon 'which the protection andenforcement of the security of a bondholder depends.

Both in law and in practice, this reliance of the security holderupon the trustee for protection of his investment is complete. It isa matter of common knowledge that purchasers of securities seldomexamine the terms of the trust indenture although they are legallybound by its terms., Even if they did examine the indenture, thesignificance of its elaborate provisions would appear only to special-ists. 5 In some instances, indeed, it is so drafted that vital provisionsapparently escape the notice of highly trained investment agencies.8

Reliance for adequacy of the security underlying the bonds, notesor debentures, is placed by the investor upon the reputation of theissuer, the underwriting bankers and the trustee. And for honest,faithful and efficient operation of the provisions of the indenture,reliance is placed upon the trustee as representative of the securityholders under the terms of the indenture.

Upon the public distribution of bonds, debentures or notes, securedby an indenture, the name of a prominent institution which will actas trustee is eagerly sought. The addition of the name of such aninstitution to the prospectus is not without advertising value to thedistributor. Likewise it is not without significance to the prospective

I See, e. g., Haazard T. 07O8e N tfona4 Bank of OitV of N. Y., N. Y. Law Tournai,April 15, 1936, at 1905.

i bid.'ibid.* In the Hazzard case, supra note 8, Judge Rosenman states that Moody's Manual

apparently overlooked the power of substitution, which proved to be highly important,until collapse of the issuer.


investors. Persons are undoubtedly influenced to purchase securitiesby the size, prestige and financial strength of the trustee. As statedby the United States Supreme Court over fifty years ago:

"The salability of railroad bonds depends in no inconsiderable degree uponthe character of the persons who are selected to manage the trust. If thesepersons are of well-known integrity and pecuniary ability, the bonds are morereadily sold than if this were not the case."v

This statement applies equally to other securities, regardless of thebusiness of the issuer. But an examination of the provisions ofmodern trust indentures and their administration by trustees willshow that this reliance is unfounded. It will show that typically thetrustees do not exercise the elaborate powers which are the bond-holders' only protection; that they have taken virtually all of thepowers designed to protect the bondholders, but have rejected anyduty to exercise them; and that they have shorn themselves of allresponsibilities which normally trusteeship imports. The "so-calledtrustee" 8 which is left is merely a clerical agency and a formalinstrument which can be used by the bondholders when and if enoughof them combine as specified in the indenture.

The trustees themselves hold no exalted view of their own func-tions under these indentures. Leonard J. Clark, trust officer of ThePennsylvania Company for Insurances on Lives and Granting An-nuities, a trust institution of long standing, testified in a hearingbefore this Commission:

"Q. You think the corporate trustee is merely a mechanical agency?A. Yes.Q. That is, it is a sort of finer bookkeeping agency, and also an instrument,

a vehicle, as you put it, which can be put into motion by the bondholders?A. By the bondholders.Q. Would you say that that defines all the duties of a corporate trustee?A. I would."

7Knapp v. Troy & Boston Railroad Co., 20 Wall. 117 (U. S. 1873). See also

.NorthamptOn Trust Co. v. Northampton Traction Co., 270 Pa. 199, 202, 112 AtI. 871(1921) ; Posner, Liability of the Trustee under the Corporate Indenture (1928) 42 Harv.L. Rev. 198, 199, 239.

1 Judge Rosenman's phrase. Supra note 3.OProceedings before the Securities and Exchange Commission in the Matter of The

Baldwin Locomotive Works (1935), at 333-334.In another case James G.- Blaine, President of the Marine Midland Trust Company,

testified before this Commission:"Q. * * * Is it a fact that the role of a corporate trustee prior to an event of

default is traditionally and in practice more or less a nominal one, performing mechanicalfunctions ?

A. I think so, yes.Q. Taking the period before there is a default under the indenture?A. Largely routine.Q. Authentication of bonds and cremation of coupons that have been paid, and other

matters of a routine nature? * * *A. Yes, sir."Proceedings before the Securities and Exchange Commission In the Matter of Kreuger

& Toll Co. (1985), at 878.


It is readily admitted by these trustees that they are a species differ-

ent from the usual trustee of a testamentary or inter vivos estate.

They say they have not intended in the indentures the assumption of

a full quantum of trusteeship duties.Nevertheless one basic, fundamental fact cannot be overlooked:

the trustee is the only agency avowedly designed for the protection

of security holders during the entire life of the security. Further-

more, under the modern trust indenture it alone is capable of effective

action. The individual security holder is impotent when actingalone and can get together with his fellow security holders only at

great labor and expense. It is likewise true that the common under-

standing of the lay investor is that the trustee is his alter ego in safe-

guarding his rights. On these facts the trustee should not be al-lowed, through indenture provisions never seen by the beneficiary,and which would not be understood if they were seen, to whittleaway at the number of his express duties until they are practicallynon-existent, and to surround itself with exculpatory clauses whichleave it harmless, despite inactivity or negligence.

Bankers, lawyers and courts who have contributed to the evolutionof the trustee under these indentures have given almost exclusiveconsideration and weight to the intent of the parties to the indenture.Accordingly, it has been assumed that the trustee could take or refuseto take practically any right or duty, power or privilege, which wasagreeable to him and the issuer. It has also been assumed that thiscontract between trustee and issuer is binding on security holders onthe theory that they acquire only such rights as the contract whichthese parties have made gives them. That is to say, the suppositionis that the indenture evidences the intent of the security holderswhose loans it secures. But that mutuality of intent which is as-sumed is in fact non-existent. To the extent that the indenture is theproduct of the borrower, the underwriter or the trustee, only theirrespective intents are reflected therein. It is no refutation of thisto say that by voluntary purchase of his bonds, debentures or notes.the security holder accepts just so much as is given and no more.The individual purchaser of such security cannot normally bargainfor special provisions. Nor can prospective buyers normally unitein anticipation of an issue, to exact desired terms. Inequality ofbargaining power between investor and issuer is inherent in thevery technique of security distribution. Yet the courts in theirtreatment of the trust indenture have proceeded on the same basisas the draftsmen and have concluded that the indenture is a contractwhich binds the security holders even though they had no part in itsmaking. The attitude of the courts is well expressed in the followingexcerpt from a case which treated the provisions of a trust indenture


as binding on the security holders in the same manner as if theythemselves had negotiated the contract at arm's length:A. * * * While it is true that such bonds are sold broadcast to large num-

bers of people, they are generally distributed originally to bankers or brokersin large blocks, and in such cases it is the custom of the latter to familiarizethemselves with the mortgage and its provisions. The final purchasers aretheir customers, and look to, and depend upon, these distributors, and notupon the obligors. The case is not, therefore, one where the obligor dealsdirectly with a numerous class, not accustomed to look carefully at the detailsof the bargain, and where the detailed provisions of the contract are sub-merged by the urgency of the demand. It may well be that these distributorsdo not pay such attention to the details as they should, yet the matter is onein which they have an interest to protect the eventual customer, and where,if they do not, they are themselves affected by the result. An investor canhardly be put in the class of those not responsible for the clear meaning ofthe instruments on which he buys; at least, if it is so, we have no means ofknowing it, and the matter must await some legislative determination." '0

It is in this condition that the courts have left the problems of thetrust indenture. Accordingly the solution becomes one for "legisla-tive determination."

The basic problem is to refashion the trust indenture for the pur-pose of according greater protection to investors. That entails pre-scribing certain minimum standard specifications for the conduct oftrustee and issuer thereunder. As in the case of other contractsinvolving persons not capable nor in a position to protect them-selves, the contents of the trust indenture can no longer be left tothe conventions of the issuer, the trustee or the underwriter.

This means that a more proper balance between the interests ofinvestors and requirements of issuers can be had only by enlargingthe definition of the trustee's duties in those cases where its failureto take swift and positive action leaves the investors without effec-tive protection of their interests. The contrary desires of issuer,trustee and underwriter must be made to bow to the insistent de-mands of investors and of the public interest in such cases.

An examination of critical conditions which prevail in this fieldand of crucial provisions of trust indentures which have been em-ployed against the interests of investors will illuminate the natureof the legislative problem. What follows will not be exhaustive ofall provisions of the trust indenture. But the discussion of a fewof the major points will be exemplary of the quality and degree ofreform which is essential.

'5 Babbitt v. Read, 236 Fed. 42 (C. C. A. 2d, 1916), sustaining the validity of an im-munity clause In the trust Indenture which provided, inter alia, that the stockholderswere not to be liable to the bondholders for watered stock. As to the frequency of suchimmunity clauses in trust indentures, see Appendix A, itfra.


SECTION II

PROTECTION OF THE INVESTORS' POSITION

A. ACCEPTANCE OF THE TRUST

A good deal of the fault for inadequate protection of investorsmay be traced to passivity on the part of the trustees at the timewhen the indenture is drafted. An examination of what transpiresbehind the scenes when the trust indenture is being drafted empha-sizes that one of the real and vital functions of the trustee in pro-tection of investors is to be performed at this point.

The trustee of a corporate issue is usually selected by the issueror the underwriter, or by agreement of both. As a general matter,the trustee does not participate in drafting the indenture. Counselfor the underwriting bankers or the issuer, or both, commonly draftthe indenture which is presented to the trustee for its acceptance.

In response to the questionnaire sent to a number of institutionsacting as corporate trustees," this Commission received informationshowing the parties represented by counsel who drafted 244 inden-tures. Excluding 10 miscellaneous cases, the returns show 'that in25 percent (60) of the instances, counsel drafting the indenture rep-resented the issuer only; in 20 percent (48), the issuer and under-writer; in 5 percent (12), the underwriter alone. In 20 percent (49)of the cases, both issuer and trustee were reported as represented bycounsel in the drafting of the indenture; in 10 percent (25), issuer,underwriter and trustee; in 10 percent (24), underwriter and trustee,and in 6 percent (16), the trustee alone or the trustee and payingagent.

So, according to reports of the corporate trustees themselves, theircounsel drafted the indentures in 16 cases and participated in thedrafting in 98 of the 244 cases. But even in this limited number ofcases the trustee's participation may well have been nominal. It mayhave been limited to the provisions relating to the powers, dutiesand liabilities of the trustee. For ordinarily the trustee does not

'accept or reject the trust on the basis of the soundness of the security(although rare and exceptional cases are frequently cited), or thefairness and adequacy of the provisions of the indenture as theyaffect security holders. On the contrary, L. J. Clark, trust officer ofThe Pennsylvania Company for Insurances on Lives and Granting

2u A copy of this questionnaire appears in Appendix A to this report.

(7)


8

Annuities, has testified before this Commission that it is not the dutyof a trustee to act as a check on the bankers and the issuer before itaccepts a trust:

"Q. You would say it has no duty, for example, to make any independentinvestigation of the company which is contemplating the issuance of newsecurities?

A. No.Q. And a corporate trustee has no duties to investigate the financial condi-

tion of the issuer before it accepts the trust?A. No.Q. The corporate trustee has no duty to see that the provisions of the trust

indenture are complied with, unless a non-compliance is brought to its atten-tion by the bondholders?

A. I do.Q. And you believe a corporate trustee has no duty to exercise any super-

vision over the management, whether within the terms of the trust or beyondthe terms of the trust indenture, unless required to do so by a specified num-ber of bondholders?

A. Yes.Q. Mr. Clark, do you believe, in the original issuance of securities, a trustee

has a duty to act as a check upon the issuing bankers and the companyissuing the securities?

A. No.""

Typically, the trustee will obtain an opinion of its counsel beforeit assumes a trusteeship. But this opinion ordinarily will not certifyto the adequacy of the indenture provisions to protect security hold-ers; it will state, as a general matter, only that the issue has beenvalidly authorized, that the indenture is "in proper form for execu-tion by the Trustee" and the securities are "in proper form forauthentication." 13

The primary purpose of counsel's opinion, according to Francis C.Grey, formerly president of Lee, Higginson Trust Co., is to in-sure that the trustee is adequately protected. He testified as fol-lows at a hearing before this Commission:

"Q. I am trying to develop, Mr. Grey, just what provisions counsel, yourcounsel, would be interested in. Would your counsel examine the agreementwith a purpose of ascertaining whether the agreement adequately protectedsecurity holders?

A. I don't know whether they would or not, sir.Q. Did you request counsel to examine the agreement with that objective

In mind?A. I don't think that we would.

22Proceedings before the Securities and Exchange Commission In the Matter of TheBaldwin Locomotive Works (1935), at 333-334. C)f. Thels, Pitfalls for the CorporateTrustee, 125 Bankers Mag. 47 (1932).

i See opinion of counsel to the trustee, in Proceedings before the Securities and Ex-change Commission In the Matter of The Baldwin Locomotive Works (1935), Commi&sion's Exhibit No. 80.


Q. Then the counsel examined the agreement In order to insure adequateprotection of the corporate trustee and not of the security holders?

A. Yes, I would suppose so, sir."* * * * * * *s

"Q. Do you recall whether you ever specifically instructed your counsel toexamine a trust indenture in order to ascertain whether the security holderswould be properly protected thereunder?

"A. I don't recall ever having so instructed them." "

Trustees who approach indentures from this point of view cer-tainly cannot be relied upon to see that they contain provisions whichafford purchasers adequate security and safety. There is nothingin the law requiring them to do so. And if they insisted that in-dentures contain provisions for the protection of bondholders, itmay be guessed that the business which they obtain from issuers andbankers would decline. Others less sensitive to the requirementsof the public interest and of investors would get the business. Theyare, in other words, interested parties, and their interests do not liewith the bondholders. They are too often interested in retaining thegood-will and patronage of the issuers and bankers.a

Nor do the underwriting bankers afford adequate protection to se-curity holders against emasculating and oppressive provisions inindentures. They, like the trustees, are financially interested in ac-ceding to the wishes of the issuer. They are also interested in sellingthe securities and retaining the good-will of their customers.

Since security holders generally are not discriminating in apprais-ing the adequacy of indenture provisions, it generally adds nothingto the sales value of the security to insert in it adequate protectiveclauses. Indeed, bankers may regard any mention to prospectivepurchasers of the all-important provisions respecting default as un-desirable. Andrew J. Dallstream, of the Chicago law firm of Pam& Hurd, has described this attitude as follows:

"In the light of recent experience one is tempted to speculate why so littleimprovement has been made heretofore in the provisions relating to remedies inthe event of default, and rights of the trustees and bondholder majorities withrespect to amendments, curing of defaults, interpretation or modification of theinstrument and readjustments and reorganizations. This may be explainedby the fact that when it has been suggested to underwriters that there beinserted in these indentures comprehensive provisions giving bondholder ma-jorities rather broad powers, subject to the approval of the trustee, to deal

14 Proceedings before the Securities and Exchange Commission In the Matter of Kreuger& Toll Co. (1935), at 115.

"See infra, at 48 et seq. In Green v. Title Guarantee & Trust Co., 223 App. Div. 12,227 N. Y. Supp. 252 (1st Dept., 1928), aff'd, 248 N. Y. 627, 162 N. E. 552 (1928), thecourt held that defendant trustee did not owe the bondholders any duty of care in draftingthe Indenture, because it did so not as trustee, but "on the employment of the StandardOil Company". The draftsman's duty was to Its employer and not to the bondholders.The defect in the indenture resulted in its being held void as against creditors.


with unexpected situations, usually the underwriters, upon being advisedthat some reference to these provisions must be made in the circular, havesaid, 'Well, then don't put them in. When we sell securities we don't talkabout defaults'." 16

The good-will of customers, furthermore, towards the underwrit-ing bankers is not dependent on the insertion of adequate protec-tive provisions. The problems and considerations involved are sotechnical that it is unlikely that security holders will be sufficientlyastute to trace a loss on their security to the absence of protective pro-visions in the indenture; and if they do observe a failure to protecttheir rights, it is only natural that they should charge it to thecorporate trustee, not to the banker. Such responsibility as they areapt to charge to the banker is for the value of the security and thefinancial condition of the issuer. For the technical protection oftheir rights they will look to the trustee, who in fact is representedas serving in this capacity.

Nor can adequate protection to security holders against emasculat-ing and oppressive provisions in indentures be expected from issuers.Their dominant interest will always be in retaining as great freedomand flexibility of action as possible. They are interested in effectivelytying up, by mortgage or pledge, as little property as possible; theyare concerned to have the greatest possible freedom to withdraw col-lateral and sell pledged property; and they are anxious to have themost liberal opportunity to avoid and postpone the consequences ofdefault. Each of these is a desire antithetical in principle to theinterests of investors. In this situation the inherent incompatibilityof interest arises, common to all creditors and debtors.

1. NEGATIVE PLEDGE CLAUSES

One example of a situation where increased watchfulness on thepart of the trustee over indenture provisions and their performanceis essential if the interests of the investors are to be safeguarded willsuffice. We refer to negative pledge clauses and the notorious historyof their circumvention. These clauses commonly appear in deben-tures-unsecured obligations of the corporation. They are in gen-eral designed to insure investors that claims upon corporate assetswill not be incurred which will rank prior to theirs. Consequently,they specify that none of the borrower's assets will be mortgagedor pledged; or, in some instances, that the debenture will be ratablysecured in the event that corporate assets are mortgaged or pledged.17

16Dallstream, Administration of Trusts Created Under Corporate Mortgages (1936), at

2-3.17 See, e. g., the indenture of Paramount-Publix Corp., dated Aug. 1, 1930, securing the

5% percent Sinking Fund Gold Bonds due Aug. 1, 1950. Article Four, Sec. 9, provides:"So long as any of the Bonds shall be outstanding the Corporation will not create, or

permit the creation of, any mortgage or other lien upon any property or assets directly


11

It seems clear that provisions of this type, set out in prospectuses,

greatly enhance the attractiveness of the securities to investors. But

the cavalier manner in which they have been circumvented or nulli-

fied by issuers, leads us to the conclusion that they should be out-

lawed, or that the trustee should take more definite responsibility

for the adequacy of these protective features, lest they be nullified by

issuers.An example of the illusory nature of the protection which these

clauses afford, is provided by an incident from the history of Para-

mount-Publix Corporation developed at a hearing before this Com-

mission. In 1932, this company was obligated on $25,000,000 of de-

bentures 's which were widely held by the public."9 These contained

a familiar negative pledge clause: that so long as the debentures"shall be outstanding the Corporation will not create, or permit the

creation of, any mortgage or other lien upon any property or assetsdirectly owned by the Corporation, without equally and ratably se-

curing the [debentures] Bonds thereunder". 20

Paramount had $9,600,000 in short term unsecured notes outstand-ing in the spring of 1932, held by a number of banks, chiefly NewYork banks.21 It lacked cash sufficient to pay all these notes. 22

One of these banks refused to renew the note it held, and it wasfeared that the others would follow suit.22 Further, Paramountneeded substantial new money in order to carry it through the sum-mer, for even in normal years production costs were heaviest duringthe summer when income was lowest, and it had been customary in

owned by the Corporation, without equally and ratably securing the Bonds thereunder,and an executed copy of every such indenture and other instrument under which the Bondsshall be so equally and ratably secured shall forthwith be delivered to the Trustee; pro-vided, however, that the Corporation may, without equally and ratably securing the Bonds,

"(1) create or assume any mortgage or other liens on property hereafter acquired, tosecure the payment of all or any part of the purchase money thereof,

"(2) create or assume any mortgages or liens on individual real estate parcels or lease-holds to provide money for building or construction improvements hereafter made uponsuch properties,

"(3) acquire property subject to any mortgages, liens or encumbrances thereon existingat the time of such acquisition, and

"(4) renew, replace or refund any mortgages, liens or encumbrances which by the pre-ceding clauses (1), (2) or (3) it is permitted to make or subject to which it is permittedto acquire property or any mortgages or other liens now existing which the Corporationhas heretofore created or assumed to secure the payment of all or any part of the purchasemoney of, or for building or construction improvements upon, the property subject to suchmortgages or liens, or any mortgages, liens or encumbrances now existing subject to whichthe Corporation may heretofore have acquired property."

18 Proceedings before the Securities and Exchange Commission In the Matter of Para-mount-Publix Corporation (1935), at 17.

n Id., at 19.0 Id. at 67-69, 115-116. See note 17, supra. Paramount's management and its counsel

agreed that this clause prevented any direct lien on the company's assets without ratablysecuring the debentures. Op. oit. supra note 18, at 113.

21Id., at 110, Commission's Exhibit No. 17, at 16-17, 57-58.21Id., at 110."Id., at 120-123, 126.

75957*-36- 2


past years for Paramount to borrow money at this season.2" Accord-ing to Sir William Wiseman, of Kuhn, Loeb & Co., who testified atthe hearing before this Commission: " * * Paramount had atthat time about six to seven million dollars tied up in partly finishednegatives and if they had not been able to finish them those nega-tives would have been worthless, completely worthless, and moreoverthey wouldn't have been able to finish their program for the fall.It would have meant bankruptcy * * * .,, 25

Paramount had several meetings with its bank creditors,26 as aresult of which the decision was reached that the banks would extendthe existing credits and (with other banks) would also provide ap-proximately $4,275,000 of new credit, against which Paramountmight draw to complete the films then in production and for itsanticipated summer requirements, on condition that the banks ob-tained security both for the existing loans and the new credit. 2

T Thelatter meant that the debenture provisions would have to be eitherviolated or avoided. The latter course did not prove to be impossibleto Paramount's lawyers. Assets of the company directly owned werenot pledged; they were transferred to a subsidiary created for thesole purpose of holding them; this subsidiary paid the parent forthese assets by notes which the parent endorsed to the banks.2 8 Theeffect of this was to give the banks a claim on these assets prior tothat of the debenture holders. Austin C. Keough, general counselto Paramount, elaborated this in his testimony:

"Q. Prior to the transfer of these assets from Paramount to Film Production,the holders of Paramount debentures had the status of a creditor with respectto those assets; is that correct?

A. Yes, a general creditor of the corporation who could become a judgmentcreditor could have executed judgment against whatever assets that Paramount-Publix then had.

Q. Now, is it also true that after the transfer of these assets from Paramountto Film Production the debenture holders of Paramount no longer had thestatus of a creditor with respect to those assets, but they had only a claimagainst the stock of Film Production Corporation?

A. I think that was the legal effect of the transaction.Q. In other words, then-and I don't want to get into the question of the

legality of this, Mr. Keough-in other words, then the-certain banks weregiven a claim on certain assets of Paramount prior to the claim of the debentureholders by virtue of this creation of Film Production Corporation and the restof the arrangement?

A. Well, if you will permit me to state it in the language of the legal rela-tionship as I understand it, certain banks became direct creditors of Film

m Id., Commission's Exhibit No. 17, at 15.M Id., at 126.2id., at 122-126.27M., at 125-126, Commissioner's Exhibit No. 17, at 16, 57-59.

0 Id., at 112.


Production Corporation, Film Production Corporation held title to certain

assets: moving picture films and the right to receive rentals from the distribu-

tion of other moving picture films. Should the maker of the obligation, Film

Production Corporation, default in honoring its obligation, and the holders of

the obligation obtained a judgment, levied execution, execution would be levied

against those assets. In that sense and in that sense only would I say that the

banks had any claim on assets.Q. Now, on the other hand, Mr. Keough, if the debenture holders reduced

their claim against Paramount-Publix to judgment and proceeded to levy,

they would not be able to levy against these assets which had been trans-

ferred, but would levy against the stock of Film Production Corporation which

was held by Paramount-Publix; is that correct?

A. I think that is a correct statement of the legal consequences.""=

The trustee for the debenture issue was Chase National Bank.

One of Paramount's attorneys, Robert T. Swaine, testified before

this Commission that he consulted the bank and its attorneys and

submitted the facts concering the transaction to them and that "It

is a reasonable assumption" that the attorneys approved since "Chase

didn't do anything about it." 30 Nor did the indenture charge Chasewith any duty to supervise the company's transactions affectingobservance of the negative pledge clause, or to give security holdersnotice of transactions like this.

As noted above, the business (as contrasted with the ethical or legal)argument in favor of such transaction was (1) that receivershipwas staved off; and (2) that investment in films was salvaged.3 1 Thevalidity of that business argument need not be determined here.Motivation for evasion or avoidance of such negative pledge clauses

will always have varying degrees of propriety. But if issuers andtheir lawyers are left unrestrained in fixing the degree of protectionafforded by the negative pledge clause, the use of such clause willbecome grossly deceptive. As a matter of fact, there is reason tobelieve that as presently drafted these clauses are frequently of

doubtful value to investors.In 1929, Insull Utility Investments, Inc., a holding company,

issued $6,000,000 of debentures; in 1930 it sold a new $60,000,000issue. Among its assets it held stock of various Insull operatingcompanies. Investors were promised in the debentures that the

company would not mortgage or pledge its property "unless theinstrnent creating such mortgage or pledge shall provide that this

debenture shall be secured thereby equally and ratably with all

other obligations issued or to be issued thereunder," 82 with the ex-

ception, among others, that without securing the debentures the com-

fId., at 114-115.

,oI., at 212.

"Id., at 126.Kelly v. Central Hanover Bank & Tru8t Co., 11 F. Supp. 497, 502 (S. D. N. Y. 1935).


pany might "at any time mortgage or pledge any of its propertyfor the purpose of securing loans to the company contracted in theusual course of business for periods not exceeding one year." s' Thedebentures purported to create an additional safeguard by a cove-nant that the company would "not create or assume any additionalindebtedness if as a result thereof its total indebtedness will exceedfifty per cent of the then value of its assets."

With its credit exhausted in Chicago, officers of the companycame to New York in 1931 and borrowed seventeen million dollarsfrom a number of New York banks. The loans were secured by thepledge of stock from the company's portfolio. During the com-pany's receivership and before it was adjudicated bankrupt in Sep-tember 1932, debenture holders brought suit on the basis of thedebenture provisions, seeking the return of the pledged securities, or,alternately, to be equally and ratably secured thereunder. This wasthe case of Kelly v. Central Hanover Bank & Trust Co. Their peti-tion was dismissed.84

Even if the banks had knowledge of the retroactive provisions inthe indenture, the court's opinion would deny any remedy to thedebenture holders. The court held that the negative pledge clauseforbade a pledge of assets, without ratably securing the debentures,only if it secured "a funded debt or possibly also * * * un-funded long term borrowing". It did not, the court said, applyto promissory notes for less than one year, even though these notescontained collateral security clauses, and even though they wererenewed. 5 But a differently worded clause would not have led to adifferent result in the case. The court held that, since the issuerwas solvent at the time of the pledge to the banks, (a) the negativepledge clause did not raise a lien or servitude on the assets of thecompany; and therefore no claim can be asserted upon the assetsin the hands of the banks; and (b) that the debenture holders couldnot seek equitable relief, because they had an adequate remedy atlaw. This remedy at law was available because the pledge to thebanks was a breach of covenant by the company, permitting eachdebenture holder to accelerate the maturity of his security and suethe issuer at law for the entire principal. At the time of the pledge,the company was solvent, and, the court said, the debenture holderscould have recovered "one hundred cents on the dollar".

If the judge in this opinion has correctly stated the law, negativepledge clauses generally are revealed as useless and misleading ver-

sa Thi"Ibid. See Notes (1936) 49 Harv. L. Rev. 620; (1935) 30 Ill. L. Rev. 487, which dis.

cuss other authorities, some of which have enforced, under certain circumstances, negativepledge clauses against transferees with notice.

JOBupra note 82, at 504.


biage. They may be drafted so as to leave the issuer a wide avenueof escape (as in the Insull and Paramount cases); even if theirlanguage is designed to protect investors as adroitly as these clauseswere drafted to benefit the issuer, they may be of no use. If theissuer is solvent when its assets are transferred to banks, the deben-ture holders are merely unfortunate-they cannot obtain reliefagainst the banks. True, they may immediately accelerate, and suethe issuer. But if there is no trustee for the issue (as in the Insullcase), or if the trustee does nothing (compare the Paramount case),this will be small comfort. Individual security holders are unlikelyto learn of the transfer of assets until the company is insolvent-,when their right of action is worth little. A corporate trustee,under our present system, may not learn of it, or, if it does, it mayneither give notice to security holders nor move itself to acceleratematurity and sue the issuer.

The judge's opinion indicates that he fully appreciated that theinvestors purchasing the Insull debentures were misled:

"The debenture holders unfortunately relied at best on the unsecured prom-ises of the company, if indeed they actually appreciated the legal character ofthese debentures. Probably many, if not most of them, were led on by thethen alluring name of Insull. Even the comparatively slight safeguard of atrust indenture, under which some duties might have been imposed on thetrustee for their benefit, was absent. Such was the character of the instru-ments, miscalled securities, that they were led to buy as investments. Fortheir misplaced reliance they must bear such consequences of the company'sbroken promises as cannot be made good by the company itself, unless undersome principle of equity they should be borne by another. * * *

"Of course, these conclusions indicate no approval of the issuance and saleto the general public of debentures which might be thought to afford butwhich actually fa4l to give any real rotection to the purchasers." "

There can be no doubt that the problem is primarily one of con-trol over the issuer rather than the trustee. Perhaps negative pledgeclauses in securities should be outlawed. On the basis of presentlegal decisions, they constitute, by and large, a misrepresentation ofthe nature of the protection afforded. Unless and until legal deci-sion are obtained firmly establishing the validity of these clausesagainst pledgees and transferees, investors frequently will obtain lit-tle protection from them. It is clear that issuers and their lawyersshould not be permitted, unchecked and uncontrolled, to whisk awayfrom the reach of investors assets to which they have properly lookedfor protection of their investment. But it is properly the functionof corporate trustees to prevent this, so far as possible. In the ab-sence of legislative or administrative prohibition, trustees, with aneye to the adequacy of protective clauses in indentures, can make

Id., at 514 (Italics supplied).


measurable progress in eliminating negative pledge clauses whichare misleading and deceptive. And if such clauses continue to beused, trustees should require that they be drafted so as to preventeasy circumvention such as in the Imnu8 and Paramount cases; theyshould require information of actions pertinent to performance of theissuer's obligations under the clause; and they should take actionpromptly to remedy any violation.

2. RELEAsE AND SUSTITUTION OF COLLATERAL

Another instance of major importance where investors have suf-fered because neither issuer, underwriter nor trustee has been carefulto insist upon their protection is presented by indenture provisionsrelating to release and substitution of collateral.

The report of the United States Senate Committee on Banking andCurrency contains a summary of an instance of an oppressive substi-tution clause which allowed the issuer to deprive investors of thesecurities which were originally pledged. It again illustrates thepossibility of flagrant abuse of the power to substitute collateralunder trust indentures without check by either house of issue orcorporate trustee. The report of the Senate Committee summarizesthe incident as follows:

"The investment bankers were responsible for the provisions in the Kreuger& Toll bond indentures which occasioned tremendous losses to the Americaninvesting public. In 1929, under the leadership of Lee, Higginson & Co.,a syndicate composed of that firm, Clark Dodge & Co., Brown Bros. & Co.,Guaranty Co. of New York, National City Co. of New York, Union Trust Co.of Pittsburgh, and Dillon, Read & Co., purchased $26,500,000 of the $50,000,0005 percent secured gold debentures of Kreuger & Toll Co. The price to the'syndicate was 96 less 3/2 percent. The bonds bought by the American syndicatewere sold to the American public through the orthodox syndication method.

"The indenture agreement covering the $50,000,000, 5 percent secured golddebentures of Kreuger & Toll Co., dated March 1, 1929, provided for the depositwith the trustee or depositary of certain bonds specifically designated assecurity for the debentures.

"The agreement further provided that Kreuger & Toll Co. might substitutefor the bonds deposited other securities of the following character anddescription (called 'eligible' securities):

"(1) Bonds or notes issued or guaranteed by any sovereign state, or anypolitical subdivision thereof, including any municipality, having authority toissue or guarantee bonds or notes and having a population in excess of300,000.

"(2) Bonds or notes issued or guaranteed by any mortgage banking institu-tion or institutions, society or societies (in which the company may but neednot have a partial or controlling interest), and secured by mortgage onagricultural or city property or entitled by special law to priority on suchproperty.

"(3) Shares in railroad or other companies, a minimum dividend on whichIs guaranteed by any sovereign State.


"Under the debenture agreement Kreuger & Toll Co. had at all times the

right to withdraw any portion of the eligible securities deposited and to sub-

stitute for any portion thereof other eligible securities, or cash, provided that

such withdrawals did not impair the required ratio of 120 percent between the

par value and income of the eligible securities on deposit and the principal

amount and interest payable on all outstanding debentures.

"The agreement further provided that in any case in which the trustee or

depositary desired proof as to whether any securities tendered by Kreuger &

Toll for deposit were eligible securities, or any fact in respect of the required

ratio of principal or the required ratio of income, the trustee or the depositarymight rely upon a certificate of the company stating that such securities were

eligible securities. The trustee or the depositary would be fully protectedin relying upon such certificate, but had the right in its discretion to requirefrom the company advice of counsel or proof that the securities so tendered fordeposit under the agreement were eligible securities.

"In brief, the Kreuger & Toll 5 percent gold debentures were specificallysecured by a pledge of foreign government bonds and bonds guaranteed byforeign governments, which at the time of the issue in 1929 had a par value ofover $60,000,000, as compared with the $50,000,000 par value of the secureddebentures. Under the provisions of the indenture agreement Kreuger & Tollcould substitute for the pledged bonds other eligible bonds, provided the ratiowere not disturbed.

"At the time the bonds were sold, the collateral, aggregating at par somewhatmore than $60,000,000, had a probable market value at least the equivalent tothe amount of the bonds sold to the public. With few exceptions, the bondscomprising the original collateral were regarded as fundamentally soundinvestments, and the income derived from them was In excess of the sumneeded to pay the interest on the debentures.

"The four vital deficiencies in the substitution provisions were that the basisof substitution of collateral was merely par value rather than market value;that the ratio of 120 percent of income was required to exist only at the timeof substitution and for no period thereafter; that there was no limitation uponthe nature of the government whose securities were substituted, except that thepopulation it governed had to exceed 300,000; that the certificate of the trusteeas to the eligibility of the securities being substituted was sufficient in the firstinstance. These deficiencies were pointed out by Dr. Max Winkler, an expertin foreign bonds.

'Senator Fletcher. But they allowed the substitution of bonds or securitiesat par instead of at market value?

'Dr. Winkler. That is correct.'Senator Fletcher. Is that unusual in a debenture of this kind?'Dr. Winkler. It would be except for the additional provision in this case that

substitution must not, at the time the substitution is made, disturb the ratio.What happens immefiately afterwards no one can tell, but at the time ofsubstitution a ratio of 120 percent with respect to both par value and incomemust be maintained.

'Senator Couzens. Was that ratio based on par or on actual value?'Dr. Winkler. The ratio was based on par.

'Mr. Marrinan. And further, with respect to the matter of eligibility, in theexamination yesterday reference was made, perhaps not in well-chosen words,to the possibility of substituting bonds of a minor political subdivision inChina. Was there any basis for stating or holding out such a possibility?


'Dr. Winkler. I believe there was If I understand the prospectus correctly,because eligibility is confined to any bond of a political subdivision, regardlessof locality, which has a population of more than 300,000 inhabitants.

'Mr. Marrinan. Would it have been possible, Dr. Winkler, under this sub-stitution provision of the indenture to convert obligations, sound obligations inthe pledged collateral, into issues which possessed no inherent merit or intrinsicvalue whatsoever?

'Dr. Winkler. Not entirely; because the substituted bonds had to be of atype which would not disturb the ratio to which we alluded awhile ago.

'Senator Couzens. And who would be the Judge of that?'Dr. Winkler. The Kreuger & Toll Co., if I understand the prospectus cor-

rectly.'Senator Couzens. In other words, Kreuger served on all sides of the question.'Dr. Winkler. It would seem so.'Senator Fletcher. The trustee had nothing to say about that.'Dr. Winkler. The trustee had the right to ask the company to furnish proof

as to eligibility, and the company would merely have to send a certificate to thetrustee advising the trustee that the substituted bonds were eligible.'

"After the disposal of these bonds to the American public, Ivar Kreuger, thedominant figure in Kreuger & Toll Co., engineered a series of substitutions,replacing the original collateral with securities distinctly inferior in quality.Typical of such substitution was the replacement in 1930 of French Governmentbonds having a high investment standing, with Yugoslavian bonds possessing amuch lower rating.

"Had there been no substitutions, the value of the original pledged collateralat the time of the hearings, January 12, 1933, would have been at least $24,-500,000, with an annual income of $1,681,500. The substituted collateral atthe time of the hearings was worth about $9,750,000, with an annual incomeof $628,350.

"Although it was the continuing duty of the Investment bankers sponsoringthe issue to see that the conditions and covenants of the indenture agreementwere fulfilled, and although the trustee was charged with the duty of seeingthat the collateral substituted for the original pledged securities were of therequired nature and character, both the original sponsors and the trustee wereflagrantly derelict in the performance of their duty. They made no inquiryconcerning the compliance by Ivar Kreuger with the provisions of the inden-ture agreement governing the substitution of collateral."'

The Federal Trade Commission, in its investigation of utilitycorporations, uncovered another situation of this sort in connectionwith debentures of National Electric Power Co., an Insull holdingcompany. 8 To secure an issue of $10,000,000 of bonds in 1928, thecompany had pledged stocks of three operating companies and oneholding company. The book value of the pledged collateral was$13,659,353 as of December 31, 1927; as of December 31, 1930, it was$11,897,250. The shrinkage therefore amounted to $1,762,103. Ofthis, depreciation in the pledged holding company stock accountedfor $1,368,500.1 ,

5B Stock Exchange Practices, Report of the Committee on Banking and Currency, 73rdCong., 2d Sess., Report No. 1455 (1934), at 121-123.

38F. T. C. Report on Utility Corporations (1932), Part 42, at 364 et 8eq.- Id., at 865 et seg.


In the latter part of 1931, National Electric Power Co., as author-

ized by the indenture, requested the trustee that it be allowed to

withdraw the pledged stock of the operating companies and substi-

tute additional stock of the holding company.' 0 The book value

of the collateral to be substituted exceeded the book value of the

property originally pledged, and the reported earnings of the sub-

stituted stock for 1930 were greater.41 But there was a significant

difference in the type of the collateral. Aaron Hughes, an investi-

gator for the Federal Trade Commission, stated this difference asfollows:

"Q. Is there some difference, however, between the securities originallydeposited and those now on deposit?

A. Yes, sir.Q. What is the difference?A. The original common stocks, with the exception of the common stock

of New England Public Service Co., which is a holding company, were stocksof operating companies which were preceded only by the bonds and preferredstocks of such operating companies.

The common stocks now deposited as security are the common stocksof holding companies. These common stocks are not only subordinate to thebonds and preferred stocks of the issuing holding company, but betweensuch stocks and the physical properties of the operating companies, whichrepresent the actual and real values, there stands the bonds, preferred andcommon stocks of the sub-holding companies and the bonds and preferredstocks of the operating companies." I

The indenture contained a provision permitting withdrawal of anyof this collateral, and requiring the trustee to deliver it upon writ-ten application of the company, provided that, as shown by an"earning certificate" supplied by the issuer, the amount of earnings

of the substituted securities for a period of 12 consecutive monthswithin the last 15 months equalled at least twice the annual interestrequirements for the debentures.43

On December 21, 1931, the trustee granted the company's applica-tion for withdrawal and substitution of collateral, which was ac-companied by an earnings statement complying with the terms ofthe indenture. The securities which were withdrawn were stock ofthree operating subsidiaries of the corporation, and they remainedof substantial value. But the substituted securities were stock of asingle holding company, a subsidiary of the issuer. 44 In July, 1932,this subsidiary, the National Public Service Company, went intobankruptcy and its stock became worthless."5

'Id., at 866."Ibid.12M., at 367."Id., at 364.Id., at 367.Hazzard v. Chase National Bank of Gity of N. Y., N. Y. Law Journal, April 15, 1936,

at 1905.


The trustee permitted the substitution, all provisions of the in-denture being complied with. There is no evidence that either is-suer or trustee at any time took steps to protect investors from thehazards of this type of substitution. Indeed, investors were notput on notice that the issuer had any substitution power. The cir-cular by which these bonds were offered contained absolutely nomention of such power. It recited merely that the debentures wouldbe secured "by the deposit with the trustee under and subject tothe provisions of the indenture of the entire common capital stock* * * of the three operating companies and 85,000 common sharesof the holding company." 4 Not only, therefore, did issuer, trusteeand underwriter fail to protect investors from the breadth andflexibility of the substitution clause; they also failed to give anynotice that the securities advertised as originally deposited mightbe withdrawn.

The recent case of Hazzard v. Chase National Bank of City ofN. Y.47, decided by Judge Rosenman in the New York SupremeCourt, involved the liability of the trustee for permitting thatsubstitution. It indicates that investors may have no recourseagainst the trustee even where the trustee appears clearly to havebeen negligent in permitting withdrawal and substitution of securi-ties. According to this case, it seems that trustees may with im-punity accept trusts in which issuers have retained power to with-draw from investors the securities originally pledged and substituteothers of little value; and that trustees need not investigate orrefuse to permit withdrawal and substitution even though theyknow of the unsubstantial value of the securities offered forsubstitution.

The facts show that certain departments and officials of the ChaseNational Bank were in a position to realize the disparity between thevalue of the securities withdrawn and those substituted. A vice-president of the bank not connected with its trust department,represented the bank on the boards of both the National ElectricPower Company and the National Public Service Company, andwas a member of the latter's executive committee."s The bank, whileacting as trustee for the debenture holders, was the largest singlecreditor of the Power company. 9 In addition, the principal officersof the company and of other .companies of the system were heavilyindebted to it upon obligations "which were past due on the dateof the substitution, and some of which were under-collateralized

"s Op. cit. supra note 38, at 953."1S1upra note 45.'s Ibid.

Ibid.


and uncollectible." 5 The files of the bank itself showed that the

substituted stocks were considered by its investment department as

speculative."'The indenture gave the trustee the power to investigate any

matters stated in the earnings certificate, at the expense of the

company. But despite this power and its knowledge of the situation,the bank made no investigation. One of its trust officers, a "subordi-

nate" official, checked the papers with the terms-of the indenture, and

its attorney made "a few unimportant verbal corrections." 52

Judge Rosenman relates in his opinion the facts above recited.

He sets out in detail the various "exculpatory clauses with which

this indenture fairly bristles." 5 The trustee could investigate,but it need not; the trustee is protected in acting upon any "notice,resolution, request, consent, order, certificate, report, opinion, bond,or other paper or document" believed by it to be genuine; it is pro-tected in acting upon any statements, etc., required by the indenture,not only as to facts, but as to opinions expressed therein; in general,it is not answerable or accountable under any circumstances what-soever, "except for its own gross negligence or bad faith". 54

After consideration of the legal authorities, Judge Rosenman con-cluded that the trustee was not liable to debenture holders for thedamage resulting from this substitution. He stated that "it isobvious that the defendant, as a creditor of the [company], occupieda position inconsistent with its role as a trustee under the inden-ture", 5

5 and he found that the defendant could not escape the con-sequences of its negligence, were it not for the terms of the inden-ture. But in view of the express negation of duty, responsibilityand liability in the indenture, the bank could be held liable onlyfor gross negligence. And the issuer, underwriter or trustee-whoever was responsible-had so carefully drafted this indenture,and the bank had so meticulously kept within its letter, that grossnegligence could not be established, despite the injury to innocentinvestors which had been wrought. Judge Rosenman concluded:

"I am constrained to conclude that the defendant was not guilty of thatkind of gross negligence, in view of the fact that everything which it didwas specifically permitted, and that everything which it failed to do was specifi-cally excused, by the express provisions of the trust indenture itself. Althoughthe defendant was negligent, as judged by the standards of care imposed upona common-law trustee, it cannot be said that under the language of theindenture it was guilty of willful passivity or of reckless disregard of the

50 Ibid.5' Ibid.

SIbid.RId., at 1906.5 Ibid.*Ibid.


rights of the debenture holders when, in fact, it complied with every detailof its contractual duty.""

"The facts in this case show", said Judge Rosenman, "perhaps a8clearly as can be imagined, how utterly unjiust to the investingpublic is the modern trust indenture."

"The cruel fact is that not only is the trustee not required to exercisethat greater skill and watchfulness and prudence and skill which It has, butit is even absolved from exercising merely the ordinary care which a singleindividual should exercise as to his own affairs.

" Billions of dollars have been invested on the strength of indenturessuch as the one involved in this case. This defendant alone, at the time ofthe substitution, was acting as trustee under 850 similar indentures, totalingabout five billion dollars.

"In such indentures the use of the word 'trustee' is clearly a mis-nomer * * *

"The trustee under a corporate indenture on the other hand, has hisrights and duties defined, not by the fiduciary relationship, but exclusivelyby the terms of the agreement, His status is more that of a stakeholder thanone of a trustee."'

Judge Rosenman concluded that the entire system should bechanged by legislation. Particularly, he urged, the right of releaseor substitution of collateral should be carefully circumscribed.5 8

Disagreement by disinterested persons with his conclusion is difficultto imagine.

The result of the present system is that neither the underwriter northe issuer has accorded security holders adequate protection underthese indentures. The story of negative pledge clauses and of releaseand substitution provisions are merely graphic illustrations of thatpoint. The conclusion is irresistible that the interests of prospectivepurchasers of securities are adequately represented by no one. Pros-pective investors are in no position to insist upon adequate protectionin the technical provisions of the indenture. The general investingpublic has neither the ability nor the opportunity to express its viewsas to the provisions of indentures underlying the securities which arebeing offered. If a particular investor should realize and object tothe inadequacy of indenture provisions, he would generally find thathe cannot invest in bonds or debentures. Indentures securing suchissues have become almost completely standardized. The vices anddeficiencies of a particular indenture will generally be found in all.The investor must acquiesce in them, or refrain from purchasing any

' Ibid.I7Tbid. (Italics supplied).

0 As conditions to listing on the New York Stock Exchange, the Committee on StockList requires (a) that "For additional issues of bonds, the trustee must certify that (1)increase is in conformity with terms of mortgage or indenture, giving numbers, denomi-nations and amount authenticated; (2) additional collateral deposited; and (3) disposi-tion of prior obligations"; and (b) "The Trustee must notify the Stock Exchange Ifdeposited collateral is changed or removed, and furnish . list of collateral substituted."


corporate obligations issued under an indenture. It is no exaggera-tion to say that this situation has led to indentures which providea minimum of protection to investors compatible with salability ofthe securities, maximum freedom to issuers and the greatest lack ofresponsibility of trustees.

Our conclusion therefore is that at the very inception of the securityissue the trustee should act as a protector of the interests of prospec-tive investors. Its concern should not be exclusively with its own pro-tection but with the determination of the question of the adequacyof provisions of indentures against subversive practices of issuers andbankers. Its trusteeship in fact, if not in law, starts at that point.It should be required to exercise the same diligence in exacting ade-quate protective clauses for the prospective investors as would aperson investing his own money. And it should be charged with aduty of similar dignity to see that the obligations of the issuer undersuch clauses are faithfully performed. Certainly it should not beallowed to staaid by, inactive, with knowledge that injury is beingdone to security holders.

Such approach would lead to a basic change in that system ofcorporate trusteeships depicted in the following testimony beforethis Commission of James G. Blaine, President of the Marine MidlandTrust Company:

"Q. You have stated the corporate trustee's functions are mostly mechanicaland routine.

A. Yes.Q. Let me phrase it this way. Does the corporate trustee in practice, take

active steps to protect the security holders prior to an event of default?A. No.Q. Then, does the scattered body of security holders have any representative

to protect their interests prior to the event of default?A. Not unless they organize.Q. Without organization?A. Unless there is a protective committee of some character.Q. And unless there is default of some kind, there is little occasion for the

organization of protective committees?A. I think so." "

Additional support for the conclusion that this condition shouldno longer be tolerated but that these trustees should be transformedinto active trustees will appear in consideration of some of thematters which follow.

B. RECORDATION AND CERTIFICATION

Corporate securities issued under indentures of the type here dis-cussed may be secured by a pledge of property or of other securities,

01P. oit. suPra note 14, at 874.


or merely by certain protective provisions such as those relating tomaintenance of specified capital ratios, or forbidding pledge of prop-erties. Primarily, returns to investors are dependent upon the earn-ings of the corporate issuer; but if those earnings become insufficientto meet all corporate obligations, the investor must depend upon theadequacy and sufficiency of the pledged security and upon observanceof the protective provisions in the indenture.

Where there is a real estate or chattel mortgage, the first essentialfor the protection of investors is to see that the mortgage is properlyrecorded. Obviously individual investors cannot take care of record-ing the mortgage. And if the mortgage under applicable state lawsmust be refiled, investors cannot as a practical matter see to it thatthis is done. In any event their natural tendency is to rely uponthe issuer and the trustee for such technical details.

Sometimes an issuer fails, deliberately or negligently, to look outfor the interests of security holders in this respect. Trustees havecarefully guarded themselves against liability for such failure. Thus86 percent (365) of the indentures which we have examined in thisconnection contain an express provision that the trustee is under noobligation to see to any recording, registry or filing of the indenture.The result of this provision is that in the occasional cases whereinvestors have lost their security because of failure to record theyusually have no recourse against the trustee.60

The theory of the courts is that the contract, exempting trusteesfrom such responsibility, governs. As stated by the New YorkCourt of Appeals:

"As this action has been brought in the State of New York, the courts belowhave been of the opinion that these provisions of the trustee's agreementrelieving the trustee from the duty of recording the instrument andfrom its negligence were against the public policy of this state. We donot see how this can be, especially in view of the fact that this state,contrary to most other jurisdictions, has sanctioned agreements exemptingcarriers from liability for negligence. * * * Unless there is somethingimmoral or fundamentally unjust in the arrangement, there is no policy of ourstate which forbids the enforcement of contracts or agreements which arelegal according to the law of the place of performance. * * * In the absenceof any gross or wilful negligence, there was nothing immoral about this trustee'sagreement. Considering its slight financial interest in the transaction, thebank was merely prudent and cautious in limiting its liability and definingits duties. The plaintiff could have ascertained all the facts upon inquiry;

BeZ v. Title Trust & Guarantee Co., 292 Pa. 228, 140 Atl. 900 (1928) ; Benton v.Safe Deposit Bank, 255 N. Y. 260, 174 N. E. 648 (1931) ; but cf. Green v. Title Guaranteed. Trust CJo., 223 App. Div. 12, 227 N. Y. Supp. 252 (1st Dept., 1928) (dictun thattrustee is liable for failure to reflle chattel mortgage, even in presence of exculpatoryclause).

In Miles v. Vivian, 79 Fed. 848 (C. C. A. 2d, 1897), the trustee was held liable forfailure to record a mortgage, there being no exculpatory clause.


nothing was hidden or concealed. Such agreements have been recognized by

the courts." 1

By and large the individual bondholder is not able to investigatethe initial representations made by the issuer as to the quality andnature of the security nor to determine whether or not the indenture

has been properly recorded. Obviously recordation will not always

be the primary concern of the issuer. So far as recordation goes,it would seem that the natural agency to perform such task wouldbe the purported representative of the security holder, the trustee.The strength of this argument is heightened when it is consideredthat the trustee is "selected in part to give tone to the obligationand encourage the sale of securities, as a sort of certificate of themortgagor's standing." 62

It would involve no radical or revolutionary step to place thisresponsibility on the trustee for the reason that the conscientioustrustee under the present system will feel that in fact, although notin law, he has that responsibility in spite of the exculpatory clause.Certainly when a mortgage indenture describes specific real estate,the practice of some reputable trustees is to see to the recordingthemselves before the securities are certified and released for distribu-tion. And the practice of other trustees is to certify and releasethe securities only on being satisfied by the issuer that recordinghas taken place. To require the trustee in such cases to take responsi-bility for seeing to proper recordation is to require by law substan-tially what is presently required by the most meticulous standardsof current practice. The objective of the proposed reform is to placeupon the trustee the obligation for failure to record, file or refilethe mortgage in the proper recording office. If the response is thatthe failure to record arises only in the very exceptional cases, theanswer may be given that though such cases appear to be rare, theywill be severe when they do arise.

Each bond, note and debenture usually will have printed upon ita statement by the trustee that it is one of the securities mentionedand described in the indenture to which it refers. But the courtshave held that this certification does not guarantee that the mortgagehas been recorded, or that the lien has effectively attached. It isconstrued by the courts as no more than "a statement identifyingthe bond whereon it is written as one of those mentioned in themortgage." s That is, in legal effect the certification is no more than

6 Benton v. Safe Deposit Bank, supra note 60. at 266, 267, 174 N. H. at 650. And seeNote (1931) 40 Yale L. J. 1110.

GzNorthampton Trust Co. v. Northampton Traction Go., 270 Pa. 199, 202, 112 Ati. 871(1921).

68 Tschetinian v. City Trust Co., 186 N. Y. 432, 436, 79 N. 1D. 401, 402 (1906). "Thus,the trustee is not liable, by reason of its certification, for the inadequacy or dissipation


a guarantee that the particular security is issued under the indentureand is not a counterfeit or over-issue. The courts have allowed thetrustee the protection of the terms of its bargain. 4 The result isthat here, as elsewhere, the trustee has taken care to restrict itsfunctions to that of a mechanical agency.

Conditions precedent to certification are commonly set forth inthe indenture. They may relate to deposit with the trustee of acertain quantity or quality of security; the existence of specifiedearnings of the issuer; and the like. The trustee normally is givenprotection against liability for certifying when such conditionsprecedent have not been satisfied if it obtains an adequate certificatefrom an officer of the issuer attesting to the happening of the con-ditions.,5 But the consequences to investors are serious if the cer-tificate contains false or inaccurate statements and the trustee actingmechanically and perfunctorily takes no steps to investigate the ade-quacy of such statements and proceeds to certify bonds, notes ordebentures without careful inquiry and analysis.

Certain facts disclosed by the Federal Trade Commission's investi-gation of the issue of $2,700,000 first and refunding mortgage goldbonds, 5 percent series, due 1955, by Minnesota Power & Light Co.66

provide an instance of inadequate protection to bondholders bytrustees in this respect. Minnesota Power & Light Co. was a mem-ber of the Electric Bond & Share group. The bonds in question wereissued under a mortgage and deed of trust which directed the trusteeto authenticate and deliver additional bonds upon specified condi-tions. These conditions had as their general purpose assurance thatthe bonds were adequately secured and that the earnings of theproperty were sufficient to service them.

In the first place, the indenture provided that before the trusteecertified the bonds, it shall have received certification of the cost ofthe property additions which were to secure them and of their fairvalue.61 The first certificate was to be supplied by the company; thesecond by an engineer appointed by the trustee.6 8

of the security, for the quality of the lien, misrepresentation as to its value, or for failureof the company to meet the payment of principal or interest on the bonds." Posner,supra note 7, at 206, and cases there cited.

"Of course, if the trustee is grossly negligent in certifying the bonds or acts willfullyin disregarding the conditions precedent to certification he Is liable, as the courts haveheld that such acts cannot receive protection of the immunity clause. Doyle v. Chathamd Phenix Nat. Bank of City of New York, 253 N. Y. 369, 171 N. E. 574 (1930) ; Conover v.Guarantee Trust Co., 88 N. J. Eq. 450, 102 Ati. 844 (1918). As to an implied duty torequire from the issuer a proper statement as to the purposes for which the bonds wereto be used, see Rhinelander v. Farmers Loan & Trust Co., 172 N. Y. 519, 65 N. E. 499(1902).

05 Doyle V. Chatham & Phenix Nat. Bank of City of New York, supra note 64, at 375,171 N. E., at 576.

64F. T. C. Report on Utility Corporations (1930), Part 26, at 370.C Id., at 369.

a Ibid.


The indenture provided further that bonds could be issued to the

extent of 75 percent of the cost or fair value of the additions, which-

ever was less.6 9 The property concerned in Application B-6, for the

$2,700,000 issue, had been purchased by the Minnesota Co. from thePike Rapids Co. (another member of the Electric Bond & Share

group 70) for $3,794,685.47. 71 This cost was certified to the trustee.The trustee's engineer certified the fair value of the property to be$4,050,000.2 According to the testimony before the Federal Trade

Commission he "passed upon the principal franchises, and studiedthe territory and industries served, examined the revenues of thecompany and rates charged-and there were several hundred rateschedules in effect--and weighed the essential factors relating to thevarious phases of his assignment. These services were performed ineleven days, for which compensation was paid at the rate of $30 aday." 71 The Minnesota Company acquired the property at cost toPike Rapids Co. But included in this cost were items aggregating$1,490,994.14, consisting principally of payments for financing andservicing by affiliated companies of the Electric Bond & Sharegroup.7 4 Deduction of this amount from the stated cost of the prop-erty would have forced the trustee to refuse to certify the $2,700,000of bonds.

75

In the second place, the indenture required that the company sup-ply the trustees with a net earnings certificate showing that the earn-ings available for interest on the bonds equalled at least twice thecombined interest on the bonds already outstanding, plus those tobe issued . 7 It further provided that not more than 15 percent ofsuch earnings should consist of (a) net non-operating income and/or(b) net income derived from the operation of leased properties. 77

To comply with these provisions, the net earnings certificate shouldhave shown eligible earnings amounting to $2,396,000. Accord-ingly, the certificate stated the net earnings "calculated in accordancewith the provisions of * * * said mortgage" as $2,400,743.62/9

Actually, the earnings certificate had not been calculated in ac-cordance with the indenture. The certificate showed on its facethat the company had included net non-operating revenue and reve-nue from leased property in excess of the 15 percent maximum of such

'ld., at 367.0 Id., at 370, 388.

71Id., at 371.7 2Id., at 371.

7s Ibid.71 Id., at 372.7 Id., at 872 et seq." Id, at 372.7 Id,, at 369-370, 372." Id., at 373.7Id., at 617.

75957"-8-----8


net earnings permitted.80 The 15 percent limitation in the indenturewould permit the inclusion of only $360,111.64 of earnings fromthese sources."' But the company nevertheless included net earningsfrom these sources of $1,052,691.77.2 Had these earnings been in-cluded only to the extent permitted by the indenture the coverageof interest requirements by net earnings, specified in the indenture,would not have appeared. 3 Nevertheless, the company and its coun-sel represented that the net earnings certificate complied with theindenture; and the trustee certified the bonds.84 Only blind accept-ance of the result stated in the certificate coupled with disregardof its component items could have permitted the authentication andissuance of these bonds.

But in addition, the net earnings statement included figures inexcess of the amounts shown on the books of the company. Theamounts reflected in the earnings statement were said to includecertain "hypothetical revenues derived from hypothetical sales ofpower" between the company and its subsidiary, the Great NorthernPower Co.,5 This is summarized in the following testimony ofSamuel Meisels, investigator for the Federal Trade Commission,before that body:

"Q. Does the computation under this method [including hypothetical reve-nues] * * * result in getting a larger sum than the books show for actualincome?

A. The actual income on the B-6 Application shows $227,312.64 in excess,which amount represents the net hypothetical revenue to the MinnesotaPower & Light Co." "

The result of including this "hypothetical revenue" was to permitthe authentication and issuance of a greater amount of bonds. Sotestified Mr. Meisels:

"A. The actual net combined earnings for this period amounted to $1,813,-319.44, while the net earnings derived from the calculation based on hypo-thetical sales and cost of electrical current amounted to $2,040,632.08. Thedifference, or $227,312.64, would have had a decided effect on the amountof bond that could have been issued." "

This case is an example of highly questionable practices by issuersto escape the restrictive provisions of indentures. These provisions,because of their pretension of affording protection, unquestionablyenhance the sales value of the security. But so long as they can becircumvented and violated by issuers with the acquiescence of trustees,

80 Id., at 618.MI., at 873.

93 rbld.mId,, at 617-619." IR, at 374.Old., at 875.0W L.


they are merely misleading. They seem to afford investors a meas-ure of security against overreaching by issuers. But in fact, theyare at most a hollow declaration of principle by the issuer; the in-vestor, lacking an active guardian of his rights, cannot see that theirwords are translated into action.

The conclusion is irresistible that in certifying the bonds, notesor debentures the trustee should be under an obligation to use rea-sonable care and diligence in ascertaining the truth of the represen-tations of the issuer as to the existence of the conditions on whichcertification properly can be made. This will in the normal casemean appointment of independent engineers, appraisers or account-ants by the trustee to examine the properties or accounts of the issuer.At all times it will mean meticulous care in examining the adequacyof the representations of the issuer. At no time will the trustee beable to shut its eyes to the incongruities and inconsistencies in thecertificates presented by issuers and to proceed to certify irrespectiveof inadequacies which reasonable care and diligence would reveal.Only in such manner can investors be adequately protected againstoverreaching on the part of issuers.

C. APPLICATION OF PROCEEDS

Generally, the circular describing an issue to prospective investorsspecifies the use to which the proceeds will be put. Under theSecurities Act of 1933, as amended, such disclosure must be includedin the registration statement which is filed.18 Control over applica-tion of proceeds is essential lest the investor not obtain what hebargained for. But the investor is in no position to check theapplication of proceeds.

An individual investor has not the facilities to see that a corpora-tion has devoted the proceeds of a loan to paying short-term obliga-tions, replacing machinery, improving plant and equipment, or erect-ing a building as specified. If this highly important function is tobe performed, or if its performance is to be supervised, it mist bedone by a single agency.

It is natural to suppose that this is properly a function of thetrustee. But in 53 percent (222 of 413) of the indentures which weexamined, there was an express statement that the trustee was underno obligation to see to the application of proceeds. This provision is,of course, given full effect by the courts.89 Even in the absence ofsuch express provision, the trustee will escape liability to bondhold-ers if the issuer has diverted the proceeds of an issue to uses otherthan those specified, as the result of the doctrine that it owes no

, See Schedule A, item 18, Securities Act of 1983; and Schedule B, item 2.NewAaU V. Norritown Tr iat o., 280 Pa 195, 124 AtL 837 (1924).


duty to the bondholders in this respect unless it affirmatively assumedsuch an obligations ° If the trustee does not affirmatively or by clearimplication undertake to receive the proceeds of a bond issue oroversee their proper application,,' courts have held that its failureto do so is excused.9 2 And in only 24 percent (95 of 395) of thetrust indentures examined, were the proceeds of the issue received bythe trustee. Even in these instances, the indenture may limit thetrustee's duty by requiring merely that the issuer shall furnish thetrustee with a statement certifying that the proceeds are to be usedfor the specified purposes.93 Apparently the trustee, in these cases,is under no independent duty to ascertain that the certificate iscorrect and is complied with.

The tragic results to investors of this absence of supervision overthe application of proceeds of security issues are matters of record.In the real estate field, reliance was placed upon the underwriter toperform this function. As usual, the trustee assumed none of theseduties. Thus there have been instances of failure to erect buildingsin which purchasers of bonds supposed they had invested, of diver-sion of proceeds to service other issues sponsored by the same under-writer; and of other similar abuses 4

It is clear that investors should have all possible assurance thatthe funds which they pay are invested in accordance with their ex-pectations. And it seems obvious that this function is properly aduty of the trustee, the designated representative of the bondholdersin the indenture. It should not be permitted to repudiate or toescape this responsibility.

In fixing the desirable objective in this regard, considerable weightmust be given to the argument that it is impractical for the trusteeto follow proceeds of security sales so closely that it becomes involvedin the business administration of the borrower, as in the case offunds borrowed for general corporate purposes, or to reimburse thecompany for moneys actually expended.

91 Seq~rity-First National Bank of Los Angeles v. J. G. Ruddle Properties, 12 P. (2d)468 (Cal. App. 1932), mod. and aff'd, 14 P. (2d) 850 (Cal. App. 1932), aff'd, 218 Cal. 435,23 P. (2d) 1016 (1933) ; see National Waterworks Co. v. Kansas City, 78 Fed. 428, 434(C. C. W. D. Mo., 1896) ; Fletcher, Corporations (1931), Sec. 3188.

91 Welch v. Northern Bank & Trust Co., 100 Wash. 349, 170 Pac. 1029 (1918) ; Patter-son v. Guardian Trust Co., of New York, 144 App. Div. 863, 129 N. Y. Supp. 807 (3d Dept.1911).

12 Supra note 90.13 According to answers to the Commission's questionnaire, in the 95 instances-22 per-

cent of the total (415)-where the trustee did receive the proceeds, the conditions ofrelease were : in 40 percent (38 of the 95) a certificate of the architect, engineer, super-intendent of construction or the like ; in 25 percent (24 of the 95) the order of the issuerof the bonds was all that was required. Of the remaining 33 cases, 15 called for retire-ment of all or part of prior indebtedness, the rest were a miscellany of minor conditions.

" N. Y. Joint Legislative Committee To Investigate Legal Investments for SavingsBanks, et at. (1933), at 1607 et seq.


The trustee's hand might be strengthened in this connection byrequiring the filing of certificates of proper application of proceedsas supplements to registration under the Securities Act of 1933, asamended, and the Securities Exchange Act of 1934. Potential .lia-bility thus created for misstatements in these certificates would tendto discourage improper application of proceeds.

If the proceeds of the bond issue are to be used in erecting build-ings, the trustee could without undue hardship to itself or to thedebtor, superintend the application of funds in a manner substan-tially in accordance with current and reputable practice. This obli-gation should extend not only to situations where the loan proceedsare to be directly transmitted into physical property which will goto form all or part of the security for the loan, but also where thesecurities are being sold to refund outstanding indebtedness; to retirespecified prior liens; or to acquire other specified properties. It isnot enough here that the trustee satisfy this obligation by requiringthe borrower to furnish it with a certificate attesting to proper useof the proceeds. There must rest a duty upon the trustee to exercisereasonable care to follow their application. In no sense would thisconstitute a trustee an insurer. At the same time the duty to exercisereasonable care should not be made hollow by permitting the trusteeto be satisfied with a mortgagor's certificate of compliance. As amatter of fact, a certificate of compliance furnished by the borrowermight in some cases amount to or approximate all that reasonablecare *would require; in others it might not. The decision and therisk should be the trustee's upon the facts of the particular case.

Certainly, in any case where the trustee, including any departmentor principal official of the trustee, has reason to believe that proceedsare being, or are about to be, misapplied, the trustee should becharged with the duty to investigate and take appropriate action toprevent diversion. It should not be permitted to remain passivewhen in possession of facts threatening the security of investors.

Such reform measures will at times merely conform with, and atothers extend only slightly, the standards of conduct presently em-ployed by the most reputable and conscientious trustees. But theywill supply investors with protection against the tragic results ofa system which at times has shown too great a regard for freedomof action of issuers rather than for meticulous protection of investors.

D. PAYMENT OF TAXES AND MAINTENANCE OF CAPITAL RATIO

Reliance upon technical performance of their slight responsibili-ties is common to corporate trustees. And sometimes they haveneglected to perform even the negligible duties which the indenture


places upon them, particularly in matters which will result in de-fault of the issuer. Particularly where an act or omission of theissuer results in a situation where the trustee can declare a defaultunder the indenture, the trustee has sometimes failed to call for theperformance which would disclose the default, or has apparentlyignored the omission. Well protected from investors by exculpatoryclauses and the inertia of scattered holders, the trustee in some in-stances has worked with the issuer to avoid or stave off publicationof notice of default, perhaps because of negligence, or fear, or itsown judgment of the interests of the investors, or devotion to theissuer. Postponement of announcement of nonpayment of interest,principal or sinking-fund requirements is a familiar example.

The real estate field abounds with instances of abuses of varioussorts by trustees for bond issues. No attempt will be made in thischapter to recount all of them, or to state any in detail. Some aredescribed elsewhere in this report."' In the years 1925-1931, it wascommon practice for underwriters like S. W. Straus & Co., AmericanBond & Mortgage Co., and others, to advance their own funds tomeet principal and interest payments which the issuer could notsatisfy. In this way they were able to stave off default, maintaintheir advertised record of "-- Years Without Loss to Any Investor",and sell additional bonds.

In the interim, unpaid taxes were allowed to accumulate, impos-ing upon the property increasing liens superior to those of the bond-holders, and the physical properties were allowed to deteriorate.Failure to pay taxes constituted a default under the indentures, butthe trustees took no action to notify bondholders to foreclose or totake possession. The trustees in these instances were officers oraffiliated banks of the underwriters. It is natural, therefore, thatin the performance of their duty to bondholders they should behampered by their duty to their affiliated companies.

Harold Moore, an official of American Bond & Mortgage Co.,and trustee of many of its issues, testified before this Commissionthat the instances where he, as trustee, notified bondholders of non-payment of taxes were extremely rare:

"Q. Mr. Moore, what would you normally do as trustee under such circum-stances? Do you ever recall an instance, to be more specific, where you astrustee advised the bondholders that taxes were in arrears?

A. No, sir.Q. You did not?A. No, sir.Q. How would the American Bond and Mortgage Company normally handle

that situation? Do nothing about it?

91 See Part III, Committees for the Holders of Real Estate Bonds (1936), for instancesof the practices described here and in the following paragraphs.


A. Yes. They did not notify the bondholders of tax default.

Q. They did nothing about it, nothing to advise the bondholders?

A. Nothing.Q. That was their consistent policy?A. As I recall it, yes.Q. And that was consistently your policy as trustee?

A. Yes, sir. I would like to qualify that. My recollection is that as to

certain of the properties in which I was trustee I did address communications

to them with respect to the status of these properties, particularly those where

I had been operating them, in which I did include statements as to the status

of the taxes.Q. Would that be after the committee was formed?

A. I have a recollection that with respect to the Miles Standish issues,

Boston, I had taken that action prior to the time of the formation of the

committee.Q. You do not consider it, however, a part of your obligations as trustee to

give such notice?A. Well, I don't know that I can generalize in just that way.Q. Well, if you had felt it your duty, you presumably would have given such

notice?A. You asked me if I felt that I should. I don't recall having had the general

feeling that I should have done it." "

The interest of the underwriters, according to the policy of thereal estate houses, was to keep the fact of default secret as long asthere was any hope of selling more bonds and working out the situa-tion. Their trustees were apparently ready and willing to serve thisinterest, despite the fact that the bondholders' security was beingprogressively impaired. When reorganization became necessary theunderwriter had nothing to gain, either in control of the situationor in prestige, by further concealing defaults. Customarily, in thereal estate field, it selected the committee or was influential in itsselection. It would be interested in the success of the committee'sobtaining deposits. For this purpose, notification to them of defaultsin taxes would be helpful. It is not strange that trustees affiliatedwith these underwriters should awaken to their duty to notify bond-holders only when such notification furthered the interests of theunderwriter.

Our conclusion is that irresponsibility of the trustee for givingnotice of tax defaults should no longer be tolerated. Protective pro-visions of trust indentures which allow the trustee to shirk or escapesuch responsibility should be outlawed. Here again the requirementis for the same meticulous care and reasonable conduct as wouldprevail were the trustee itself the mortgagee.

Another example of a trustee's ignoring default is afforded by in-cidents in the history of The Baldwin Locomotive Works. In 1910

"Proceedings before the Securities and Exchange Commission In the Matter of S. W.Straus & Co., et al. (1935), at 2232-2234.


this company had issued ten million dollars of 30-year first mortgagebonds.9 In 1930 it issued $12,000,000 of 3-year 5 percent goldnotes.98 The indentures securing both these issues contained cov-enants of the company differing materially in detail, but generally tothe effect that it would maintain a stated ratio of assets to liabilities.They further provided that the company must, at stated periods, de-liver to the trustee a schedule showing its assets and liabilities in aspecified manner.99 The trustee under both indentures was The Penn-sylvania Company for Insurances on Lives and Granting Annuities.

It was of great importance to investors that these covenants shouldbe kept. They insured presentation of the company's financial con-dition in a manner which would enable investors intelligently toappraise their securities, to receive warning of impending default,and to take steps to conserve their investment before further lossoccurred.In response to complaints of investors after announcement in Oc-

tober, 1934, of default upon the Baldwin first mortgage bonds, thisCommission investigated the situation. Among other things, itexamined the effect which the announcement had upon another Bald-win security, the issue of 5 year, 6 percent Consolidated MortgageBonds. The Commission's findings were in part as follows:

"The fact that The Baldwin Locomotive Works and its subsidiaries had re-ported substantial net deficits for the past three years made its current assetposition a dominant factor in establishing market values for its bonds, par-ticularly the Consolidated Mortgage Bonds of 1938. Prior to the report for theyear ending in 1934 the Company had published merely a consolidated balancesheet and a consolidated profit and loss statement. Those statements con-solidated the statements not only of subsidiaries completely owned by theparent company, but also of one subsidiary,. the Midvale Company, of whosestock the parent company owned only slightly above sixty percent. The resultof this method of stating the financial condition of Baldwin Locomotive Workswas to portray a net quick asset position better than that of the issuing cor-poration, especially in view of the fact that the quick assets of the MidvaleCompany constituted a very substantial portion of the consolidated quickassets. Even if such assets of wholly owned subsidiaries were considered tobe those of the parent, the quick assets of this partly owned subsidiary would

O1 Op. cit. supra note 13, at 10-12.98s., at 49. In a voluntary reorganization In 1933, new consolidated mortgage bonds

replaced these notes. Id., Commission's Exhibit No. 83.D The covenant in the bond indenture required that "The unencumbered quick assets of

the Corporation * * * shall at all times equal or exceed the aggregate indebtednessof the Corporation * *." It further provided that "Within ninety (90) days afterthe close of each fiscal year of the Corporation", it should deliver to the Trustee a swornschedule showing "in general and summarized form, the nature, description and value ofthe quick assets of the Corporation on hand at the date of the close of said fiscal year;and the description and amount of the aggregate indebtedness of the Corporation at suchdate * * *." Id., Commission's Exhibit No. 6, at 59, 60.

The covenant in the note indenture contained a provision that the Corporation wouldmaintain a stated ratio of current assets to current liabilities. Id., Commission's ExhibitNo. 22, at 12. Other provisions of this covenant appear in the text above.


have to be segregated In order to determine accurately the working capitalposition of the parent company-a fact essential to any adequate analysis of

the position that should be accorded the Consolidated Mortgage Bonds." 10

In the indenture securing the first mortgage bond issue was acovenant by the Baldwin company that "the unencumbered quickassets of the Corporation. * * * shall at all times equal orexceed the aggregate indebtedness of the Corporation. * * *"

The second paragraph of the indenture provision in which this wascontained specified that at stated periods the company had the dutyto deliver to the trustee a schedule "showing in general and sum-marized form, the nature, description and value of the quick assetsof the Corporation on hand at the date of the close of said fiscalyear; and the description and amount of the aggregate indebtednessof the Corporation at such date * * *"

Nevertheless, the provisions of this indenture were continuallyviolated by the company. The statement which it furnished to thetrustee, under the bond and note indentures, clearly was not in con-formity with the requirements of the indentures. But the trusteeaccepted these statements without protest until defaults in interest orprincipal payment were publicly announced.

Analyzing the detriment to investors which resulted from thefailure of the Baldwin company to fulfill its covenants, the Com-mission stated:

"Despite what seems fairly apparent under this indenture-that the unen-cumbered quick assets of Baldwin Locomotive Works rather than of theBaldwin Locomotive Works and its subsidiaries must at all times equal orexceed the aggregate indebtedness of Baldwin Locomotive Works-no effortwas made by the trustee, the Pennsylvania Company for Insurances on Livesand Granting Annuities, to insist upon this interpretation. Indeed, since be-coming trustee, the trustee seems to have acquiesced without question in aninterpretation that called only for the unencumbered quick assets of theBaldwin Locomotive Works and its subsidiaries to equal or exceed the aggre-gate indebtedness of Baldwin Locomotive Works. Had the other interpreta-tion been Insisted upon, It is obvious that a default in this respect would havebeen recognized as existing for some time past.

"In any event, it is clear that the trustee at no time within the past fewyears has called for the performance by Baldwin Locomotive Works of theduties expressly placed upon it by the second paragraph of the NineteenthArticle of the Indenture. Instead of the sworn schedule of a specific naturethere demanded, the trustee was satisfied to accept the mere annual reportof the Corporation, the inadequacy of which has already been described.

"The Commission cannot but observe with regret this casualness whichaccompanied the assumption of the fiduciary duties of trusteeship by theabove-named trustee."m

'oRelease No. 167, Securities Exchange Act of 1934, April 11, 1935.Ibid.


With respect to the failure to comply with the note indenture,George H. Houston, president of The Baldwin Locomotive Works,testified as follows in another proceeding before this Commission:

"Q. Mr. Houston, I now place before you again Commission's Exhibit 22,which is a trust indenture to which we have just referred. On page 14 of thatindenture does the company covenant that it will furnish to the trustee a state-ment setting forth, as of the date of the commencement of the new fiscal year,the amount of its current assets and current liabilities as defined in theindenture?

A. It does.Q. Now are the current assets defined in the indenture on pages 12 and 13?A. They are.Q. And is paragraph (b) of that definition of current assets in the following

words: 'Securities (other than securities issued by the Company or its whollyowned subsidiaries) which are marketable, taken at not more than their marketvalue, and including shares of stock of the Midvale Company and General SteelCastings Corporation which shall be taken at cost to the Company, or theirmarket value whichever is lower.' Does that so state?

A. It does.Q. Now, Mr. Houston, I should construe that as meaning that the current

assets of the company, as set forth in the balance sheet furnished to the trustee,must include a statement of the value of the stock of the Midvale Company,either at cost or market, whichever is lower. Is that a correct construction?

A. I think it is a reasonable construction.Q. Was that done?A. Not that I know of, beyond the Annual Report.Q. And the Annual Report does not do that, does it? Does not the Annual

Report set forth-does not the Annual Report for 1930 and '31 set forth as anasset of the Baldwin company, consolidated with the rest of its assets, Baldwin'sevaluation of the entire assets of The Midvale Company?

A. It does.Q. And is that not a violation of this provision in the trust Indenture which

appears on page 14?A. It might be interpreted so, if the trustee so interpreted it.Q. Has the trustee ever brought suit?A. No, I don't know as the trustee has ever raised the question." i'

L. J. Clark, of The Pennsylvania Company for Insurances on Livesand Granting Annuities, the trustee for the notes, supplementedMr. Houston's testimony as follows:

"Q. Mr. Clark, you have heard the testimony of Mr. Houston. Did youknow, after the balance sheets of 1930, 1931, and 1932 were furnished to thePennsylvania Company, that those balance sheets were not in accordance withthe provisions of the trust indenture?

A. Yes, we must have known it, because we made a request for it in theother form.

Q. You made a request when?A. In 1933.Q. When were these notes due?A. March 1933.

-m Op. ot. supra note 13, at 125-127.


Q. When did you make that request?A. In June 1933.Q. You made your request after the notes were due and after that ma t urity

had not been met?A. Yes."'

Elsewhere in this report appear references to this trust company'sconception of the duties and functions of a corporate trustee."0 4

These references and the relation of its conduct in the Baldwin inci-dents are not cited as unique examples; there is ample evidence thatthey reflect the attitude and practice of corporate trustees generally.The motivating causes of this condition are analyzed elsewhere. Inthe Baldwin case, its consequences to security holders are clear.Failure to comply with the provisions of the indentures discussedabove constituted a default, but the trustee, amply protected by in-denture provisions, took no steps to demand that the default becured or to announce its existence to security holders. In 1934 thedecline in the company's financial condition took place and the an-nouncement of default occurred without warning to security holders.With reference to the three-year notes, the company continued opera-tions and prior to their maturity set up machinery to effect a reor-ganization under its own control and direction.

E. NOTICE OF DEFAULT

The failure of the trustee to give notice of default was also dis-cussed in the hearing before this Commission, by L. J. Clark, trustofficer of The Pennsylvania Company for Insurances on Lives andGranting Annuities, trustee of the Baldwin mortgage bonds andnotes:

"Q. That is, after being notified of a failure to comply with the provisionsof a trust indenture, the trustee Is bound to notify the company of that failureto comply and demand that the company comply?

A. No, I would say not.Q. You say the trustee may exercise its discretion?A. It may exercise its discretion.Q. Is that because of a provision in this trust indenture?A. That I don't know, but it Is a general practice.Q. I call your attention to page 29 of this indenture. Page 29 contains this

provision: 'Unless and until the Trustee shall have received written noticeto the contrary from the holders of not less than twenty-five percent in amountof the Notes at the time outstanding, the Trustee may, for all the purposesof this Trust Indenture, assume that the company is not in default under thisTrust Indenture and that none of the events hereinbefore denominated defaultshave happened.'

Was that the provision under which you were acting in Ignoring this default?A. I would say so.

11 Id., at 822-323.2O" See supria, at 4, 7-8; infra, at 87--88, 72-78.


38

Q. Then, the effect of this provision is that even though the trustee knowsthere has been a default, the trustee can with impunity pretend there hasbeen no default unless it receives a demand from twenty-five percent of thenoteholders?

A. Yes.Q. That is, the trustee knew-A. The trustee acted under those conditions.Q. What does the trustee do?A. The trustee is a vehicle through which the bondholders take action.Q. The trustee is the vehicle through which the bondholders would take

action?A. Yes.Q. It is not more than that, in your opinion?A. No.Q. That is, the trustee is a vehicle which can be put into motion by twenty-

five percent, or some other percentage, of the bondholders?A. Yes.Q. It has no independent duty then?A. No.Q. And when there is a provision in an indenture that the company shall

furnish to the trustee annual statements in a particular form, that provisionis presumably for the protection of the security holders, isn't it?

A. Presumably, or for their information.Q. For their information or protection; but when there is such a provision

in a trust indenture and a company fails to furnish it to the trustee, thetrustee can do nothing but point to a provision like this one on page 29 of thetrust indenture, stating that it is deliberately ignored, and say: 'My part isprovided for in the indenture'?

A. Yes." 105

As Mr. Clark testified, "it is general practice" for the trustee touse its discretion as to whether it must notify the company of adefault and demand compliance. It is also virtually standard prac-tice to provide in indentures that the trustee can shut its eyes to theexistence of a default unless it is formally notified of it by holdersof a specified percentage of the outstanding bonds. Approximately63 percent (266 out of 422) of the indentures which we have studiedcontained such provision.10 6 The language of these clauses is broadenough to relieve the trustee from the necessity of becoming consciousof default even if it controls the issuer and has actual notice of thedefault.

105 Op. cit. supra note 13, at 324-326.'" These indentures required demand by various percentages of the security holders

The distribution of the 266 cases was as follows:0 to 10% ------------------------------ 114

11 to 20% ------------------------------- 921 to 30% ------------------------------ 10231 to 40% ------------------------------- 541 to 50% ------------------------------- 2Majority --------------------------------- 4Percert not specified ------------------------ 80


39

In the case of R. Hoe & Co., Inc., manufacturers of printingpresses, it clearly appears, from the record of the hearing beforethis Commission, that officers 107 of the Guaranty Trust Company,trustee for the Hoe company bonds,108 and officers 109 of the Guarantycompany, affiliate of the trustee, knew of an impending default sev-eral weeks prior to its public announcement. An officer of GuarantyCompany had stated on March 16, 1932, "Several weeks ago itbecame quite clear that it would be a very unwise thing for R.Hoe and Company to attempt to make the April 1st sinking fundinterest payments on its bonds and notes." 110 But the bondholdersdid not know. Nor could they find out. A bondholder wrote thecorporate trustee on March 9th to ask if April 1st interest wouldbe paid. Through its trust officer, Arthur E. Burke, the trusteeinquired of Charlton B. Hibbard, director of the Hoe Company andofficer of Guaranty Company, what answer to give the bondholdersand "whether we can tell them definitely that the company hasadvised us that they will be unable to meet the April 1st interestpayment." Mr. Hibbard told Mr. Burke to tell the bondholdersthat "we are not in a position" to advise them.11 2 These instructionswere followed.1,3 Mr. Hibbard defended the failure of GuarantyTrust Company to give notice to the bondholders of the impendingdefault on the ground that to give such notice would result inpreferential treatment to those bondholders who were so advisedand might seriously hurt the company's business."1 ' He stated:

"Q. But you don't seem to lay much emphasis on the Trustee to protect thethe interests of the bondholders, or is supposed to. (sio) Instead we have,for example, the Guaranty Trust Company lulling its bondholders into quies-cence about the situation.

A. The thing was not official, and I think the Guaranty Trust Companyhad no right to assume it was official until the directors meeting. Certainlythey could not make any such announcement prior to that time, * * *.

Q. I would like to get your opinion. Suppose the Trustee .does knowalmost for a certainty, that the directors are going to vote not to pay theinterest due on bonds, do you think the Trustee should or should not notifyIts bondholders?

A. I don't think they should if it is almost a certainty; not until it isa certainty.

Q. Not until it is a certainty. Where do you think the Trustee's obligationslie?

101 Proceedings before the Securities and Exchange Commission In the Matter of R. Hoe& Co. Inc. (1935), at 122-123.

'10id., at 70-71.10Id., at 122-123.

" Od., at 123.m Id., at 118.lu Ibid."'I'd., at 120."A I at 126.


A. In that one respect you mean?Q. Yes. Why shouldn't it communicate what it knows to the bondholders?A. Well I'd want to give that a good deal of thought.Q. Well a private trustee, if he knows of a serious situation, generally

either takes action upon it for the benefit of his beneficiary, or communicatesthe situation to the beneficiary.

A. Well I just-of course the only way that a trustee can reach the bond-holders of a negotiable security is by advertising or using the bests lists avail-able. Now however they may do it, there is bound to be preferential treat-ment in those that get the letter first or see the advertisement first. I thinkIt is a dangerous thing for the Trustee; I think somebody is going to benefitby preference.

Q. You mean if a trustee gives out public notice that there is a serioussituation in the company, that those persons who receive that notice first, willbe enabled to sell their bonds at an advantage as against those who don'thappen to pick up the paper that morning?

A. It is not only that, but if they do it without consulting the company,they may do a very material harm to the company's business and the bond-holders in that way, it is very serious, a matter of giving out a notice likethat is a very important matter to the business of the company, affecting itscredit and ability to get orders. I think the trustee would be taking a verygreat and unwarranted responsibility in this case. I am not ready to makethat generally, but in this case.

Q. In this case?A. I am sure the operating officers of the company would have been very

worried about the effect of such a notice.Q. Well-A. Prior to any action by the directors or any action by the company.Q. I quite agree that the operating officers might have been very much

worried about it, but the trustee's concern is the bondholders, not the company.A. The operating officers are the men who have got to pay the interest and

principal on the bonds and the business of the company makes the bonds good.Q. Maybe they are the men who ought to know of it, the trustee ought to

act with that in mind?A. Well that is a matter of opinion or judgment in individual cases.Q. Of course it is in individual cases, but that is always a situation facing

the trustee?A. But my understanding of the responsibility of a trustee would put any

such action way beyond anything that they ought to assume, and it would bea very dangerous thing for a trustee to do, particularly where it is a questionof opinion. * * *

Q. Your conception of a trustee is more or less of a passive agent who sitson an issue and watches it?

A. I think that is the reason that we don't put him in unless a certainamount ask him to. Maybe we should have trustees with broader responsi-bility, but I don't think the present indenture gives him that responsibility;that the intention was at the time that he should not take the responsi-bility." 11

Mr. Burke, the trust officer, testified that he did not recall everseeing a provision in an indenture providing that the trustees should

-. Id., at 125-128.


give notice to the bondholders of any default. 156 He believed thatwhether or not, apart from the indenture, a corporate trustee shouldgive such notice "depends upon the circumstances." 117

As a matter of fact Guaranty, the trustee, never advised the bond-holders of the default. The directors of the Hoe company formallyvoted on March 17 to notify the trustee of its inability to make theinterest payments on April 1st. Guaranty Trust Company was then"officially" notified. Mr. Hibbard testified:

"Q. Then what did Guaranty Trust Company do? Did it forthwith com-municate with the bondholders?

A. Not to my knowledge.Q. There was further delay In Guaranty Trust Company's announcement to

the bondholders of the default?A. I don't know; I don't think the Guaranty Trust Company ever made

such an announcement, nor do I feel that they should have.Q. Now that announcement was made in what manner?A. By the bondholders committee, to the best of my recollection.Q. Now when was that bondholders committee formed?A. I think it was about a week after that meeting."

"Q. That would make it about March 25th or 24th?A. That is my recollection.Q. Do you recall when the bondholders committee announced the default?A. Somewhere about that time, I should think March 25th or 26th * * *."

But there were reasons in addition to conventional inertia whichled Guaranty Trust Co., the corporate trustee, to leave the matter tothe protective committee and to lull the "bondholders into quiescenceabout the situation." 119 In February of 1932, two months prior topublic announcement of default, the Guaranty Trust Company andother bankers of the Hoe company were planning the formation ofvarious protective committees.120 Guaranty was heavily interested inHoe in capacities other than as trustees for the bondholders. It wasa creditor;2" it held securities junior to the bonds ;122 its securitiesaffiliate was underwriter of Hoe securities ;128 and it was in control ofthe company.' 2' When default appeared inevitable, the managementbegan to arrange a friendly receivership,' 25 and Guaranty began toform protective committees so that it could dominate and control thereorganization. If it attained this position of dominance in the

"' Id., at 422.' Id., at 423.

"OId., at 128-129." Id., at 125.'Id., at 110-111.

I., at 895-397.1d., at 274-275.

18 Id., at 294-295.SId., at 26-0, 35, 42, 49.

1lIS., at 148 et sg.


reorganization, it would of course be in a position to control or influ-ence the treatment of various claimants and interested parties, in-cluding itself in its many capacities. To this end the news of theimpending default was suppressed until the stage was set and all themachinery prepared for reorganization. So testified Mr. Hibbard:

"Q. Well, I am wondering then, Mr. Hibbard, if all of this delay in making theannouncement of the default was conceived for the purpose of getting thereorganization procedure and the reorganization units, the committees, organized,so that immediate action could be taken to assume a dominant, controllingposition in the reorganization?

A. Yes." "

Our conclusion is that to relieve the trustee of all obligation to givenotice of defaults is undesirable. Rather it should have the affirma-tive obligation to take such steps towards advising security holders ofimpending or actual defaults as are, in view of all the circumstances,reasonable and necessary for their protection. To publicize transientand technical defaults might do irreparable damage to securityholders and issuer alike. No rigid and inflexible rule can be pre-scribed. What is needed is a standard of conduct prescribed by lawwhich requires the trustee to take the same action it would take wereit the investor. Had such standard of conduct been exercised in theHoe case the probabilities are that the reorganization which ensuedwould not have been so exclusively in the hands of insiders withconflicting interests to serve.

F. CONDITIONS PRECEDENT TO ACTION

The Guaranty Trust Company, in the case just recited, failed tonotify bondholders of the impending default not because it lackedknowledge or power, but because it did not desire to do so. Thecorporate trustee is generally adequately equipped with powers; itsinactivity is the product of its own desires coupled with provisionsin the indentures which relieve it of any duty to act. The lack isnot of power, but of duty and responsibility.

For example, the trustee generally is given ample powers in inden-tures to bring suit, in its own name, to collect principal and to fore-close and enforce rights under the indenture against the pledgedproperty. 76 percent (324 out of 423) of the indentures studied,contained the express provision that the trustee possessed the powerto sue in its own name and to recover the entire principal unpaid,in the event of default by the issuer in the payment of principalwhen due, whether on the due date of the securities or upon theiraccelerated maturity. And the more general provision, that on thehappening of these same conditions the trustee could in its own name

- Zd, at 182.


enforce the rights under the indenture against the property, wascontained in 91 percent (377 out of 415) of the cases. In all but 5 ofthese indentures (98 percent) it was expressly provided that thetrustee was vested with the ezclusive power to enforce such rights.

But instances of trustees taking such action, unless and until theyare forced to do so by bondholders, are not common. Trust inden-tures normally contain express provisions that, despite the happeningof specified defaults, the trustee has no duty to foreclose or to initiateother judicial proceedings or any other action specified in the inden-ture, unless the bondholders holding a stated percentage of the prin-cipal amount of securities then outstanding make a demand upon it.Ninety-three percent (391 out of 420 cases) of the indentures exam-ined by this Commission contained such provision.127 In 57 percent(226 out of 391) of these, even after the necessary request had beenmade, the trustee retained by express provision the power to electthe remedy to be pursued. It can be compelled to take that particulartype of action which bondholders desire only if a specified and higherpercentage demand it.12s Trustees have even denied any duty toexercise their power to declare maturity of the securities accelerated.In 93 percent (396 out of 424) of the indentures, the trustee had noduty to accelerate prior to demand by a substantial percentage ofsecurity holders.129

Even this does not tell the whole story. It is not enough that therequired percentages of security holders, having in some manner beenassembled, shall give notice of default and make the demand uponthe trustee. Almost uniformly there is this further barrier; theindenture expressly provides that the trustee has no obligation totake any action which in its opinion is likely to involve it in expenseor liability unless the security holders furnish it with indemnity.

12 The percentage required to make demand upon the trustee varied as follows:1 to 10% ------------------------------------------ 1211 to 20% ----------------------------------------- 1821 to 30% ----------------------------------------- 23931 to 40% --------------------------- ------------ 841 to 50% ------------------------------------ 7Majority ------------------------------------------- 107

In 234 Indentures this provision appeared. But the percentage required to direct theremedy to be pursued is usually higher than that required to compel unspecified action.The distribution was as follows:

25% -----------------------------------------50 ------------------------------------------- 11Over 50 -------------------------------------- 189

' The specified percentages were as follows:1 to 10% ------------------------------------------ 1311 to 20% ---------------------------------------- 1621 to 30% ------------------------------------- 22281 to 40% ------------------------------------41 to 0%------------------------------------ 7Majority ------------------------------------------- 132

75957 '--86----4


Of 424 indentures examined by this Commission, 405 (96 percent)contained this provision.

These provisions are regarded as a matter of law, as parts of a"contract" between the trustee and security holders. For most securi-ties there is no restraint upon the number of such provisions whichcan be inserted, or upon the percentage of security holders whosedemand is necessary to require the trustee to act. For the compara-tively few issues listed on the exchange, there is an exceedingly lim-ited prohibition. The New York Stock Exchange and the New YorkCurb Exchange both specify that the Committee on Stock List "willobject to any provision in an indenture whereby the consent of morethan 30 percent of the outstanding bonds is necessary to initiate anyaction by the Trustees which may appear necessary for the protec-tion of bondholders, subject, however, to the limitation that there isno objection to a provision by which the action of a majority inamount of such bonds will rescind any minority action."

It is obvious that this requirement affords investors no real protec-tion against inert trustees; it merely places a liberal top-limit uponthe conditions to action which the trustee may impose upon securityholders. But the result of these conditions is definitely detrimentalto investors. When the necessity for action arises, every bit of delayis hazardous and may be definitely injurious.

In order to obtain the necessary amount of security holders to makethese demands and thus force the trustee to act or to mature their ownright to do so, security holders normally will have to form a pro-tective committee. To form such a committee they must communi-cate with their fellow security holders. In order to communicatewith them, they need their names and addresses. Without such listthey must resort to general advertising which is costly and ineffective.At best this method is a poor substitute for a list, for scatteredsecurity holders are difficult to reach through such a medium. Thuswithout a list of security holders, united effort is thwarted in itsinception. The result is that they do not organize and matters driftalong or the organization'is perfected slowly and expensively. Butsuch lists are difficult to obtain for, as elsewhere mentioned, theyare usually in the exclusive possession of interested groups, i. e.,the underwriter and the issuer. The latters' interests frequently areopposed to those of the security holders. In any event the history ofreorganization demonstrates that those who possess the lists maintaintheir monopoly on them, giving access only to the favored few whosefriendship and sympathy are known quantities. But whether thesecurity holders obtain a list or not, the steps necessary to marshalla sufficient percentage of security holders to make the demand on the


t-ustee are time-consuming. Irreparable loss to security holdersmay occur in the interval-such loss being clearly traceable to thetrustee's inaction. The situation has been graphically described byone trust officer as follows:

"If an event of default happen, the responsibilities and difficulties accumulatearound the trustee's devoted head. Suppose one occurs and the required numberof bondholders do not get together and form a protective committee, andthere is no one to make request of the trustee to proceed under the foreclosureclauses of the indenture: What shall the trustee do? He can sit back withfolded hands and say that the proper number of bondholders have not calledhis attention to the default and he has not been indemnified under the termsof the agreement, therefore he will do nothing. This may be strictly withinthe letter of the indenture, but, as Scripture has it, 'The letter killeth, thespirit maketh alive'. Is it not a reproach against any issue of bonds that thetrustee has so wrapped himself up in nonresponsibility clauses that his signatureon the back of a bond is mere waste of ink? " 130

An example of the present impossibility of obtaining action bythe trustee, appears in the reorganization of the Cuban Cane ProductsCompany, which was studied and investigated by this Commission.When sale of the Cuban Cane properties to satisfy bank creditors'first mortgage was imminent in January 1934, the committee forthe outstanding Cuban Cane debentures desperately sought, for theprotection of the debenture holders, to have the sale deferred. 131

The sale was scheduled for January 30.13' Demand was made bythe committee January 17 on Manufacturers Trust Co. as trusteefor the debentures requesting that it take some action to defer thesale. Counsel to the committee testified:

"Q. You were attempting, as a committee, to get the corporate trustee totake effective steps to protect the debenture holders against an event thatwas about to happen, namely, the foreclosure sale?

A. I felt, that, as counsel for the committee the danger was so real itwas the duty of the committee to leave no stone unturned to prevent thatdanger from becoming a reality." '

On January 29, the day before the sale, the trustee replied 184stating it was willing "to take any reasonable steps for the purposeof protecting the debenture holders." It added, however, that it hadno funds as trustee available for the purpose and stated "we mustask that the debenture holders either arrange to put us in funds oradequately indemnify us against expense and liability before we can

'" W. G. Llttleton, vice-president, Fidelity-Philadelphla Trust Co., 56 Trust Companies835, 337-338 (1933).

"s Proceedings before the Securities and Exchange Commission In the Matter of CubaCane Sugar Corporation (1935), at 783-784.

mid., at 786.In Id., at 784.1 UId., Commission's Exhibit No. 211. (For practices of trustees in demanding in.

demnity before acting, see Appendix A, Section IV, Table 2, infra.)


undertake any proceedings." It suggested a down payment of $1500and closed with the following:

"As soon as we, as successor trustee are placed in funds or adequatelyindemnified, we shall be glad to take up with you and your representativethe advisable steps for the protection of the debenture holders and to carrycut these steps at once."

Laurence A. Crosby, counsel to the committee, testified on thisbefore this Commission:

"Q. You write the Manufacturers Trust Company on January 17 of a verydangerous threatening situation that is developing and will come to a headon January 30, and they write you and your committee, 12 days later, January29, on the eve of the event in Cuba; that is correct?A- That is correct.Q. And the position they take is that 'as soon as we, as successor trustee,

are placed in funds or adequately indemnified, we shall be glad to take up withyou and your representatives the advisable steps for the protection of thedebenture holders, and to carry out those steps at once.' In view of the salethat was about to happen on January 30, this letter from the ManufacturersTrust Company was equivalent to a refusal to act at all, was it not?

A. Of course, * * * it would have been very difficult to take in 24 hours theaction which they request in their letter.

Q. And furthermore, the only thing they agree here to do is to discuss withyou and your counsel advisable steps to be taken.

A. That is correct * * *." 1

It was alleged that the Manufacturers might, between the 17th andthe 29th, have learned of a change in the situation which made thedanger to the debenture holders less imminent; there was no indi-cation that it did so learn.136 Mr. Crosby testified:

"Q. Did you have any other communication with the Manufacturers TrustCompany between January 17 and January 29?

A. Not to my knowledge.Q. This wouldn't seem to be very effective protection of debenture holders,

would it?A. That letter by itself, of course, was not effective. It didn't do us any

good at all. We could not have acted on it.Q. It would have been impossible to have taken any effective steps?A. In time. I think that was a reply written for the record, I might say.

I never conversed with them or wrote them in any way about it. As I say, Ihad gone to Cuba and the crisis had been removed before that letter.

Q. You did, however, on the writing of that letter of January 17, visualizea real function that the corporate trustee might have performed in thissituation?

A. I didn't have any idea, frankly, * * * that they would do very much.Q. Why didn't you, Mr. Crosby?A. Probably because they had no funds, and I was not in position to give

them any funds, or furnish them with indemnity.

as d., at 786-787.' Id., at 787.


Q. Is It your experience in this matter, Mr. Crosby, that the corporate trustee

would not act unless he was indemnified by the applicant?A. It is my experience that corporate trustees will not engage in litigation

or incur expenses unless they are indemnified or see some prospect of getting

their money back.Q. Then, though they are trustees under indentures and are representatives,

In a broad sense, for the security holders they will not do it, as you say?

A. That is true. It is my understanding that their rate of compensation

is not such that would justify them to engage in litigation or take other steps

which would involve material expense or risk."

As Mr. Crosby testified, corporate trustees commonly have notexercised their fulsome powers, however pressing the emergency,unless bondholders have furnished them with adequate indemnityand have complied with the formalities of demand. But in the criti-cal times of default and reorganization, it is absolutely essential thatthe bondholders be represented. The trustee should by law be trans-formed into an active trustee, receiving compensation commensuratewith the increased responsibilities which that entails. With suchactive trusteeship the paralysis in the cases described above woulddisappear.

It is only by requiring an active trustee that investors can be rea-sonably certain that they will get what their investment entitles themto receive. Delay until a substantial percentage of bondholders gettogether, make demand upon and furnish indemnity to the trustee,may mean, for example, that rents and profits will be diverted toother interested parties. Security holders can hardly expect a metic-ulous segregation of funds for their benefit by the equity owner,unless this is insisted upon by a vigilant, active trustee: Unless thetrustee moves expeditiously to impound rents and profits, the securityholders are likely to lose them.13

For the protection of bondholders, they or their representative, thetrustee, should promptly intervene in receivership or bankruptcyproceedings of the issuer. Such intervention should be the duty ofthe trustee and the privilege of bondholders."' In the role of inter-venor, the trustee can check the disposition and segregation of oper-ating receipts; the operation of the property by the receiver or bank-ruptcy trustee can be watched; and claims against the estate can bescrutinized. At the present time, trustees sometimes do intervenein equity or bankruptcy proceedings. The fact that the trustee is aparty may preclude participation in the proceedings by individual

117Id., at 787-789.

I!, See Part III of this report, Committees for the Holders of Real Estate Bonds(1936), for further discussion and Illustration.

10 Desirability of explicit treatment of the matter in Section 77B may be Indicatedby In re 1080 North Dearborn Building Corp., 7 Fed. Supp. 896 (E. D. Ill. 1934).


bondholders.140 If the trustee, therefore, does not vigilantly partici-pate in the proceedings in the interests of the bondholders, itsintervention may be more harmful to them than helpful.

We shall hereafter analyze the motivating causes for this inertiaof corporate trustees. But aside from frequent conflicts of interestwhich tend to prevent them from being aggressive champions of therights of their beneficiaries and apart from a tradition of inactionand passivity which permeates this field, there are frequently subtlercausative factors which militate against vigorous and aggressiveaction by the trustee in behalf of all of the bonds, notes or debentureswhich it represents. This is illustrated by an incident in connectionwith the bankruptcy of Union Power Corporation, a utility holdingcompany, 4 ' and the reorganization of Federal Public Service Cor-poration, its subsidiary and an intermediate holding company. 42

Here was a case where the corporate trustee neither took actionfor the protection of the bondholders upon its own initiative norwhen requested by representatives of an independent committee.The position taken by the trustee was not simply the consequence ofcool indifference. While this may have contributed, evidence intro-duced at a hearing before this Commission indicates that majorfactors were a complacent confidence in the integrity of the principalhouses of issue, and the trustee's desire to retain the good will ofsuch houses for the sake of the business advantages which mightthereby accrue.

Union Power Corporation owned the common stock of FederalPublic Service Corporation.1 3 This constituted the chief asset ofthat corporation."' In 1928, Union Power Corporation issued$1,500,000 face amount of 6 percent secured convertible gold bonds.1

The security behind these bonds was the common stock of Federal.1 4

The trustee for the issue was the Harris Trust & Savings Bank ofChicago.147

140 See Moore and Levi, Federal Intervention I. The Right to Intervene and Reorgani-

zation (1936) 45 Yale L. J. 565, 602 ff.141 Proceedings before the Securities and Exchange Commission In the Matter of Fed-

eral Public Service Corporation (1935), at 24-25, 409. Union Power Corporation wasincorporated In 1927 under the name of Utilities Development Corporation. Id., at 14.

142 Id., at 26. The company was incorporated a few days after Utilities DevelopmentCorporation. Id., at 23-24. The two companies were formed in pursuance of a planto bring together a group of utility operating companies, the stock of which would beheld by Federal. hI., at 25-26.

dId., at 24, 760, Commission's Exhibit No. 43.'4 Id., at 417, Commission's Exhibit No. 307.' I., at 57-58, Commission's Exhibits Nos. 42, 43.144 Id., at 59, Commission's Exhibit No. 43.1'7Id., at 949, Commission's Exhibit No. 43. The trust company was also registrar

for the bonds and fiscal agent. Id., at 949-950.


These bonds were distributed by a banking group in which H1. M.

Byllesby & Co. had a 50 percent interest. 14 In May, 1932, Federal

Public Service Corporation went into receivership. 49 Prior to that

time H. M. Byllesby & Co. had obtained control of the Union Power

voting stock.9 0 The ownership of the stock, however, had been sold

by H. M. Byllesby & Co. to Utilities and Industrial Corporation,'9 '

an affiliated investment trust. 52

Representatives of H. M. Byllesby & Co. took the lead in formingthe bondholders' and noteholders' committees which in turn under-took to formulate a plan of reorganization for Federal Public

Service.'53 The plan, which was approved by the receivership courton November 15, 1933,'15 provided nothing for the common stockwhich secured the Union Power bonds. 5 On January 31, 1934,Union Power Corporation filed a voluntary petition in bankruptcy' 6

and on February 6 ,1934, the company was adjudicated a bankrupt.15

During all this time its bondholders had been without representa-tion. No committee had been formed to represent them. 58 Thetrustee in bankruptcy for Union Power Corporation reportedbut a nominal amount of assets other than the common stock of

141d., at 57-58, 74-75, Commission's Exhibit No. 42. The other houses were Bartlett

& Gordon, Inc., and Hoagland, Allum & Co. Ibid. The three houses owned control of theUnion Power Corporation voting stock. Id., at 72-73. H. M. Byllesby & Co. had nointerest in the company prior to this time. It was given 18,000 shares of the votingstock to induce it to participate In the financing. Id., at 63, 64-65. Of the remainingshares of this stock, Hoagland, Allum & Co. held 10,000 shares, and Bartlett & Gordon,Inc. and Byron T. Gifford, president of the company, each 16,000 shares. Id., at 72-73.

'Old., at 371-372.u°Id., at 482.151 Id., at 531, 533.

2-'Id., at 531, 533, 534. H. M. Byllesby & Co. owned stock representing 13.053 percent of the voting power in Utilities and Industrial Corporation (Id., at 534) and bycontract managed its affairs. Id., at 534-35. All the directors of that corporation, andall except one of Its vice-presidents, were associates of H. M. Byllesby & Co. Id., at537-539.

1 Id., at 608, 739-741, 748, Commission's Exhibit No. 177. Chairman of the bond-holders' committee was Mord M. Bogle, a Byllesby associate. Id., at 627-628. Secretaryto the committee was R. Miles Warner, a Byllesby employee. Id., at 319. AnotherByllesby associate, Howard K. Kirk, was a member of the Noteholders' Committee. Id.,at 641. Counsel for the Bondholders' Committee were Cummins, Hagenah & Flynn,counsel for H. M. Byllesby & Co. Ibid. A subsequently formed Reorganization Committeewas composed of Mr. Bogle and Mr. Bliss, Chairman of the Noteholders' Committee andvice-president and director of E. H. Rollins & Sons, Inc. Id., at 315, 857-858. Co-counselfor this committee were Cummins, Hagenah & Flynn, and Chapman & Cutler, counsel forthe Noteholders' Committee. Id., Commission's Exhibit No. 235.

1 Id., at 751. The plan was ultimately carried into effect pursuant to the provisionsof Section 77B of the Bankruptcy Act, in October 1934. Id., at 754.

155 Id., at 760.1 Id., at 916, Commission's Exhibit No. 807.

17 Ibid.RmId., at 916-918, 960-961. It was testified "that the underwriters had sent out

number of communications to the bondholders and that shortly after or perhaps In con-templation of the petition, I don't know which, a final letter had been sent out to bond-holders, advising them of this petition in bankruptcy.' Id., at 918.


Federal Public Service. 159 The liabilities in addition to the bondsincluded over $500,000 in unsecured claimsle ° of which approximately$280,000 were held by Utilities and Industrial Corporation.' 6'

The position of the indenture trustee had been one entirely of in-ertia. When inquiries were received from Union Power bondholdersduring the pendency of the receivership of Federal, the holders werereferred to H. M. Byllesby & Co., and were advised that the trusteewas in no position to give them any information. George A. Glow,an assistant secretary of the trust company, testified before this Com-mission as follows:

"Q. I infer from these letters, Mr. Glow, that when inquiries were receivedfrom bondholders, your practice was to advise them to communicate with H. M.Byllesby & Company?

A. Yes, sir.Q. And you also advised them that the trustee was not in a position to give

them any information with respect to the status of these bonds or the status ofthe Federal receivership?

A. We felt that H. M. Byllesby sold the issue-I don't think sold It, but thatthey were in a position to give them first-hand information which we didn'thave." la

It was the view of the trust company, based upon advice of counsel,that in the absence of demand and indemnity furnished by the bond-holders in accordance with the terms of the indenture, the trusteewas not even under the obligation to keep itself advised as to theprogress of the Federal reorganization. Mr. Glow testified:

"Q. Would you say, Mr. Glow, that the trustee of Union Power bonds, whichwere secured by this common stock, had any duty to keep itself advised as tothe progress of the Federal reorganization during the period of its receivership?

A. Just as much duty as is outlined in the indenture under which we wereacting as trustee.

Q. Do you recall any examination of the Trust Indenture being made toascertain those duties?

A. Yes, I think we did.Q. And what conclusion did you reach with respect to any duty you might

have with regard to receivership?A. We had conferences with counsel and were advised that there wasn't

anything for us to do unless the bondholders came in and requested us to doit in accordance with the terms of the indenture.

'IOd., Commission's Exhibit No. S07.GO ftbi.'m Id., at 531-533, 926-927, Commission's Exhibit No. 167. The balance of these claims

was held principally by E. H. Rollins & Sons. Id., at 528, 938; Commission's Exhibit No.166. H. M. Byllesby & Co. also held an unsecured claim. Id., at 927. In addition,Utility and Industrial Corporation and H. M. Byllesby & Co. owned the various securitiesof Union Power Corporation and Federal Public Service Corporation. Id., Commission'sExhibit No. 167.1 2Id at 954-955.


Q. And the provision of the indenture you have In mind now is the provisionwhich requires the trustee to act at the request of twenty-five percent of thebondholders and furnishing indemnity to the trustee?

A. That is right." '

This policy of complete inaction continued when the trustee wasadvised that filing of the bankruptcy petition was contemplated.Mr. Glow testified further with respect to this matter:

"Q. I show you, Mr. Glow, a copy of office correspondence of the Harris Trust,dated August 3, 1933, addressed to you. This states:

'Mr. Hansen of the above named company', (referring there to Union PowerCorporation) 'called me this afternoon advising that they are having a meetingof their Board tomorrow to consider winding up this company's affairs.'

The document then goes on to say: 'Mr. Hansen asks that we consider thismatter and also advise who would be satisfactory to us as counsel and astrustee. He would like to hear from us by tomorrow noon.'

Then as a last notation: 'W. H. Milsted, dated 8-4-33'. It states: 'I talkedwith Hansen and advised him that we didn't feel as though we should enterinto the arrangements'.

And under date of August 10, 1933, over your signature, is the statement:'Bob Farrell advises us not to make any recommendation or suggestion inregard to this matter. If the company wants to file a petition in bankruptcy,that is its affair and not ours as trustee.'

Do you recall Mr. Hansen making any suggestions to you, Mr. Glow?A. Yes, sir.Q. As stated in this document, the trustee's decision, upon advice of counsel,

was not to take any steps with regard to proposed bankruptcy of UnionPower?

A. I think that is correct." 16

As shown by the following testimony, subsequent to the filing ofthe bankruptcy petition, the trustee continued to take no actionitself in regard to inquiries from bondholders:

"Q. Did I understand you to state that during the period preceding, theHarris Trust had taken no steps with respect to the Federal reorganization?

A. That is right.Q. Now, our record shows, Mr. Glow, that the voluntary petition in bank-

ruptcy for Union Power was filed under date of January 31, 1934. I showyou two letters, apparently sent out by yourself * * *. Both of these letterswere in response to inquiries with regard to the Union Power bonds. In bothletters the inquirer was referred to H. M. Byllesby & Company. Do yourecall that subsequent to the bankruptcy of Union Power Corporation it wasthe policy of the trustee to refer inquiries to H. M. Byllesby & Company?

A. I think we did. We tried to refer them to them and to the trustee inbankruptcy.'

The extent of the trustee's activity during this period was to havecounsel file a claim in behalf of the bondholders, advise the bond-

"' Id., at 955-957.' Id., at 957-958.

laId., at 955-99


52

holders that they should file their claims individually, because therewas a question as to whether the claim filed by the trustee was valid,and to ask counsel "to follow the situation." 166

But as we have stated, the trustee pursued its policy of non-actioneven after representatives of the bondholders had requested that itcooperate with them and even to the point of refusing to resign inorder that the appointment of a more cooperative trustee might beobtained.

In the early part of 1934, Kenneth Teasdale and Francis X. Pave-sich, of St. Louis, Missouri, the latter a holder of Union Powerbonds, with the assistance of Edgar J. Schoen, a Chicago attor-ney, took steps to form an independent committee. 167 Meetings ofthe bondholders were called, and representatives elected to serve onthe committee."'

Under date of April 4, 1934, Mr. Pavesich, as a bondholder, madethe following demand upon the Harris Trust and Savings Bank:

"As you undoubtedly know, Union Power Corporation has filed a voluntarypetition in bankruptcy and reorganization plan pending in the United StatesDistrict Court, in equity of Federal Public Service Corporation, makes noprovision whatever for recognition of the common stock of Federal PublicService Corporation held as security for the foregoing issue. The status ofthis matter Is such that unless you take immediate and vigorous action forthe protection of the rights of the undersigned and other bondholders of theUnion Power Corporation whereof you are Trustee, we, the bondholders, willlose practically the entirety of our investment in this issue. I therefore callupon you as Trustee to take immediate action to prevent the consummationof the reorganization plan of Federal Public Service Corporation withoutrecognition of the rights of the common stock of that corporation, and such otheraction against third parties as a careful and prudent trustee would take inview of the condition of affairs of the Union Power Corporation as disclosedby the petition in bankruptcy and proceedings therein."'"

The trustee's response, as testified to by Mr. Schoen, was "Along thelines that if they were properly indemnified by a sufficient numberof bondholders, they would be more than pleased to take whatever

16 Id., at 963-964, 967-968. It appears that counsel for the trustee reported that "Anexamination of the files in the referee's office, including the Schedule of Assets and Liabil-ities, indicates no likelihood of any distribution to creditors." Id., at 963, Commission'sExhibit No. 337. Mr. Glow also stated in an inter-office memorandum that "Our counselfeels that the common stockholders in Federal should not be entitled to participate In theplan of reorganization of their own company for the reason that Its outstanding debtappears to be much greater than the value of its assets." Id., at 965, Commission'sExhibit No. 338.

2671 ., at 917.IN Id., at 918-919. The committee was eventually composed of Francis X. Pavesich,

A. H. Pitts, and Edgar B. Morse. Id., at 922. Mr. Schoen and Mr. Teasdale were namedas counsel. bid. Hugo Herring was secretary, and Mr. Pavesich also performed secre.tarial services.

'wId., Commission's Exhibit No. 317.


action we wanted them to take." 170 This was elaborated upon byMr. Glow, as follows:

"A. Well, I think he and Mr. Teasdale called one day and they had someideas that certain things should be done and I asked them what they were,and they said they weren't in a position to tell me. They felt somebody haddone wrong somewhere down the line and they wanted to know whether wewould institute proceedings of some kind. I didn't know what they wanted.

Q. Did they suggest that an investigation be made to determine whetheror not there was a basis for any proceedings being taken?

A. I don't recall whether they suggested that or not. I think they hadapparently made their investigation and were telling me in so many wordsthat something should be done by the trustee and if it wasn't done, they weregoing to do it, and I told them that we would be glad to do anything thatthe bondholders wanted us to do.

Q. Did you state, however, that before you would take any such action itwould be necessary that a request of twenty-five percent of the bondholdersbe made?

A. Yes, sir.Q. And that Indemnity be furnished?A. Yes, sir.Q. And what was the response to that statement?A. They seemed to feel that-they told me that the bondholders were all

broke and couldn't afford to put up any indemnity and couldn't afford topay our fees or charges and they said they assumed that we would hire ourown counsel, whose fees would be real high, and if we let them act as ourcounsel, 0. K. I said, well, I didn't know, I would have to take it underconsideration and I advised them in the afternoon that we would be gladto take any action that the holders of the required amount of bonds wouldask us to take, and employ our own counsel. With that they got up andwalked out-that was the end.

Q. Did you tell them in the afternoon that it would still be necessary thatindemnity be furnished?

A. Yes, sir. If I didn't tell them in the afternoon, it was so plain in themorning that I don't think they forgot it in the afternoon." 171

According to Mr. Glow, Mr. Schoen and Mr. Teasdale then askedif the trustee would resign:

"Q. And it was subsequent to this position being taken by the Trust Companythat they demanded that the Trust Company resign as trustee?

A. They asked me if we would be willing to resign. I told them I didn'tknow. If the bondholders insisted on it, there wasn't anything else we coulddo, and we would be glad to go along with the wishes of the bondholders." 172

Following this episode the committee circularized the bondholdersasking that they sign a demand for the removal of the trustee anda power of attorney to Mr. Pavesich and Mr. Herring, secretaries to

1701d., at 933.171 d., at 961-963.172Id., at 963.


54

the committee, to appoint a new trustee.1 7 Mr. Schoen testified tothe committee's reasons for taking this step:

"Q. Mr. Schoen, why were you demanding the removal of the Harris Trustand Savings Bank?

A. Because I felt that I-I will have to answer that question rather in alengthy and complicated way. I was very much dissatisfied generally. In thelast few years in regard to corporate trustees, I find in trust agreements asthey are drawn, a great number of exculpatory provisions exculpating the banktrustees from liability and enabling them to avoid liability by sitting by anddoing nothing, and I felt under the circumstances this particular case was oneof those cases where the Harris Trust and Savings Bank with whom I have,by the way, a good deal of confidence as a bank, in this committee had reliedupon its exculpatory provisions in the trust indenture and instead of goingactively into the Federal Public Service equity receivership and representingthe bondholders of Union Power Corporation had sat idly by and done nothingto protect their interests." 174

The. trustee would not cooperate with the independent committeeas they requested. It refrained even from referring inquiring bond-holders to the committee. Mr. Glow testified as follows:

"Q. Did you refer any inquiries to the Independent Bondholders Committee,Mr. Glow?

A. No, sir."

"Q. You knew that Mr. Schoen was active?A. Yes, sir.Q. You didn't refer any inquiries to Mr. Schoen, did you?A. No.Q. Why was that, Mr. Glow?A. Well, because of the attitude he took when he called on us and wanted

us to resign as trustee." "'

But while the trustee was unwilling to take any action along thelines desired by the committee, the trustee in bankruptcy for theUnion Power Corporation apparently felt no similar sense of re-straint. Fred L. Hummel, the trustee,'7 6 filed. a claim in the equityreceivership of Federal. 177 Before final action was taken on theclaim, a settlement was reached with H. M. Byllesby & Co. and theparties in interest on behalf of the Union Power bondholders.'"7

's Id., at 931-932, Commission's Exhibit No. 316.17 Id., at 932.1 Id., at 960-961.176 At the creditors' meeting neither the nominee of Utilities and Industrial Corpora-

tion nor of bondholders represented by Mr. Schoen, received the requisite number of votes.Mr. Hummel was appointed by the referee. Id., at 925-928.

77 1d., at 934-935, Commission's Exhibit No. 318.' The settlement which was approved by the bankruptcy court in the Union Power

proceedings (Id., at 939), provided, in substance, that the Byllesby and Rollins interestswaive their claims against Union Power Corporation, totalling over $500,000; that 15,000shares of common stock of the successor corporation in reorganization to Federal beturned over to the trustee In bankruptcy of Union Power Corporation; and that the bankerspay the out-of-pocket expenses of the committee and the committee's attorneys' fees.1d., at 938-939, Commission's Exhibit No. 321. The trustee in bankruptcy also received


In effecting this settlement, the corporate trustee played absolutelyno part. The agreement was reached solely as a result of the effortsof the trustee in bankruptcy, his attorney and representatives of thebondholders committee. 1 79

Upon the actual merits of the claim that was filed by the trustee inbankruptcy and upon the question whether, if pressed to trial, theclaim would have been enforced, we are in no position to express anopinion. As filed, it was based upon various charges of mismanage-ment and financial jugglery directed against the management of thecompanies and the bankers.18 0 One charge in particular should bementioned, however, since, in itself, it bears closely upon the problemof non-action by the trustee.

The offering circular for the Union Power bonds emphasized thepoint that all the common stock of Federal would be pledged assecurity for them,'" but no mention was made in the circular of thefact that additional securities could be issued superior to that commonstock.'82 The circular contained the following statement:

"The trust agreement under which the 6 percent Secured Convertible GoldBonds will be issued will provide that the company shall not create any addi-tional funded debt unless the consolidated net income of the corporation asdefined in said trust agreement shall be at least twice the annual interestrequirements on the total funded debt of the company then outstanding includ-ing that about to be issued." "'

But the limitation was construed by the company and its bankers toapply to the funded debt of the Union Power Corporation alone.

2,039 shares of the common stock of the successor corporation of Federal, according tothe terms of the reorganization, In settlement of a general claim Union had against Federal,Id., Commission's Exhibit No. 323. Each Union Power bondholder received, per $1,000bond, 13 shares of common stock represented by voting trust certificates of the new company (American Utilities Service Corp.) and a 1 percent cash dividend. Id., at 945-946,Commission's Exhibit No. 323. Contributions which had been received by the committeefrom the bondholders were returned. I., at 944-945.

Before the settlement was reached, the committee was also planning to bring fraudactions against the underwriters and to Intervene in behalf of the bondholders. Id.,Commission's Exhibit No. 320. The bondholders were advised that the benefit of suchaction would inure only to those joining in it. Id., at 931, Commission's Exhibit No.321. Among the factors which, it appears, influenced the committee to accept the settle-ment were the weak response from the bondholders, the interests of a number of bond-holders in Federal securities (including Mr. Pitts, a member of the committee) andtheir anxiety that these holdings not be disturbed. Id., at 942-944.

10 Id., at 938-944.180 Id., at 935-937, Commission's Exhibit No. 318."I Id., at 422, Commission's Exhibit No. 43.'8 Mr. Briggs, vice president of H. M. Byllesby & Co., testified:"Q. In the circular, then, Mr. Briggs, the point was emphasized that all the common

stock of Federal would be pledged for these bonds, was it not?A. That Is right.Q. But there was no mention made of the fact that Federal could issue additional

securities prior to that common stock? That is correct?A. No mention made in the circular you mean?Q. Yes.A. That is right." Id., at 422-423.'Id., at 416, Commission's Exhibit No. 43.


The claim filed by the trustee in bankruptcy asserted a priorityin behalf of the Union Power bonds over bonds, notes and preferredstock of Federal issued subsequent thereto, based upon this repre-sentation and the transactions which followed.18 ' When the UnionPower bonds were offered, Federal had outstanding, in additionto its common stock, $4,400,000 face amount of first lien gold bondsand 15,000 shares of 61/2 percent cumulative preferred stock.'8 5 Inany liquidation or reorganization, of course, these securities wouldrank ahead of the common stock which was owned by Union Powerand was pledged to secure the bonds. As the Federal system ex-panded, additional bonds and shares of preferred -stock were issued,as well as notes, all entitled to the same preference. 18 When Fed-eral went into receivership, its outstanding securities had been in-creased to $10,500,000 face amount of the bonds, $7,000,000 faceamount of convertible 6 percent gold notes, and 35,455 shares ofthe preferred stock.8 7 Except for the bulk of the preferred stockwhich had been sold through the medium of customer-ownershipcampaigns, 88 the securities were distributed principally by H. M.Byllesby & Co. and E. H. Rollins and Sons.' s

J. H. Briggs, vice-president of H. M. Byllesby & Co., testified be-fore this Commission as follows:"Q. * * * My question was this: What protection is that limitation to

the Union Power bondholders if Federal could create funded debt which wouldrank prior to the bonds of Union?

A. Well, if Federal issued bonds, they must have issued them for some-thing-property or something which would bring in return, bring in earnings,and going on the theory that Federal Public Service bonds were getting aproportional amount of earnings to cover.

Q. If this limitation did not appear in the Union Power indenture, and ifin the absence of such limitation Union Power had created an additionalfunded debt, there would be the same presumption, would there not, thatUnion Power had received something in return?

A. That is right. * * *Q. Mr. Briggs, didn't the fact that Federal could issue additional securi-

ties, cutting under the security behind the Union Power bonds make thisprotection in the Union Power indenture entirely void?

A. No.Q. Why didn't it?A. If a man buys this type of bond he is on notice that the subsidiary com-

pany underneath can issue bonds and notes on their indentures.

184 Id., Commission's Exhibit No. 818."I Id., Commission's Exhibit No. 48.121 Id., at 417-418, 809.mId., Commission's Exhibit No. 229.

3m Id., at 92 et seq.1MId., at 438, 461-463, 467, 493-494, 496-497, 506-507, Commission's Exhibits Nos.

138, 140, 144, 147, 152, 154, 155, 162. The other banking houses participating in thevarious distributions of these securities as original houses of Issue were Bartlstt & Gor-don, Inc., Hoagland, Allum & Co. and Central Illinois Company. /bid. For a period oftime, Rollins shared joint control with Byllesby of the Union Power voting stock, Id., at4T4-475, 477-478.


57

Q. So that a purchaser of these bonds should have foreseen this possibility,

you believe?A. Which possibility?Q. That Federal might Issue additional securities beneath the security be-

hind the Union Power bonds?A. He knew at the time he bought the bonds.Q. He knew what?A. That the subsidiary company could issue bonds and notes under the terms

of their indentures.Q. Let me show you the earnings statement set forth in this circular, Mr.

Briggs. Is that the earnings statement for Union Power Corporation alone, or

is it an earnings statement set up on a consolidated basis?A. It definitely says 'Comparative consolidated earnings of the company and

its subsidiaries.'Q. Does that show the funded indebtedness of Federal Power?A. The earnings statement does.Q. It shows Federal Power had outstanding $4,400,000 of first lien gold

bonds?A. That Is right.Q. It also shows Federal had outstanding preferred stock?A. That is right.Q. Is there any statement in that circular that Federal could Issue addi-

tional bonds?A. There is no direct statement to that effect.Q. Is there any statement in there, direct or indirect, that Federal could Issue

notes?A. No, there is not.Q. Or preferred stock?A. Nor preferred stock."

Furthermore, no mention was made in the circular of the following

provision contained in the trust indenture securing the Union Power

bonds:

"Nothing in this section contained shall be deemed to prohibit the issuance

and sale to the public by the Federal Public Service Corporation of any class of

stock (other than common stook), notes, debentures, bonds and any other

securities whatsoever, except as expressly prohibited in this section, providedthat the proceeds thereof shall represent the fair market value of such stock

and/or securities and shall be devoted to proper corporate purposes of the

Federal Public Service Corporation. The trustee shall have no responsibility

to ascertain or to see to It that such proceeds represent the fair market value

of such stock and/or securities or that such proceeds are devoted to proper

corporate purposes of Federal Public Service Corporation." 1

Mr. Briggs testified further:

"Q. Did the offering circular, Mr. Briggs, disclose the provisions of these

two paragraphs?A. I don't think It was necessary.Q. Did it disclose it?A. It did not.

-I., at 419-422.In x4., at 424.


58

Q. So that purchasers of these bonds were not advised of the express pro-vision In the trust indenture that the Federal could issue these additionalsecurities cutting in behind the Union Power Corporation?

A. They were not specifically advised of that." 1

The corporate trustee had apparently accepted the trust withoutfirst insisting that these matters be clarified in the offering circular.

As we stated at the outset, major factors contributing towardsthe attitude of the corporate trustee were a complacent confidence inthe integrity of the principal houses of issue, and its desire to retainthe good will of these houses of issue for the sake of the businessadvantages which it might thereby receive.

When the trust was first offered to the company, M. A. Brown,a vice-president, made the following recommendation:

"With Byllesby & Company and its associate Bartlett & Gordon holding allthe common stock of the Union Power Corporation, which is the holding com-pany for the Federal Public Service Corporation, I recommend that we acceptthe trusteeship as offered."

Mr. Glow testified that he did not know why these circumstancesshould be a factor in the trust company's decision to accept thetrusteeship.9 4 But on cross-examination by counsel for the trustcompany, he testified:

"Q. * * *. You were asked by counsel whether the fact that H. M.Byllesby and Hoagland AllLm and these other houses of origination broughtthis piece of business into the bank had anything to do with your acceptingthat trust?

A. I think it did. We, as bankers, had always enjoyed confidence in thosefirms and that was one reason why we take that kind of business on, if itcomes In through a reputable firm.

Q. Has your bank done business with H. M. Byllesby & Company?A. As long as I have been there we have had some issues for which we acted

as corporate trustee which we have handled.Q. Your reluctance to take much stock in what Mr. Schoen had to say in his

accusation was founded somewhat, was it not, on the confidence that you hadin H. M. Byllesby & Company?

A. Yes, sir.Q. Did you or did you not feel that the charges were unfounded?A. I felt they most likely were unfounded. That was my personal opinion.Q. I have one more question, Mr. Glow: Did you have any previous experi-

ence with Mr. Schoen?A. We did have an experience with him a year or so before that.Q. Was that experience satisfactory?A. No, sir." "

"2 Id., at 424-425.'9' Id., at 452, Commission's Exhibit No. 329.

Id., at 452-454.I95 jd., at 973-474.


And the further influence upon the positiop taken by the trustee inthis case of its interest in obtaining future business from these invest-ment houses is indicated by the following testimony of Mr. Glow:

"Q. Now I understand you to testify in cross examination that-and I wishyou would correct me if I am wrong-one of the reasons which doubtlesslymotivated the Harris Trust in accepting the trusteeship for the Union Powerbonds was its confidence in H. M. Byllesby & Company and the underwriters ofthose bonds. Is that correct?

A. That is correct.Q. I also understood you to say that Harris Trust had been trustee for

other issues of H. M. Byllesby & Company?A. Issues that they handled.Q. Issues that they handled. Did Harris Trust become trustee under these

various issues subsequent to the time it assumed the trusteeship of the UnionPower bonds?

A. There might have been some since then, but I don't think so. There weresome before.

Q. Some before and probably some since?A. I am not sure. We were before, I know that.Q. At the time you took this trusteeship you contemplated that you might

become trustee for future issues with respect to Byllesby, Bartlett & Gordon,Hoagland Allum?

A. Well, we always hoped to be considered trustee.Q. You were anxious to build up your Trust Department and you were

anxious to be in a position to obtain additional business from these investmentbankers?

A. Just like any others.Q. You are still interested in getting some business from these investment

bankers?A. I assume we are. That is always passed on by the executive officers of

the bank, as I said before.Q. And I understood you to say that you were inclined to believe that Mr.

Schoen's charges were not true?A. I didn't know of any basis why they should be true.Q Did you make any investigation as to whether or not they were true?A. No." 10

The trustee, of course, as appears above from time to time, hadbeen taking the advice of counsel. Its counsel was Robert Farrell,of the firm of Chapman & Cutler. 19 This firm was also counselfor the Noteholder's Committee for Federal Public Service Corpora-tion.198 That the interests of the Federal noteholders and theUnion Power bondholders were adverse is obvious.99

But there was nothing in the conduct of the trustee in this matterwhich was peculiar to this case. Mr. Farrell took pains, upon cross-

"Old., at 976-977.'Id., at 963-964.

"'Id., at 859.1I., at 974-976.

75957*-36- 5


examination, to bring out the facts that the Harris Trust & SavingsBank in its acceptance of the, trust, in its relationship with the housesof issue, in its attitude toward the bondholders, in its non-action, inits retention of counsel representing interests in conflict with theinterests of the beneficiaries of its trust, was but acting in accordancewith the settled practices of corporate trustees. In this cross-exami-nation Mr. Glow testified:

"Q. Your department has never done an extensive business as corporate

trustee, is that true?A. Well, not as large as some of the other trust companies.Q. Your acceptance of trusts has been based upon what you felt, after investi-

gating the situation, was a good, honest trust?A. Yes, sir.Q. And it is for that reason that you haven't been as large a factor in that

field in Chicago as some other banks?A. That Is right.Q. Now, when you have a default In any issue under which you are trustee,

isn't it the practice to refer those inquiries to the house of origination?A. That is right.Q. That was nothing peculiar in this situation that led you to recommend

them to H. M. Byllesby?A. That is right.Q. You testified that you didn't know much about the committee, but you

knew about Mr. Schoen. He was in frequently on this question, wasn't he?A. Yes, sir.Q. He asked the bank to resign as trustee?A. Yes, sir.Q. However, he expressed the willingness, did he not, to go right along with

you as trustee if he was counsel?A. That is right.Q. As long as he was going to run the show you were all right?A. If we would do as he told us to do, it was all right."Q. Now, it is not customary for trust companies to start law suits against

banking houses and individuals just because you are asked to, is it?A. No, sir.Q. The reason that you require indemnity, as I understand it, is that any-

body may come in with a charge or grievance against some particular houseof issue and instead of starting such a suit even though it is requested by thetwenty-five percent of the bondholders, the bank must protect Itself againstcountersuits. Is that the reason for the indemnity?

A. Yes, sir.Q. Did you have any reason to believe that the charges that were made by

Mr. Schoen's committee were true?A. No, sir.

2W With reference to the question of his suggesting to the Harris Trust & Savings Bankthat he act as its counsel, Mr. Schoen testified :

"* * * Mr. Pavesich and myself had a conference with Mr. Glow, as I recall it,and I believe in that conference I did offer Mr. Glow the benefit of whatever informationwe had and possibly the benefit of my services, but I am not definite on that point." Id.,at 934.


Q. Isn't It the policy of your Trust Department in situations of this characterto always file a claim on behalf of all the bondholders as trustee?

A. Yes, sir.Q. Wherever the court will permit?A. Yes, sir.Q. It is true that my firm was counsel for the bank and at the same

time counsel for this Noteholders' Committee. That is not an unusual situa-tion, is it?

A. No, sir.Q. The fact that any particular counsel might represent your bank and also

somebody else in interests rests entirely upon what you believe the integrityof that firm to be?

A. Yes, sir.Q. Is it usual for trustees, when a default occurs, to delve into the financial

condition of the company and find out what caused the default or whatpossible plans of reorganization might be made for the profit of your business?

A. Not to my knowledge."

Here, as elsewhere, the necessity is not for greater powers, but forpowers coupled with duties and responsibilities. Unless the obliga-tions of active trusteeship are imposed, these subtle influences offriendship and business relations are almost certain to conditionthe quality of the trustees' performance and to make the trustee atimid and ineffective representative of the security holders. Inany event, the requirement is for an independent and aggressivechampion of the interests of security holdcrs. Accordingly, the trus-tee should be required to act with that vigilance and thoroughnesswhich it could be expected to exercise if it were protecting its owninvestment.

G. PROTECTION OF MINORITIES

As we have noted above, the trustee normally will not act unlessrequired to do so by demand of a specified number of the securityholders as prescribed in the indenture. One function, therefore,of protective committees is to marshal a sufficient percentage ofthe securities to make this demand, furnish indemnity and forcethe trustee to act. Protective committees are, of course, expensive.They cannot act with the economy and efficiency of a single, con-tinuing agency like the trustee. Nevertheless, they must exercisethe surveillance and vigilance and perform some of the functionswhich the trustee might, but under existing practice does not, pro-vide. Laurence A. Crosby, continuing his testimony in the CubaCane hearing before this Commission, discussed this:

"Q. * * * we were speaking about the reasons why this debenture com-mittee was formed. Did it occur to you or any of the people with whom youwere conferring relative to the Cuban Cane Products situation that the

101 Id., at 970-973.


trustee rather than the committee was the proper agency to do the things thecommittee was trying to do?

A. The committee was trying to find some measure or means or device

or plan by which these debenture holders would have an opportunity to retain

or regain their property.Q. Yes, why wasn't the trustee the logical person to take up such matters?

A. I don't think under the existing system of corporate trusteeships that

trustees do that sort of thing. As a theoretical matter it may be possible

to have a trusteeship that would do that sort of thing, but I think it would

have to be set up on a different basis from existing trusteeships.

Q. It would have to be set up with the trusts that were active ratherthan otherwise?

A. Yes, I wouldn't expect banking institutions to undertake functions like

that except on the basis of general indemnification or higher compensation,

or some other basis than that which now exists. Corporate trustee fees are

comparatively modest. They do not cover discharging functions of this sort

and are not so generally understood." "'

This inactivity of the trustee generally leaves minorities unrepre-sented. Protective committees seldom represent all bondholders.They may represent only a majority, or that amount necessary tocompel the trustee to act. They make no pretense of acting for

bondholders who do not deposit with them or authorize them tospeak on their behalf. Nevertheless, their activities affect theminority whom they do not represent as well as the majority.

Indeed, if the minority bondholders do not constitute a sufficient

percentage of the bonds to compel the trustee to act, they may be

absolutely at the mercy of the protective committee. Under certainindentures it may be that they cannot even bring suit to collect the

money which the issuer owes them on their securities. In Allan v.Moline Plow Co., 203 a "voluntary reorganization" was effected by the

corporation. But one of the noteholders refused to acquiesce in this

change of his security. The indenture provided that the trustee

in its own name might sue upon default. It also provided that no

noteholder could sue unless the trustee refused to do so after de-

nand by holders of ?5 percent of the outstanding notes. But over

90 percent of the noteholders had accepted the plan, and there wasno possibility of the dissenter's complying with this provision. So

the minority noteholder brought suit directly to collect the amountwhich the company had promised to pay on his notes. The CircuitCourt of Appeals held that he had no right to bring suit in faceof the indenture provision.

Elsewhere in this report the "voluntary reorganization" of The

Baldwin Locomotive Works in 1933 is described. Here again, a mi-

nority noteholder dissented and sought to bring suit on his notes.

The majority had deposited their notes with a committee; demand

upon the trustee by the necessary percentage of noteholders was

2-2 op. cit. supra note 131, at 792-793.-30 14 F. (2d) 912 (C. C. A. 8th, 1926).


63

a physical impossibility; and the company interposed as a defense

the doctrine of the Moline Plow case.2 4

Thus, by virtue of indenture provisions, the dissenter may be re-

mitted to the mercy of a protective committee and the majority.

The fate of minorities cannot fairly be left in the hands of major-

ities and protective committees without control or restraint. In

order that reorganizations may be affected, some coercion may have

to be exerted upon minorities. But it does not follow that the power

to coerce should rest, unchecked, in the hands of the majority. This

is just as inequitable as it would be to provide that a majority of

the partners in an enterprise may dispose of the minority's rights

without restraint or supervision.From this point of view, the trustee could well be expected to scru-

tinize the provisions of a reorganization plan, to see that it is fair

and that it provides adequate protection to minorities. It could beexpected to insist that minorities be allowed a reasonable time withinwhich to accept the proffered exchange, and that the conditions prece-dent to such acceptance be fair. This is occasionally done by thetrustees. One of the returns which Guaranty Trust Company madeto the questionnaire which this Commission sent to corporate trusteesstated in response to a question as to the steps taken by it on andafter default:

"The plan of reorganization did .not appear to us to offer sufficient cash pay-ments for those bondholders who did not participate in the plan and who, if

they did not accept stock within a year, were deemed to have elected to acceptthe cash payment.

"As a result of our suggestions, the Debtor agreed to insert in the proposedorder a provision reserving jurisdiction in the court to consider the fairness

of extending it one year within which a borrower might elect to take- stock orcash for a good cause shown and the order was so entered." 20

This was a 77B proceeding. Even greater necessity appears forsuch action in case of "voluntary reorganizations" where the minorityis not protected by any judicial or administrative agency. In suchcases the trustee should be expected actively to represent the minorityin negotiating a plan. It could be expected to intervene in the reor-ganization proceedings and inform the court of its opinion Of thefairness of the reorganization plan. 0 It could be expected in equity

m Gellert V. Baldwin Locomotive Works, 3 F. Supp. 812-813 (E. D. Pa., 1933) ; andsee op. cit. supra note 13, Commission's Exhibit No. 54, at 16.

205 Section 4, Item 1, of the questionnaire set forth in Appendix A, infra.2 As co-author, with John W. Kearns, of an article in 61 Trust Companies (1935) 111,

at 113, on Corporate Trusteeship and 77B, Robert L. Grinnell, Corporate Trust Officerof the First National Bank of Chicago, states : "Section 77B makes no express provisionfor indenture trustees as such, being heard with respect to the fairness of a plan. How-ever, were a trustee convinced of its unfairness, it would seem to be its duty, moral notlegal, and the course of ordinary common sense, to see that its criticisms were broughtto the attention of the court charged with the responsibility of passing on the fairness


64

receivership reorganizations to scrutinize the price at which theproperty is "sold" at judicial sale, and to recommend an upset pricewhich, while permitting reorganization where justified, will not de-prive dissenters of a fair cash alternative to the new securities offered.

In this latter connection the interests of a protective committeeare in sharp opposition to those of dissenters. Thus, in reorganiza-,tions by means of foreclosure and equity receivership, the judicialsale provides the basis for calculating what a dissenter will get. Iffor no other reason, committees will be driven by the pressure ofeconomic necessity to make the lowest possible bid, in order toavoid burdening themselves with large cash requirements with whichto pay the dissenters' share of the sale price.2°7 With respect to realestate bond issues, the same condition prevails. This was affirmed bycounsel to bondholders' committees who testified before this Com-mission.

20 8

Here the trustee alone can protect the minority by taking anactive part in the proceedings, or in negotiation with the committee,to the end that the fairest, and not the lowest, price is obtained.In practice, however, the trustee's customary inertia suffices to keepit a nominal figure. Harold Moore, trustee for many of the bondissues sold by the American Bond & Mortgage Company, and a for-mer executive of that company, testified as follows before thisCommission:

"Q. You felt that American Bond & Mortgage owed an obligation to thesenon-depositing bondholders and that you, as trustee, owed such obligation?

A. Yes, I thought that the same responsibility which we had to the others,we had to all.

of the plan, and to the attention of the sponsors. If the criticisms are well founded,that should be sufficient."

Section 77 of the Bankruptcy Act grants expressly to trustees a "right to be heard onall questions arising in the proceedings", but "may be permitted to intervene" "uponpetition therefor and cause shown." 11 U. S. C. A., Sec. 205 (C) (13). Thus, the rightto intervene, as distinguished from an opportunity to be heard, is left to the discretion ofthe court. In re Denver d R. G. Western R. Co., 13 Fed. Supp. 821 (D. Colo. 1936) ; Inre Missouri Pacific R. R. Co. (E. D. Mo. 19,34), CCH Bankr. Law Serv., Par. 2291.01.And though a mortgage trustee was permitted to Intervene generally in the Denver &R. G. Western R. Co. case, In the Missouri Pacific case the court permitted . mortgagetrustee to intervene but specially.

Section 77B is less specific. The pertinent subdivision Is applicable to "any creditor orstockholder"; trustees are not expressly included. 11 U. S. C. A., Sec. 207 (C) (11).The right to be heard is limited to "question of the permanent appointment of any trus-tee" and "the proposed confirmation of any reorganization plan." Ibid. The subdivisionthen vaguely provides for a right to be heard "upon filing a petition for leave to inter-vene, on such other questions arising in the proceeding as the judge shall determine."Ibid. Intervention has been denied a trustee to contest the jurfsdiction of the court andto defeat the petition. In re 1030 North Dearborn Building Corp., 7 Fed. Supp. 896 (E. D.Ill., 1934) ; see Note (1936) 49 Harv. L. Rev. 1111, 1160. As indicated earlier In thisreport, the matter should be explicitly covered In Section 77B, rather than vaguely as atpresent. The trustee has been denied the right to vote on questions concerning the re-organization plan under Section 77B. In re Allied Owners' Corp., 74 F. (2d) 201(C. C. A. 2d, 1934). See (1935) 2 U. of Chic. L. Rev. 644.

07 Weiner, Conflicting Functions of the Upset Price in a Corporate Reorganization(1927) 27 Columbia L. Rev. 182, 139.

O Op. oit. a upra note 96, at 257S-2579.


Q. Well now could you state for the record, Mr. Moore, what either Ameri-

can Bond & Mortgage, or you as trustee, did in fulfillment of that obligation

to the non-depositing bondholders?A. I don't think that we did anything beyond our contributing our best efforts

to see that all the bondholders were notified and given an opportunity to deposit."* * * $ * * *

Q. Did you as trustee ever appear in Court and argue against confirmation

of a sale on the ground that the committee had not bid enough?A. No, sir.Q. Did you ever appear at the foreclosure sale as trustee and bid in com-

petition to the committee or other bidders with a view to getting a largerdistributive share for your non-depositors?

A. Well now I don't have any recollection of doing that.""

If inertia was not enough to inhibit action, the self-interest ofmost trustees in this field destroyed what slight possibility mighthave remained of adequate representation of dissenters. Substan-tially all of the trustees for real estate issues distributed by thelarge underwriting houses were officers or affiliates of these under-writers. And the latter, as elsewhere described in this report,210 fre-quently held junior and equity claims adverse to those of the firstmortgage bondholders. Because of this, it is doubtful that thesetrustees could be impartial advocates of any bondholders' cause,whether in the majority or minority. And their fitness was definitelynot aided by common employment of the same counsel by the com-mittee and the trustee. This is a practice usual in, but not peculiarto, the field of real estate bond reorganization.1- Obviously, it isa deterrent to vigorous action by the trustees in behalf of dissenters.

At times the protection of the bondholders will require that thetrustee file proof of claim for them in the bankruptcy or receivershipproceedings, lest these claims be lost. The activity of GuarantyTrust Company in one ordinary bankruptcy proceeding where boththe issuer and the guarantor of the bonds were adjudged bankruptsis contained in a reply to the questionnaire which this Commissionsent to corporate trustees:"* * * We then filed a blanket proof of claim on behalf of the bond-

holders in both the obligor's and the guarantor's bankruptcy proceedings. Ob-jections were raised to both proofs of claim. The referee in bankruptcy sus-tained the allowability of the proofs of claim in both bankruptcy proceedings.No appeal was taken from the decision in the issuer's bankruptcy proceedings,but an appeal was taken to our proof in the guarantor's proceedings. Ourclaim was finally approved in the Federal Circuit Court of Appeals aftermuch litigation. This litigation was very important since at the time It wasone of the first cases where the right of the trustee to file a blanket proof ofclaim in bankruptcy on behalf of the bondholders was definitely upheld. The

2Id., at 2293-2294, 2295-2296.10 Part III, Committees for the Holders of Real Estate Bonds (1936), at 93 st aeq.I lnfra, at 73 et seq.


66

net result of our success In establishing the proof of claim was that owners of

approximately half a million dollars principal amount of the bonds were

covered by our blanket proof of claim inasmuch as these owners failed to file

individual proofs. After our proof of claim was finally established we at-tempted to secure payment of the dividends amounting to 50 percent whichhad been declared in the guarantor's proceedings. We were successful In

obtaining payment of the dividends applicable to approximately 70 percent of

the bonds, covered by the blanket proof, which were in hand at the time the

payment was made to us. We made a distribution to the bondholders as aresult of the receipt of these dividends. Shortly thereafter the guarantor

filed under Section 77B of the amended bankruptcy law. We filed a supple-

mental proof of claim in this proceeding and petitioned the court to secure

the payment to us of the dividends declared In the former proceedings to be

held for account of the b6ndholders who had not as yet received the dividends.

The court denied our petition and an appeal was taken to the Circuit Court

of Appeals where it was decided that the dividends would not be paid to usat the present time pending reorganization of the company. The court diddeclare, however, that any reorganization plan which did not provide for the

payment of these dividends in cash to us for account of the bondholders would

not be considered fair and equitable. So the net result of the decision ismerely to postpone the date of the receipt of the dividends by the remaining

unpaid bondholders. If it had not been for our active steps taken entirelywithout request or indemnity, the individual bondholders who did not file proofs

of claim might not have been entitled to receive the dividends In the guarantor's

proceedings." "'

To empower I's and require the trustee to protect the interests ofminorities in these situations would merely require that the trusteetake honest and intelligent steps to protect the interest of all thesecurity holders represented by it.

z The questionnaire is set forth in Appendix A. This reply is in answer to See. 4,Item 1, of that questionnaire.

"The bankruptcy courts are generally allowing indenture trustees to file claims on be-half of bondholders without regard to whether the indenture contains a specific power ofattorney to do so. There seems to be no good reason why the corporate trustee shouldnot do so and every reason why It should. The position of the bondholder who Is unin-formed or inert is thus protected, while any bondholder who wishes to file for himselfis generally allowed to do so, the order with respect to filing claims generally providingthat the trustee's claim is automatically reduced by the amount of the claims filed bybondholders for themselves." Grinnell and Kearns, supra note 206, at 112.

n3 There has been a contrariety of judicial opinion, dependent in large measure on thewording of particular indentures, as to the power of the trustee to file proofs of claimin bankruptcy or receivership proceedings. For a review of the cases see Notes (1932)46 Harv. L. Rev. 309 and (1927) 27 Columbia L. Rev. 443, and the following subsequentdecisions: In re Paramount-Publi Corporation, 72 F. (2d) 219 (C. C. A. 2d, 1934) ; In reUnited Cigar Stores Co., 68 F. (2d) 895 (C. C. A. 2d, 1934) ; In re Hotel St. James Co.,65 F. (2d) 82. 83 (C. C. A. 9th. 1933) ; In re Prudence Bonds Corp., CCH Bankr. Serv.,Par. 3898 (L. D. N. Y. 1936) ; In re Associated Telephone Utiities Co., 12 F. Supp. 468(S. D. N. Y. 1935); National Milling & Chemical Co., Inc., V. Amalgamated Laundries,Inc., 7 F. Supp. 723 (S. D. N. Y. 1934) ; Spitz v. Fox Metropolitan Playhouses, Inc. 3 F.Supp. 606 (S. D. N. Y. 1933). To the end of making this power clear, appropriate legis-lation is desirable. It Is likewise desirable that the status of indenture trustees inbankruptcy and receivership proceedings be made explicit both as to their powers torepresent bondholders and as to their right to be compensated for the services which theymay render in such proceedings in their representative capacity.


H. FEES AND EXCULPATORY CLAUSES

Corporate trustees have pointed out, in justification of their inac-

tivity and irresponsibility that their fees are inadequate to compen-sate them for the assumption of greater duties or responsibilities.

Their fees are generally regulated by a standard schedule, adoptedby banking associations in various areas, from which deviation some-times occurs. A schedule showing sample fees is attached heretoas Appendix B. For acting as trustee under an indenture cover-ing an issue of $10,000,000 of the debentures of National ElectricPower Company, the Chase National Bank received $1,100 a year.In Hazzard v. Chase National Bank of City of N. Y. (heretoforediscussed), Judge Rosenman reviewed the activities of the Bank andconcluded:

"The defendant contends, as do financial institutions generally, that thefee usually received for acting as "Trustee" under these indentures are notadequate if the duties of an ordinary fiduciary are to be assumed. That maybe true. Conversely the fee of $1,100 per year in this case was grotesquelyexorbitant for the negligible services performed and responsibility undertakenby the defendant. The defendant did not earn its fee either in work or inrisk." =4

Judge Rosenman's characterization of the services performed bythe trustee as "negligible" is generally applicable. Leonard J. Clark,trust officer of The Pennsylvania Company for Insurances on Livesand Granting Annuities, similarly described in a hearing before thisCommission the duties of corporate trustees. We have alreadyquoted his testimony to the following effect:

"Q. You think the corporate trustee is merely a mechanical agency?A. Yes.Q. That is, it is a sort of finer book-keeping agency, and also an instru-

ment, a vehicle, as you put it, which can be put into motion by the bondholders?A. By the bondholders.Q. Would you say that defines all the duties of a corporate trustee?A. I would." "'

For the performance of such duties, Judge Rosenman's appraisalof the fees of the trustee in the Hazzard case as "grotesquely ex-orbitant" seems not inappropriate. As a matter of fact, the feesdirectly received by corporate trustees may, on occasions, be verylarge. Particularly is this likely to be true where the trustee exer-cises its power to take possession and operate the property. Thisfrequently happens in the real estate field. The records of a hearingbefore this Commission, for example, show that in the case of S. W.Straus & Co. of California the profits from operations of certain

Supra note 45, at 1906.m Supra, at 4.


properties by the trustees, Straus affiliates, were sufficient to converta Straus operating loss of about $46,000 for the period January toOctober, 1932, into a net profit of $3,347.21e

The regular fee to corporate trustees covers only their routineduties: examination of the indentures, which according to our evi-dence 217 has as its principal purpose, assurance that the trustee isadequately protected; the mechanical function of counting the bondsto prevent over-issue, and a certification which has very little legaleffect ;218 receipt and scrutiny of reports and accounts which, accord-ing to the evidence,-9 is at most cursory; and giving notice andmaking formal demands in the few instances which the indenture re-quires. It is reimbursed for any out-of-pocket expenses it may incurin publishing notices. It requires indemnity against prospectiveexpenses and possible liability before it will bring suit or act to fore-closure, and it is entitled to compensation for such activities and anyothers it may take, such as taking possession of the property.

Nor is the risk which they now incur disproportionate to theirfees. Indeed, it is no exaggeration to say that corporate trusteeshave been able to remain inactive and to perpetrate the acts whichwe have heretofore described, because astute lawyers have been ableto shield them generally from liability for negligence and all actsor failures to act except for fraud or gross negligence. We havealready referred to the indenture in the Hazzard case which JudgeRosenman said "fairly bristles" with exculpatory clauses. The gen-eral exculpatory clause in that case, which fairly portrays the sub-stance of like clauses in virtually all indentures, was in the followingwords:

"Section 5. The Trustee may execute any of the trusts or powers hereofand perform any of the duties hereunder, either itself or by or through itsattorneys, agents or employees, and it shall not be answerable or accountablefor any act, default, neglect or misconduct of any such attorneys, agents oremployees, if reasonable care has been exercised in the appointment andretention thereof, nor shall the Trustee be otherwise answerable or accountableunder any circumstances whatsoever, except for its own gross negligence or badfaith."

In addition to such a clause, excusing the trustee from any liability"except for its own gross negligence or bad faith", the indenture, asindentures usually do, contained many similar denials of respon-sibility, addressed to specific powers and duties.

By virtue of these provisions, in most jurisdictions the trustee mustbe found to have acted or failed to act with a "mental attitude of

z'- Op. ct,. supra note 96, at 1284-1236.Ml See supra, at 7 et seq.

See supra, at 23 et seq.See supra, at 29 et seq.


69

reckless or wanton disregard of the rights of others",220 or in actualbad faith.fl If it is merely careless and heedless or supine, it incursno liability because of the "contractual" denial contained in theindenture.222

On these facts, in light of the trustee's mechanical duties and itsabsolution from real risk- or responsibility, the use of the word"trustee" is indeed a misnomer.2 2 3 It is a misrepresentation to inves-tors of the nature of the protection for which they are paying. Bythe course of the development of the corporate trustee, investors havebeen exposed to exploitation on behalf of their trustee's own interests,and they have been deprived of protection which they sorely need.Judge Rosenman summed up the situation in these words:

"* * * It would be far better for the bondholders to pay a much larger

compensation to the trustee, and be able to insist upon the usual vigilanceof a fiduciary. The trustee need not become an insurer any more than, forexample, a testamentary trustee. But the trustee should be made to live upto the responsibility which nearly every purchaser assumes it has, and whichit represents to the public as having undertaken, in a sense, by the veryadvertisement of the designation 'trustee.'

"Such change can come in this state only through action by the Legislature.Trustees have accepted duties under these indentures, slight as they are, rely-ing upon judicial precedents absolving them from exercising ordinary care,and permitting them to insert practically unlimited exculpatory clauses. Therules which have been laid down by the courts can obviously not be alterednow by the courts in justice to trust agreements which have been made inreliance upon them. The entire system, however, should be changed by legis-lation, so as to provide more adequate compensation to the trustee, and theimposition of a duty of active vigilance akin to that placed upon ordinaryfiduciaries.!"4

The remedy is to require a return to the theory that a corporatetrustee is a trustee, and that it cannot pretend to be such unless itmeets the qualifications, assumes the duties and discharges the re-sponsibilities of a trustee. Such increased duties and responsibili-ties would probably merit an increase in compensation. No attemptwas made to ascertain what the profits or losses from these corporate

I Judge Rosenman, in Hazard v. Chase National Bank of City of N. Y., supra note 45,at 1906.

z' Payne, Exculpatory Clauses In Corporate Mortgages and Other Instruments (1934)19 Cornell L. Q. 171 ; Note (1933) 33 Columbia L. Rev. 97.

22 See, for example, Ainsa v. Mercantile Trust Co., 174 Cal. 504, 163 Pac. 898 (1917)Anderson v. Pennsylvania Hotel Co., 56 F. (2d) 980 (C. C. A. 5th, 1932) ; Bell v. ScrantonTrust Co., 261 Pa. 28, 103 AtI. 1019 (1918) ; Benton v. Safe Deposit Bank, 255 N. Y.260, 174 N. E. 648 (1931) ; but see Green v. Title Guarantee & Trust Co., 223 App. Div.12, 227 N. Y. Supp. 252 (1st Dept., 1928) ; Continental Corp. v. First National Bank, 285Mass. 419, 189 N. E. 184 (1934) ; Davidge v. Guardian Trust Co., 203 N. Y. 331, 96N. E. 751 (1911) ; Riggs v. Fidelity & Deposit Co., 112 Md. 50, 75 Atl. 517 (1910) ; Esta-brook v. International Trust Co., 227 Mass. 281, 116 N. E. 486 (1917) ; Note (1931) 29Michigan L. Rev. 1078.

2 Judge Rosenman, in Hazzard v. Chase National Bank of N. Y., supra note 45,at 1905.

'Id., at 1906,


trusteeships were, either in individual cases or in the aggregate.But such information if available would not necessarily be conclusiveon the amount of fees necessary under the proposed system. Addi-tional investigation and study is accordingly required to reach aninformed judgment on the extent to which these fees should be in-creased in order to compensate the trustees for the additional risksattendant on assumption of the obligations of active trustees. Buteven with an increase in fees, security holders under the proposedsystem would be paying for real protection of their interests, protec-tion which they sorely need.

We stated above that the fundamental problem of reform in thisfield was to refashion the trust indenture for the purpose of accord-ing greater protection to investors. The foregoing review of exem-plary situations leads us to the conclusion that the trustee can nolonger be allowed to be nothing but a stakeholder and an amanuensisof the group which happens to be dominant. It must be transformedinto an active trustee lest the interests of investors be neglected bothprior to and subsequent to default. To that end we make the follow-ing recommendations for appropriate legislative action:

1. That trustees should be charged with active duties and commensurateresponsibilities.

2. That the trustee be responsible for failure to record, file, or refile themortgage in the proper recording office and for failure to use reasonable careand diligence in certifying the securities.

3. That the trustee be responsible for the exercise of such reasonable careas the circumstances permit in checking the application of proceeds of securityissues to their avowed purposes.

4. That the trustee be responsible for the use of reasonable care and dili-gence in enforcing compliance with negative pledge clauses and provisions forsubstitution and release of security and in taking appropriate steps to protectthe security holders in case the issuer violates or threatens to violate them.

5. That the trustee be responsible for use of reasonable care and diligencein ascertaining the occurrence of defaults under the indenture and in givingnotice thereof to the security holders where such notice is necessary for theirprotection.

6. That, when default occurs, the trustee be responsible for failure to takesuch action, in protection or enforcement of the security; in collection of prin-cipal or interest; or in representation of their beneficiaries in legal proceedings,as is reasonably necessary for protection of the investors.

7. That all exculpatory clauses in indentures incompatible with the fore-going standards of conduct be outlawed.

As stated, the foregoing recommendations are merely exemplaryof the specific reform measures which we think are essential. Theydo not include all provisions of trust indentures which should be re-fashioned in light of the "legislative determination" of the require-ments of the public interest. But they indicate the quality anddegree of a thoroughgoing reform of the present system.


SECTION III

CONFLICTS AND PROTECTION OF TRUSTEES

The remedy for the problems in the corporate trustee field is notto be found merely in the substitution of active for passive trustees.Bondholders have suffered not only from non-activity of trustees;they have also suffered from oppressive actions of trustees who havehad interests adverse to the bondholders. An active trustee may beworse than a passive one, unless it is free of adverse interests. Itis mischievous to suggest that trustees should be more active if theyare allowed to occupy positions conflicting with their fiduciary re-sponsibilities. A prerequisite to any contractual or legislative man-date for active trustees is that they be compelled to purge themselvesof conflicting interests. Trustees should be allowed and compelledto perform those fiduciary duties necessary to protect investors onlyif they are also forced to free themselves of all adverse interests, sothat they are free to discharge their responsibilities actively andvigorously.

A. AFFILIATION WITH COMMITTEES

One of the conspicuous conflicts has arisen as a result of the trus-tee's affiliation with protective committees. Elsewhere in this reportwe develop in detail the manner in which protective committees havebeen organized and how they operated. These committees all toofrequently have been identified with interests which are not identicalwith those of the security holders whom they represent. Issuers'committees, underwriters' committees, and committees of juniorclaimants have often been formed to represent bondholders. Thetrustee cannot surrender the interests of its beneficiaries to such com-mittees and remain a trustee in fact. It is idle to expect a com-mittee composed of underwriters to require a receiver or bankruptcytrustee to sue the underwriters for their participation with the man-agement in misappropriation or diversion of the corporation's assetsand thus improve the position of bondholders. One cannot expect acommittee identified with the issurer effectively to appraise andcheck the fairness of a reorganization plan promulgated by the is-suer and designed to keep the present management in control of thecompany. And it is dangerous to rely upon a committee whose chiefinterest is with junior securities to oppose a reorganization planprejudicial to first mortgage bondholders. But these trustees have


done little or nothing to oppose such committees, or to scrutinizetheir operations.

Indeed, executive officers of trustees have served on committees to

promote a plan proposed by the management; and investors havebeen solicited by committees upon which their trustee had acceptedmembership at the solicitation of the underwriting bankers. Someof these conflicts we shall discuss below.

The records of a hearing before this Commission reveal that in the

1933 refunding of notes of The Baldwin Locomotive Works, the man-

agement proposed a plan to security holders through a "Deposit Com-mittee." The trustee for these notes, the Pennsylvania Company forInsurances on Lives and the Granting of Annuities, was representedon the committee by C. S. Newhall, its vice-president.225 He ac-cepted this position at the request of a partner of Drexel & Co.,principal bankers for Baldwin. 22

Obviously, membership on a protective committee to promote, asin the Baldwin incident, a plan proposed by the company involvesapproval of the plan. And since the protective committee repre-sents those only who have authorized it to act for them, member-ship is inconsistent with the trustee's duty to all as distinguishedfrom the majority of bondholders. Mr. Newhall testified beforethis Commission as follows with respect to this conflict:

"Q. Well, assuming, Mr. Newhall, that it was the trustee's primary dutyto bring suit against the company in the event that a provision of the trustindenture had been violated, do you see any conflict with that particular duty

which would result by virtue of an officer of the trustee being a member ofa protective committee?

A. I don't see any.Q. As a member of this Protective Committee, whom did you think you

represented?A. I represented the bonds that were owned by my company and all the

other bonds too.Q. The undeposited as well as the deposited bonds?A. I represented the bonds as they were deposited.Q. You represented only those bonds that were deposited?A. Yes.Q. Does a corporate trustee represent all the bonds, or only the bonds

which he owns, or only the bonds which *are deposited with their ProtectiveCommittee?

A. The trustee represents all the bonds as set forth in the terms of theindenture.

Q. Now, suppose, Mr. Newhall, that the corporate trustee discovered thata material provision of this indenture had been violated, and suppose a cor-porate trustee wanted to bring suit against the company to enforce paymentof the principal of those notes; and, on the other hand, a Protective Com-

mittee was functioning which was promoting a readjustment plan which would

2 Op. oft. supra note 13 at 160.Id., at 292-298.


involve the exchange of those notes for new securities. If an officer of the

trustee was a member of this Protective Committee, wouldn't there be a

conflict there that might result in absolute paralysis and no action by the

trustee?A. It depends entirely upon the terms of the indenture."

But in fact a more pointed illustration of the conflict could hardly

be found. For, as heretofore discussed, in this very case a minority

noteholder was dissatisfied with the plan offered to noteholders. But

the trustee did not sue on his behalf and he had no remedy under the

indenture by suit in his own name. 228 It is no answer to say that

justice to the majority required that the minority yield to their will

or go without remedy. Certainly this is not true if the majority is

unreasonable-if, for example, it is dominated, directed and con-

trolled by a protective committee constituted by the issuer or under-

writer to promote a plan oppressive to security holders. And bymembership on a protective committee the trustee has tied its hands.

It can no longer be a judicial representative of all bondholders, it canno longer see that the minority is given adequate opportunity toparticipate or a fair cash alternative. It has thrown its weight onthe side of the majority.

We have already quoted the testimony of Mr. Hibbard of Guar-anty Trust Co., to the effect that Guaranty, as trustee, delayed noticeof the default of R. Hoe & Co., Inc., in order that the reorganizationmachinery might be organized and protective committees formedand mobilized for action.229 Guaranty Trust Co. through its affiliate,Guaranty Co., was represented on the bondholders' protective com-mittee.2 0 As a result, Guaranty, as trustee for the bondholders,could not possibly act as a check upon the protective committee ormajority bondholders. And Guaranty controlled the Hoe Company;certainly, it could not be expected to act as a check upon the man-agement in the reorganization. Its affiliate was the investmentbanker for the Company. Certainly Guaranty, as trustee for thebondholders, was in no position to protect their interests as againstits own affiliate.

The affiliation between Guaranty Trust Company and the bond-holders' protective committee had the further consequence that thecommittee could not be expected to act as a check on the trustee.Moreover the same counsel, Davis, Polk, Wardwell, Gardiner &Reed, represented both the bondholders' committee and the GuarantyTrust Company, as trustee. The tangle of conflicts in which thisfirm found itself as a result of this dual relationship is illustrated

221 Id., at 294-296.

121 Supra, at 62 et seq.

Supra, at 42.10 Op. olt. supra note 107, at 268, Commission's Exhibit No. 7.


by the following episode. The Guaranty Trust Company, as willbe explained in detail later, was a general creditor of the Hoe Com-pany. Its bank credit was secured by a pledge of Hoe's accountsreceivable. In June 1932, after the bondholders' committee had beenformed, a bondholder brought suit against Guaranty Trust Com-pany as trustee claiming that the pledge of Hoe's receivables againstGuaranty's bank loan was a violation of a covenant in the mortgageindenture forbidding the creation of the lien prior to the lien onthe bonds.231 The plaintiff set forth a violation of its trust byGuaranty and sought the appointment of a receiver to hold thepledged receivables "in trust for the benefit of the bondholders". 232

The law firm of Davis, Polk, Wardwell, Gardiner & Reed defendedthe trust company.23 3 There was no discussion among members ofthe firm as to the propriety of their acting simultaneously for thebondholders' committee and the trustee. 23 4 Leighton H. Coleman, apartner in the firm, testified as follows:

"Q. That is, you determined to decide for yourselves whether you were in aninconsistent position, depending solely upon the merits of the claim as you sawthem?

A. Exactly.Q. Sort of an individual judgment on your part?A. No, I think in that particular instance you have to make an individual

judgment.Q. You think so?A. I don't know who else could make it.Q. That is, if you are counsel for the bondholders committee and for the

trustee?A. I should think so.Q. To make that upon the merits of the claim before--A. Well I think if the claim were at all doubtful, perhaps we might consider

there was an inconsistent position, but on the face of this, this was so trans-parent that it wasn't possible to raise any question of inconsistency.

Q. Purely on the basis of the merits of the claim?A. Purely, and knowing the character of the plaintiff, that had something to

do with it." "

The merits of the action were a problem for judicial decision. Thefact remains that had there been recovery in the action, it would haveinured to the benefit of one of the firm's clients, the bondholders, tothe detriment of another of its clients, the Guaranty Trust Company,trustee for the bondholders.

Employment of the same counsel by the committee and the trusteeis a factor that must inevitably be a deterrent to vigorous action by

. Id., at 461-462.-Id., at 462-463.

= 1., at 461-462.2"Id., at 404.m Id., at 471-472.


the trustee in behalf of non-depositors. But this is a common practice.It is usual in, though not peculiar to, real estate bond reorganizations,as we have set forth in our report on Committees for the Holders of

Real Estate Bonds. Edward P. Morse, who was counsel to trusteeas well as to committee, was questioned about this practice before thisCommission:

"Q. Has your trustee client ever urged your committee client to raise theante, to make the bid a little better?

A. I think there are some instances where some of the trustees have suggestedthat the bid should be increased.

Q. Some of your clients?A. Yes.Q. Was that at your suggestion?A. You mean that I would suggest it?Q. Would you suggest to your trustee client, and your trustee client give it

to the committee client, that the bid be raised?A. No, you take the plan to the trustee and say: 'I want you to consider the

amount of this bid and plan.' Those people are better equipped to consider theamount of the bid than I am, if they want to consider it, because I am not areal estate operator and most of those trustees are.

Q. Well, one of your clients, the committee, would be interested in keepingthe bid down and the other client, the trustee, would be interested in gettingthe bid up, maybe? I wondered how you would reconcile your position betweenthose two clients.

A. Well, as I said before, in many instances we had asked the trustee toemploy independent counsel for that specific purpose." 286

Mr. Morse did not, however, "think there is any obligation in thetrustee necessarily to determine that the bid shall be more or less thanthe amount contemplated" (i. e., by the committee) :

"Q. That might very easily result in the bondholder having a choice betweena very unfair plan or a very inadequate cash amount?

A. I have said that the trustee should look at the plan, I meant to add that.Q. The trustee should review the fairness of the plan?A. Yes.Q. Did your committee in negotiating plans submit to your trustee the plan

for consideration?A. Yes, we present the plans to the court and to the trustee.Q. That is, your committee will present to your trustee the plan that your

committee has drawn?A. Yes.Q. What position would you as counsel take in that situation? Where

would your interest lie? With the trustee or against it?A. I would not have anything to do that would determine the business ques-

tion involved in the trustee's examination of the plan of reorganization."

"Q. Now, you come back to the question of the trustee passing upon that plan.The trustee would obviously need the advice of counsel, wouldn't he, in manyinstances?

' Op. cit. supra note 96, at 2600-2601.75957 -6---6


A. Yes, in many instances.Q. Where would you stand? Would you be for the trustee or against him?A. In many instances we have asked the trustee to select counsel for the

purpose.Q. You step out and get additional counsel?A. In many instances we have done it, yes.Q. Where you were representing the Hazlewood committee?A. Yes.Q. So that independent counsel could do what?A. Examine the plan and consider the bid and advise the trustee.Q. So that you in your practice recognize the point of inherent conflict be-

tween the committee and the trustee?A. No, I don't know that I do.Q. Why did you step out then?A. I prefer to be careful, and I would rather not have criticism where I

think there is any possibility of question arising.Q. So you would, I take it, invariably submit the plan to the trustee for

approval, and advise the trustee to get independent counsel?A. I would say that we do it almost invariably. There may be some cases

where we did not.Q. What use were you then to the trustee if you couldn't serve him at that

most critical stage, in fairness to this plan?A. Well, we handled the foreclosure proceeding * * *."

This presents the anomalous situation, constantly recurring, of atrustee having to pass judgment on the work done by its counsel foranother client whose interests are in conflict with those of personsrepresented by the trustee. In these circumsta nces, it might be ex-pected, and we may judge from the following statements of Mr.Morse, made before this Comnmission, that the check was never more

than perfunctory:"Q. Do any of your trustee clients ever appear and contest the contention

of your committee client on the fairness of the plan?A. Not to my knowledge.Q. Did you ever have a plan not confirmed by a court, or a sale not confirmed,

on the basis that the plan was unfair?A. No; we have had some plans slightly modified but nothing to any great

extent that I remember.Q. No court ever held that the bids that the committee made were inadequate?A. I don't remember whether we ever had to raise the bid or not." s

Conflicts such as these become even more acute in cases where the

trustee for a particular issue is represented by counsel who are alsorepresenting a committee for another security, the interests of theholders of the two classes of securities being adverse.

We have discussed above the non-action of the Harris Trust &

Savings Bank, trustee for the 6 percent Secured Convertible GoldBonds of Union Power Corporation, in connection with the bank-ruptey of that company and the reorganization of its subsidiary,

-. Id., at 2590-2591, 2502-2593.u Id., at 2598.


Federal Public Service Corporation. The corporate trustee pursuedits policy of non-action with the advice of its counsel, RobertFarrell, of the Chicago law firm of Chapman & Cutler. Itasked counsel to "follow the situation," but as Mr. Glow, assistantsecretary to the Harris Trust & Savings Bank, reported, "Qurcounsel feels that the common stockholders in Federal should not beentitled to participate in the plan of reorganization of their owncompany for the reason that its outstanding debt appears to bemuch greater than the value of its assets." This common stock, aswe have shown, was the security behind the Union Power bonds."9

Chapman & Cutler, however, were also counsel for the Note-holders Committee for the Federal Public Service Corporation.240

It is obvious, as we have stated, that the interests of the noteholdersand of the Union Power bondholders were adverse.'4 1 Mr. Glowtestified before this Commission:"Q. * * * The ultimate distribution to the Union Power bondholders,

in view of the fact that they were secured by the common stock of Federal,and In view of the fact that the common stock of Federal was by far thechief asset of Union Power Corporation, would depend, would it not, uponwhat the common stock of Federal was given in the reorganization ofFederal?

A. I think that is right."S S S , * S ,

"Q. You knew, did you not, that the common stock of Federal was givennothing in the Federal reorganization?

A. That was my understanding.Q. And it would follow, would it not, Mr. Glow, that anything that might

be given to the common stock of Federal would have to be given to it atthe expense of the security that did receive something from the Federalreorganization?

A. I don't know. I assume that that is correct.Q. And you know that among the securities of Federal which did participate

In the plan of reorganization were the notes of Federal?A. I don't recall that.Q. D1l you know that at the time, do you know?A. I don't recall.Q. Our record shows, Mr. Glow, that that was the case. Now, with these

facts before you, doesn't it follow that the notes of Federal and the commonstock of Federal were In a position of adverse interest?

A I should think so. The note holders would naturally receive somethingin preference to the fellows who made the note-the maker of the note."'

Mr. Glow, his testimony indicates, had not known that Chapman &Cutler were also representing the noteholders committee for Fed-eral.2 4 3 Whether or not executive officers of the trust company were

Supra, at 48."o Supra, at 59.

Ibid.2p. cit. eupra note 141, at 974, 975-976.

Ou Id., at 964, 975.


78

aware of this fact does not appear. But, as we have shown above,on cross-examination by Mr. Farrell Mr. Glow testified that the situ-ation was "not unusual," resting entirely upon the trust company'sbelief in the "integrity" of the firm:

"Q. It is true that my firm was counsel for the bank and at the same timecounsel for this Noteholders Committee. That is not an unusual situation, Is it?

A. No, sir.Q. The fact that any particular counsel might represent your bank and also

sombeody else in interests, rests entirely upon what you believe the integrity ofthat firm to be?

A. Yes, sir."

Whether or not the conflicting interests of his noteholder clientshad any influence upon the advice given by Mr. Farrell to his trusteeclient, or whether or not it had any influence upon his judgment inappraising the situation, can not be demonstrated. We do not ques-tion the integrity of his firm. But no counsel can bring to a situationsuch as this the free, impartial judgment which an aggressive repre-sentation of the interests of the trustee's beneficiaries requires, if atthe same time he is under an obligation to protect clients whoseinterests are distinctly adverse.2 5

There is respectable authority among trust companies and theircounsel that employment by the trustee of counsel to the committeeis undesirable. One writer has expressed it as follows:

"The trustee requires counsel during the course of the foreclosure proceedingsunder a bond issue, and usually prefers to select an attorney who is not repre-

4Id.. at 972.

21 Another case where the same counsel represented a corporate trustee and also a com-

mittee for a class of securities other than that for which the trustee was acting Is to befound in the current reorganization of The Baldwin Locomotive Works. The companyhad outstanding in the hands of the public approximately $2,650,000 face amount ofFirst Mortgage Five Per Cent Sinking Fund Thirty-Year Gold Bonds. Op. eit. supra note13, at 11-12, Commission's Exhibit No. 6. Junior to these bonds were Five-Year 6 Per CentConsolidated Mortgage Bonds and the preferred and common stock. Id., at 9-10, 12-13,Commission's Exhibit No. 7. In the proposed plan of reorganization, the rights of thefirst mortgage bondholders were not, for all practical purposes, materially altered, and inreturn for the modifications that were to be made, the holders would receive cash com-pensation. 1., Commission's Exhibit No. 159. No committee was formed to representthese bondholders. Id., at 377-378.TLe Pennsylvania Company for Insurances on Lives and Granting Annuities was trus-

tee for the first mortgage bonds. Id., Commission's Exhibit No. 6. General counsel forthis company are the Philadelphia law firm of Saul, Ewing, Remick & Saul, and this firmwas also counsel for the Preferred Stockholders' Committee. Id., at 422, 424.

With reference to the question of his firm's conflict of position, Maurice Saul testifiedbefore this Commission, as follows:"* * * Certainly that was a problem that came up. We are general counsel to thePennsylvania Company. If there was any conflict between the first mortgage bondholdersand the preferred stockholders, we certainly could not represent both interests. Uponour appointment to this committee I immediately notified the trust company I was ac-cepting that appointment, and if there was any conflict in interest that they would haveto get other counsel, and they said that was satisfactory." Id., at 423 Mr. Saul was ofthe opinion that neither at that time nor subsequently did any conflict arise. I., at, 423,424-425. He added:"* * * I told the Pennsylvania Company if a conflict did arise they should getother counsel. That is as far as a lawyer can go. He cannot represent two conflictinginterests, At least, no reputable lawyer can." Id.. at 423-424.


senting any other interested party. The trustee has a clear right to employ

counsel of his own choosing, but it frequently happens that the trustee will be

urged to employ the attorney who is representing the bondholders committee, in

order to save expense to the bondholders. The trustee, ordinarily, has no

objection to this method from the standpoint of legal qualifications of the

attorney, as most attorneys who represent bondholders committees are fully

competent to advise trustees as to their duties. These attorneys sincerely

believe that they can act impartially in advising both the trustee and the

bondholders committee. It is difficult to see, however, how such an attorneycan be a very forceful advocate of the rights of both parties when situationssuch as the following arise:

"The trustee in possession of a trust estate is usually authorized to useoperating income to pay operating expenses. It is frequently necessary todetermine just what is included within the term 'operating expenses' or othersimilar language which may be used in trust indentures. It is ordinarily in theinterests of the bondholders committee which, in a large majority of cases,becomes the future owner of a trust estate, to maintain the property in a highstate of efficiency, and this absorbs most of the operating income. On the otherhand, the non-depositing bondholders share in whatever net operating incomeremains in the hands of the trustee at the time of the foreclosure sale, and themore money spent before the sale, even though beneficial to the trust estate,the less money will be left for the non-assenting bondholders. The trusteemust act impartially and needs the advice of independent counsel.

"Another situation also illustrates the need for independent counsel. Thebondholders committee always desires to make a very small bid at the trustee'ssale in order to reduce the cost of acquisition of the trust estate. The trustee,on the other hand, is under the duty of selling the property at the highest priceobtainable. The trustee's counsel will be of little help in such a case if hehappens to also represent the committee.

"More important to the trustee, perhaps, are questions relating to indemnity.That is to say, the more protection given to the trustee by way of indemnity,the harder the burden on the bondholders committee, as it is the committeewhich, of necessity, must furnish such indemnity. When the trust officer seekslegal advice, with respect to his need for indemnity, he would not consult theattorney who is representing the committee.

"Still another instance of apparent conflict arises. If one attorney performsservices for both the trustee and the bondholders committee, it will be beneficialto the committee if a large portion of the fee for such dual services be chargedto the trust estate, and a small portion of the fee to the bondholders committee,thus causing the non-depositing bondholders to bear a larger share of the costs.The trust officer needs advice from independent counsel.

"Some bondholders committees believe, however, that the very existence ofthese apparent conflicts of interest furnishes the reason for the employment ofa single attorney to represent both the trustee and the committee. Such anattorney, it is urged, is familiar with the problems of both the trustee and thecommittee and may be able to arrive at a solution eminently fair to bothsides.

"The experiences of the last few years have, however, only served tostrengthen the convictions held by most trustees, that it is a mistake to yieldto the wishes of the bondholders committees in this respect." 246

246 Ben W. Utter, Trust Counsel, Title Guarantee and Trust Company, Los Angeles,

Calif., in 56 Trust Companies 653, 656-657 (1933). For similar views see W. G. Little-ton, Vice-President, Fidelity-Philadelphia Trust Co., Id., at 338.


To recapitulate, affiliations of trustees and committees by reason ofcommon counsel or by reason of trustees being represented on com-mittees raises potentialities of grave conflicts of interest.247 Thetrustee shares such conflicts as the committees may have-whetherthese conflicts arise out of the committee's representation of junioror senior securities, by reason of the committee's affiliations with theissuer, by virtue of the identity of interest between committee andunderwriter, or otherwise. But even if the committee has no suchconflict of interest, it will normally represent less than all of thesecurity holders. The trustee on the other hand represents all ofthe security holders. It may incapacitate itself to serve adequatelyall of the security holders if it becomes identified with the committee.The history of reorganization demonstrates that majorities are notadequate champions of the interest of the minorities. The trusteewho becomes affiliated with the committee by virtue of a commoncounsel or by representation on the committee has thrown its weighton the side of the majority and is no longer an effective representa-tive of all the security holders against the oppressive or unreasonableactions of that majority.

This affiliation is not an uncommon one. From questionnaire re-turns received by this Commission from 723 protective committeesit appeared that in 265 (or 36 percent) the trustee was representeddirectly on the committee. Furthermore in 143 cases out of 887(or 16 percent) counsel to the committee was also general counsel tothe trustee.

These are situations which the law must rectify in furtherance ofthe objective of making the trustee a vigilant and aggressive cham-pion of the rights of all the security holders it represents, freed fromthe tangle of conflicting interests which such ties and connectionscreate.

It may however be essential for the trustee to be the focal point

for organization of bondholders in times of trouble and for forma-tion of a protective committee.21

8 This may mean that the trusteeshould act as chairman of a bondholders' meeting where a committeeis selected or that it should undertake directly to have a committeeformed. But further than that its identification with the committeeshould not go.

B. AFFILIATIONS WITH JUNIOR INTERESTS, SHORT-TERM CREDI-TORS, MANAGEMENT AND UNDERWRITERS

Representation of the trustee on a protective committee is not

generally an isolated conflict. Usually it is the summation of a

24 For another example of such conflict, see Appendix E, (afra.

U8 For illustrative material on practices of trustees in this connection see Appendix C,Satra.


number of conflicts which have existed throughout the trusteeship.One conflict, not uncommon, is the identity of interest between thetrustee and owners of junior securities or equity interests. This hasbeen conspicuous particularly in the real estate bond field, as we havepointed out in our report on Committees for the Holders of RealEstate Bonds. As discussed there, the trustees were usually officers,directors or affiliated corporations of the houses of issue. Thehouse of issue, as a result of advances made by them to meet pay-ments of taxes, principal and interest, had acquired junior securi-ties or equities in the properties. As owner of the equity the houseof issue would at times operate the property. It was to the obviousadvantage and self-interest of these houses to preserve these juniorsecurities and equities against being diluted or wiped out by thebondholders whom the trustee represented. It could hardly be ex-pected that the trustee, so closely identified with the house of issue,would take adequate steps to preserve the bondholders' positionagainst these adverse claims of the houses of issue. And it is a mat-ter of record that the trustees did not. The many ways in whichthe inaction of these trustees served to protect the investments of thehouses of issue need not be repeated here. One example will suffice.The bondholders after default were entitled to the benefit of earn-ings and income of the property. By reason of the active or passiveconnivance of the trustee, however, such covenants were violated tothe detriment of the bondholders and to the advantage of the equityowner. One such case concerned a bond issue underwritten by Amer-ican Bond & Mortgage Co. That underwriter owned the equity ofa property which secured an issue of first mortgage bonds distributedby it. One of the company's officers was trustee of the bond issue.While the bondholders might have claimed segregation of the in-come for their benefit after default, nothing was done by the trusteeto that end. As a result the property was "milked" by the under-writer in its capacity as equity owner.

The minutes of a protective committee for American Bond &Mortgage Co. issues, including the bonds above discussed, containan interesting discussion of this situation between certain membersof the committee and Harold Moore, an official of the company.Mr. Moore testified concerning them before this Commission as fol-lows:

"Q. Perhaps Commission's Exhibit 431 will refresh your recollection. It isan excerpt from the minutes of the Hazlewood Committee of July 25th and26th, 1930. On page 9, Mr. Rickaby is reported as having said:

'That m'ney that the 35 Clark Street Corporation has, while it legallybelongs to the 35 Clark Street Corporation, it is really the first mortgagebondholders' money-it Is accumulated risk.

Mr. Moo That is correct.The CHAIRMAN. Do I understand the American Bond & Mortgage Company

has common stock ownership in this now?


Mr. RIOKABY. They own all the common stock of the 35 Clark Street Corpora-

tion which took this property over last summer, before corporation was formed,

and to use harsh language, they milked up $35,000 to $75,000 before they starteddepositing rents.

Mr. Moopm. That is true; the same thing would be true in any number of

properties where the owners have not paid all of the income on their mortgage

Indebtedness.' * * *"

Mr. Moore testified before this Commission in respect of the fore-

going matter, as follows:

"A. Well, it doesn't call to my memory those particular facts, except as they

show in that particular statement, and as I said before, I have no reason to

believe that is not accurate, but just at the moment I do not have any recollec-tion of what did transpire in connection with that situation.

Q. From that statement it would appear-

A. That I knew of that situation at the time.Q. That would appear, would it?A. Yes.Q. From that statement it would likewise appear that the rents collected

between August 29th and January 30th were not used to pay back taxes?A. That is correct.Q. It would likewise appear from that statement that those funds were not

applied on the first mortgage indebtedness?A. That is correct, it so appears.""'

This is a gross example of abuse of the fiduciary responsibilitiesof a trustee; but it is an abuse not uncommon to the real estate field.And it is symptomatic of the disrepute into which trusteeship underindentures has fallen.

The effect on the security holders of a trustee's identification or

affiliation with owners of junior securities or equity interests may attimes be more difficult to measure or ascertain than in the foregoingcase. It may mean merely that the advocacy of the cause of thesecurity holders is less aggressive and more timid than it otherwisewould be. The mischief which ensues will more often be subtle than

flagrant. Yet it is clear that it is incompatible with the fiduciary ob-

ligations of a trustee that it own or represent or be affiliated with those

who own or represent securities which conflict with or are adverseto those of the beneficiaries of the trust. Divorce of the trustee fromsuch adverse interest is essential.

An excellent statement of this necessity may be found in North-ampton Trut Co. v. Northampton Traction Co., where the SupremeCourt of Pennsylvania, addressing itself to the argument that atrustee could represent both senior and junior mortgages, said: 251

"We can easily imagine many situations where a trustee might so act as to

be a positive benefit to junior creditors, without infringing a particle on thefirst creditor's right; * * *."

m6 Op. c4t. supra note 96. at 2248-224925 Id., at 2249.m 270 Pa. 199. 203. 204. 112 At. 871. 872 (1921).


but went on to say:

"It Is not necessary to determine what conflicting claims may arise, either

with regard to the extent, validity, terms of the mortgage or application of

income from the operation of the property; it is sufficient that they may well

arise, and public policy requires where controversies are brought into court,

that each party should be represented by someone whose single object it is to

secure all to which each party is entitled, unhampered by personal relations

to an adverse party, who is bound in conscience to be a loyal and vigorous cham-

pion without any obligation to a conflicting creditor or party." '

Frequently there appear multiple and manifold conflicts of inter-ests of the trustee. Thus in the Hoe situation, Guaranty Trust Co.

was interested not solely as trustee for the bondholders. Its securi-ties affiliate, Guaranty Co., was represented on the Hoe directorate ;253

with banker associates it had obtained control of the company in1924 by common stock acquisition ;2

54 and it controlled the voting

trust for Hoe's common stock, two of its officers being trustees, andthe third trustee being a partner of Edward B. Smith & Co., invest-ment bankers.2 55 It had a 97 percent participation in the publicissue in 1924 of $4,500,000 of Hoe bonds 25 for which Guaranty TrustCo. was trustee and coupon paying agent. As we shall develop later,Guaranty Trust became a bank creditor of Hoe and depositary ofits funds.2 57

It was in reflection of these diverse interests that Guaranty partici-pated in the Hoe reorganization as we have already described. Withthese many interests in the situation, obviously it could not regard itsfunctions in the reorganization as solely on behalf of bondholders.It was identified with the management and with its bankers. Itwas itself a short-term creditor. Consequently, at every turn wefound it serving its various proprietary rather than its fiduciaryinterests. As we have already described, its trust officers consultedwith the management as to whether a bondholder should be informedof an impending default, and information was withheld at the sug-gestion and in accordance with the plans of the management. And,as Mr. Hibbard testified, it withheld this information in order thatthe management and its bankers, with both of whom Guaranty Trustwas affiliated, might set the reorganization stage.

These many interests of Guaranty Trust Co. in Hoe bore fruit inother ways which can be demonstrated directly to have injured bond-

m!bid. (Italics supplied).218 Op. Cit. supra note 107, at 431 (1935).264 Id., at 23-24.

25 Id., at 26-29. 431-432.6 Id., at 13.

25 It was also registrar for the Hoe Class A stock (Id., at 73), transfer agent for thevoting trust certificates (Ibid.), depositary for the common stock (Id., at 74), depositaryfor the three protective committees for Hoe securities formed in 1932 (Id., at 430), and,In large measure, was the committee for the Hoe bonds. Id., at 431.


holders. As we have said, Guaranty Trust Co. became depositary ofthe company's funds, 2

5' and it extended a line of credit to the com-

pany."6 In 1926 the Hoe company executed a loan agreement anddeposited as security for its loans receivables "approximately equal-ing the amount of the loan" 260 from the Guaranty, then approxi-mately $1,700,000.21 1 In 1928, this agreement was modified. Thecollateral was increased to 120 percent of the loan, and Hoe wasprivileged to withdraw any collateral in excess of that amount.262

Boudinot Atterbury, former officer of Guaranty Company, testi-fied before this Commission that it was "very customary" to have thetrustee extend lines of credit to the mortgagor and that in this casecounsel did not advise against it:

"Q. Do you recall any conversations respecting the desirability of theGuaranty Trust Company being trustee under the mortgage as well as thelender of funds to the company on a line of credit?

A. No, I don't.Q. Do you know if that was ever discussed with any of your counsel or

associates?A. So far as I can recall there was no conversation along that line. It was

a very customary arrangement.Q. You say that was customary?A. Very customary. It seems to me a very customary arrangement that the

same institution which is trustee of a bond issue should be available for bank-ing support for the company. It is likely to know the situation more inti-mately than some outside institution, and would have a real interest in de-

veloping it and supporting it in every waY possible.Q. In other words, it was an accepted procedure?

A. I think it would be, as a matter of personal opinion, extremely unfortu-nate if any question should be raised as to the right of a banking institutionto loan to the company for which it acts as trustee, assuming always that itproceeds in good faith. * * *

Q. Isn't there a possibility of essential conflict between a short term creditorand a long term creditor?

A. I can conceive that a situation might arise where such a conflict wouldresult, but on the other hand, wouldn't you be depriving a company ofvaluable banking support, and might you not be handicapping the financing

of Industry in general if you did make a definite and strict requirement alongthose lines? I say that the situation should be followed in good faith.

Q. You will agree,- though, that there are situations which occur where

a certain amount of money is available which both short term and long termare after and that there might be a divergence of interest there, and conse-quently if they have the same person representing both interests, or eventhe same counsel representing both interests, there may not be fair treatmentof either.

A. I can easily see that where bad faith was shown there might be a realconflict of interest.

2w Id., at 70.29 I.. at 69."Ol&. at 988.f Id., Commission's Exhibit No. 20.

2 I4., at 884-885.


Q. To the best of your recollection you would say that your counsel did notadvise you against acting in those two capacities?

A. I should say so, very definitely." m

But what transpired makes clear that good faith to the securityholders requires that the trustee be freed from such contradictorydemands of loyalty.

In January, 1932, the Hoe company appeared to be in difficulties.Guaranty proceeded to apply the proceeds of collections on the col-lateral to reduce the loans.2' 4 Nevertheless, on January 30, 1932,there was $285,300.21 in pledged collateral in excess of 120 per centof the loan, which Hoe might draw down under the loan agreement,thereby decreasing Guaranty's margin of security. s5 So the loanagreement was modified and the right of Hoe to withdraw this col-lateral was taken away.266

Guaranty Company controlled the Hoe company. Consequentlyon March 17, 1932, the Hoe directors ratified this modification ofthe loan agreement which resulted in depriving Hoe of the possi-bilities of using over $200,000.267 On the same day the directorsvoted to default on the payment of interest due April 1, 1932, onthe bonds, of which Guaranty Trust C6. was trustee.

The record is clear that Guaranty acted to secure its own positionas creditor with knowledge of Hoe's difficulties and the impendingdefault and reorganization. The possibility of a default on the bondswas being discussed in May, 1931,2ss and reorganization plans werebeing considered late in 1931.29 By February 1932, plans for cre-ation of protective committees were under way. 270 Apparently theGuaranty's trust officer by March 10, 1932, was aware that thecompany "has advised us that they will be unable to meet the April1st interest payments",2 71 and Guaranty decided not to advise bond-holders of this fact.272

If this collateral had not been appropriated by Guaranty TrustCo., it could have been withdrawn by Hoe and would have increasedthe assets to which the bondholders might resort for payment oftheir claims. But with knowledge of the default, Guaranty's onlyconcern apparently was to protect its own position-collect on itsoustanding loans. Guaranty not only withheld information of the

21Id., at 71-73. There are at the present time restrictions on loans made by mem.ber banks of the Federal Reserve system to their affiliates. See U. S. C., Title 12, Secs,371c, 221a.

2" Op. cit. supra note 107, at 390.2Id., at 395.205 Id., at 139-140, 390-392.

7 Id., at 392.

26 Id., at 106-107."I Id., at 108-109.20Id., at 110-111.m Id., at 118.21 Supra, at 39 et eeq.


86

imminent default from its cestuis; it capitalized on its inside knowl-edge of the situation to modify the loan agreement, freeze the de-posited collateral and salvage its own interests.

In this case, however, receivers for the company were ap-pointed. 7s These receivers, among others, challenged the validityof the modified loan agreement which gave Guaranty the benefitof the excess collateral.24 As a result, in June 1932, Guarantyrestored to the estate the excess collateral appropriated by it."'

This is not the whole story. Guaranty took further steps to assurethat its own claims against Hoe would be completely paid. Againstthe outstanding loan, it applied Hoe's checking balance of about$84,000 on May 11, 1932.276 Nor is this all. Guaranty was couponpaying agent for the bonds. In this capacity, it held a small amountof money to be paid to bondholders upon presentation of coupons.2 77

These were the same bondholders for whom Guaranty was trustee.Nevertheless, Guaranty, in April 1932, following the appointment ofreceivers for the Hoe Company, seized these funds and applied themon the loan account. 27 Whether or not Guaranty had been trusteeunder the indenture, its appropriation to its own purposes of fundswhich it held as paying agent is subject to serious question.21 Cou-

r7 Op. cit. supra note 107, at 225-226.M Id., at 397.

9" Ibid.27 Id., at 399.7 The amount was $1,194.83 held by Guaranty Trust Co. in an account maintained for

payment of bond and note coupons payable October 1, 1931. Id., Commission's ExhibitNo. 47. at 157.

278 Id., at 400-401, Commission's Exhibit No. 47, at 158.2" Cf. Northwest Lumber Co. v. Scandi navian-Ameriean Bank of Seattle, 130 Wash. 33,

225 Pac. 825 (1924) ; Steel Cities Chemical Co. v. Virginia-Carolina Chemical Co., 7 F.(2d) 280 (C. C. A. 2d, 1925) ; Sinclair Cuba Oil Co. v. Manat! Sugar Co., 2 Fed. Supp.240 (S. D. N. Y., 1932) ; 5 Michie, Banks and Banking (1932) ch. 9, sec. 129; but cf.Guidise v. Island Refining Corp., 291 Fed. 922 (S. D. N. Y., 1923) ; In re InterboroughConsolidated Corp., 288 Fed. 334 (C. C. A. 2d, 1923). For relevant provisions in the' in-denture under consideration, see pp. 21-22, and Sec. 75, thereof.

Guaranty Trust Co. in some other cases seems to have been more solicitous of theprotection of the bondholders against diversion or appropriation of funds which had beendeposited to meet interest. Several instances are set forth in the returns to the ques-tionnaire which this Commission sent to corporate trustees. See Appendix A. The fol-lowing information has been compiled from Guaranty's returns Nos. 4, 8 and 9:Return No. 4: Trustee filed a proof of claim on behalf of all bondholders against funds ondeposit with the receiver for the fiscal agent, which funds had been deposited prior todefault to meet the next maturing interest coupon. Hearing was held thereon, trusteecausing a notice of the hearing to be mailed to all bondholders of whom It had a record.Proof of claim allowed and funds disbursed to bondholders by trustee. Guaranty was nota creditor of the debtor in any capacity.Return No. 8: Return states: "In addition, on behalf of the bondholders, we applied tothe court and established the fact that approximately $10,000 on deposit at the time ofthe receivership, to pay past due coupons should be considered as trust funds and heldfor the account of the holders of the past due coupons rather than paid to the receiversof the obligor." Guaranty was not a bank creditor of the issuer although it did hold theissuer's bonds in trust accounts for others.Return No. 9: This return states: "Shortly after the default and the appointment of re-ceivers, the receivers claimed the balance which we held for payment of past due coupons,and we contested their right to this money on the ground that it was held by us in trust.


87

pling this with the fact that Guaranty was in fact trustee under theindenture, one is justified in condemning this action as a flagrant abuseof fiduciary duty. By virtue of these maneuvers and direct col-lections, Guaranty was completely paid off by August, 1933.280 Butin the reorganization which followed the receivership, and whichGuaranty dominated, the bondholders, for whom it was trustee, hadto accept a substantial cut.

After Guaranty had seized all Hoe assets in its possession andapplied them against the loan account, it decided to resign ascorporate trustee. 21 It actually resigned in August, 1932.282 Thereason given for its resignation was that it "might be [in] incon-sistent and conflicting positions." 258 This realization, to say theleast, came late. Guaranty Trust Co. was advised by its counsel,Davis, Polk, Wardwell, Gardiner & Reed, that it should resign ascorporate trustee. Leighton H. Coleman, a partner of that lawfirm, testified as follows before this Commission:

"Q. Will you state the reasons why Davis Polk advised Guaranty Trustthat it should resign as corporate trustee?

A. As I recall it, there were two reasons, one that Guaranty TrustCompany was a banking creditor of R. Hoe Company, Inc. and was engagedin a controversy which resulted in settlement of part of its loan and wefelt there might be litigation with regard to that in which Guaranty Trust,as banking creditor, would have to take part, and that might involve con-troversy between it, as banking creditor, and itself as corporate trustee.

Q. Did you render that opinion, you personally?A. I think I did. It may have been my partner, Mr. Sunderland."

"The second reason was that there was always a possibility that the trusteemight be requested by bondholders to commence foreclosure action or takesome other steps in proceeding and we wanted it to be entirely free to do sowithout any conflict.

During all of 1932 and the spring of 1933 we had a great deal of correspondence with thereceivers and their counsel regarding the status of these coupon monies, but failing toconvince them In this manner that these monies were held by us in trust the questionwas finally taken before the court in the summer and fall of 1933. The receivers filed apetition asking that the court order us to return these monies to them, and we filed ananswer setting forth our position. A number of affidavits executed by our officers whowere familiar with the facts were presented to the court in support of our position. EarlyIn 1934 the court declared that these monies were held by us in trust and ordered us touse them for payment of coupons due prior to the default. After the period duringwhich an appeal could be taken had expired, we resumed payment of such coupons. Wewere in constant conference with our counsel during these proceedings and they, ofcourse, represented us at the various hearings before the court." Guaranty was notcreditor in any capacity of the debtor.

Henry A. Theis, vice-president, Guaranty Trust Co., writing in 125 Bankers Magazine(1932) 47, 51 says, "A provision we have found to be of special value is that funds held

by the trustee, whether for the payment of interest, principal or what not, shall bedefinitely earmarked as 'trust funds'. Holders of bonds should appreciate the value ofsuch a provision, particularly in these times of frequent defaults asJ receiverships."

M5 Op. cit. supra note 107, at 396.21 Id., at 428.2Id. at 425.I Id.. at 428.


Q. And that possibility of conflict with respect to your second point mightarise because of Guaranty Company's position as a banking creditor?

A. It might arise because of its position both as banking creditor and ascorporate trustee.

Q. Mr. Coleman, do you think that a trust company occupies an incon-

sistent position when it is both corporate trustee and banking creditor?A. Not necessarily.Q. You thought that it did in this case, on the facts of this case?A. I think you have to examine into the facts of each case; I don't think

you can lay down a general rule.Q. You think that default makes a certainty of that?A. No, I wouldn't say default necessarily makes it certain. I say default

makes it more nearly certain, but I don't know that we would necessarilyadvise a corporate trustee to resign after default merely because the bankingdepartment had a loan. I mean you have to consider each case on its merits.

Q. Prior to default, there is a possibility of that inconsistency, isn't there?A. I think there is always a possibility of an inconsistency but I think you

have to remember you are dealing with honest and reputable business people

and if the real conflict should arise, they'd be the first ones to want to par-ticipate. (sic)

Q. The common law of trusteeship never made a distinction on the basis ofparticular individuals?

A. No, I think the common law in personal trustees and corporate trusteesare developed along slightly divergent lines.

Q. I agree with you, very much along different lines.A. Whether rightly or wrongly I wouldn't like to state now.Q. In other words, you think an analogy as drawn between the law of

private trusteeship and corporate trusteeship are few and far between?A. I wouldn't say few and far between, but they do differ, yes." "

Self-interest of the sort which motivated Guaranty is a powerfuldeterminant of action. However honest or conscientious a trusteemay be, if it occupies a creditor position competitive with that ofits beneficiaries, self-interest may lead to violations of fiduciary obli-gations. And these violations of fiduciary duty, motivated as in theHoe case, by desire to protect its personal position in the company,are made possible, easy and perhaps irresistibly inviting if thetrustee, because of affiliations with the management and its bankers,is able to enlist their cooperation.

The Hoe case is not the only one in which Guaranty Trust Co. hasacted adversely to bondholders for whom it was trustee, or has failedto act on their behalf, because of its desire to protect its own finan-cial interests. Nor is Guaranty Trust the only institution whichhas occupied a position adverse to bondholders for whom it wastrustee, and which has sacrificed the bondholder's interests in orderto salvage its own.

Cuba Cane Sugar Corporation was organized by a group of NewYork investment and commercial bankers in 1915 to develop sugar

SIL., at 454-457.


lands and mills on the island of Cuba. One of the banks originally

interested in this company was Guaranty Trust Co. As shown by

the company's first report, for the year ending 1916, Guaranty was

represented on the board by two of its officials.285 Eugene W. Stetson,

vice-president of Guaranty Trust Co., became a director and member

of its executive committee in 1919 or 1920 289 and continued as a

director of this company and its successor, Cuban Cane Products

Co., Inc. 2 7 Guaranty was also represented on the board of the

company's wholly owned subsidiary, Eastern Cuba Sugar Corpora-

tion."'8 Guaranty Trust was also a depositary for the company'sfunds and trustee for the $25,000,000 issue of Cuba Cane deben-tures.

2 89

Guaranty Trust Co., with other New York banks,290 in 1928 hadoutstanding a line of credit of $12,000,000 to Cuba Cane Sugar Cor-poration. In November 1928, this line of credit was unsecured, asit had been for several years prior.2 " The Cuba Cane debentures($25,000,000) matured on January 1, 1930. These were bad timesfor the sugar industry and it was apparent that the debentures couldnot be paid off, but would have to be refunded. So in November,1928, the bank creditors, including Guaranty, took steps to obtainsecurity for their loans to Cuba Cane (as Guaranty had done in theHoe case). This was required as a condition to further extensionof credit.2 9 2 In that month, sugar acceptances and stocks and bondsof Cuba Cane affiliates were pledged to the banks.292 Guaranty andthe Chase National Bank, in June of 1929, also obtained a secondlien on this collateral to secure a new loan of $1,250,000.294

In that same month,292 June of 1929, readjustment of the com-pany's debentures was decided on in order to provide against the1930 maturity.296 As a further reason, it was alleged that the banksrefused to make the loans necessary to its operations without re-settlement of its financial structure.297 A reorganization was effectedin the next few months. It was taken for granted by all concernedin effecting the reorganization that by virtue of their secured posi-tion, there could be no bargaining for concessions from the banks.!!)

Op. oft. supra note 131, at 18, 19.Id., at 419-420.Id., at 420.

• Id., at 483.Id., at 42, 712.

2 Id., at 103, 104.2'Id., at 104.w2 Id., at 124, 138.'MId., at 129.

'Id., at 130-131.21 Id., at 191, 192.

' Id., at 192.2r Ibid.

' Id., at 164-165, 288-286.


Charles Hayden, chairman of the Reorganization Committee,testified before this Commission:

"Q. That is, it was clear in the minds of everybody that the banks weregoing to come out whole in this picture?

A. They had made secured loans to permit the company to go on.Q. That is, they had security and there was no bargaining with respect to

the bank creditors?A. None whatever.Q. Did Mr. Stetson at any time urge that the debenture holders should get

a little better treatment and the bank creditors should get a little worse treat-ment than was provided in that plan?

A. Never did to me." m

And, indeed, by provisions of the plan, the outstanding bank debt wasassumed by the reorganized company2 °0

But the advantage of the banks was the result of the action takenin November, 1928, to collateralize their loans. No criticism couldattach to such action by a bank creditor which has no inconsistentduties. Its responsibility to its stockholders and depositors maywell justify its engaging in every legal and honorable maneuver toassure collection of its loans. But when a bank has assumed fi-duciary obligations to bondholders, it has pledged itself not to sacri-fice their interests. And Guaranty Trust clearly took action heredetrimental to them. Improvement of its position as bank creditormeant, by the same token, impairment of the security of the othercreditors. Thus, when reorganization became necessary, the attain-ment of a superior position by the banks was a fait accompli: theonly creditors from whom concessions were sought were the deben-ture holders. Guaranty found itself in the impossible position ofhaving two masters whose interests were antithetical; it could notdischarge its duty to both.

Indeed, officers of Guaranty Co. and Guaranty Trust Co. weremembers of protective committees in this reorganization. EugeneW. Stetson, vice-president of Guaranty Trust Co., was a member ofthe Reorganization Committee, and Joseph R. Swan, then presidentof the Guaranty Co., was chairman of the Debenture Committee. Inlight of our previous discussion, comment upon this would be super-fluous.

Mr. Stetson, in another and later episode connected with EasternCuba Corporation, a subsidiary of Cuba Cane, had resigned from aprotective committee because of the conflicting position of Guarantyas trustee and as creditor.30 1 Asked why he did not likewise resignfrom the reorganization committee of Cuba Cane, he testified:

"A. I didn't think it was necessary.Q. What differentiates that situation from the Eastern Cuba situation?

Id., at 164.Id., at 137.

.14, at 507, 508.


A. Because no complications arose at that time similar to the complicationswhich subsequently arose in this case (i. e., Eastern Cuba)."

* * * * * * *

"Q. You prefer not to elaborate the differentiating circumstances?A. Exactly.Q. And you prefer not to say why you did not resign from the reorganization

committee?A. I have already said I didn't think it was necessary.Q. And you prefer not to elaborate on that?A. Exactly." "2

But this does not complete the story of Guaranty and Cuba Cane.Subsequent to consummation of the reorganization referred to above,Guaranty continued as trustee for the debentures. Guaranty andother banks continued to lend money to the reorganized "Cuban CaneProducts Co., Inc." We make no attempt to relate all the methodsby which the banks obtained security for the loans which they made.But apparently, about July, 1931, Mr. Stetson of Guaranty becameconcerned about the banks' protection. In that month, Charles Hay-den, director of Cuban Cane and senior partner of Hayden, Stone &Co. (one of the company's bankers), wrote to Mr. Stetson:

"Dear Gene:I am in receipt of your letter of even date. I quite concur in fully protecting

the banks and getting quick action it is absolutely essential that the Counselfor the Cuba Cane get into conference with the Counsel for Chase and Guarantyat the earliest possible moment * * * "I

Under date of July 24, 1931, Eastern Cuba, a wholly owned sub-sidiary of Cuban Cane, mortgaged its principal free assets to CubanCane, the Central Hanover Bank being trustee, and Cuban Canepledged bonds issued pursuant to that mortgage to the banks tosecure loans.304 The result of this move, apparently induced by adesire to fully protect the banks, was that the banks obtained a claimupon assets indirectly owned by Cuban Cane, prior to that of thedebenture holders. Guaranty and its associates appear indeed tohave acted quickly; but in its rapid movements Guaranty seems tohave ignored the effect of its action upon the debenture holders, itscestui.

The final sequence in this series of events took place in June 1935.In their successive and ever-increasing moves to obtain adequatesecurity, the bank creditors of the Cuban Cane had in 1930 causedthe management to execute a mortgage of its property and assets tothem, the Central Hanover Bank & Trust Co. being trustee.-o5 InApril of 1932, some $9,500,000 was owed to these creditors, one of

1 ' Id., at 510-512.'Id., at 442."I Id., at 445-446.

1l., at 424-426.75957"-86--


whom was Guaranty Trust Co.306 Receivership proceedings werebegun in April, 1932, in the Federal District Court for Delaware, andthe banks moved to foreclose their mortgage pursuant to a plan ofreorganization contemplating transfer of the assets to a new com-pany.

On January 21, 1933, Guaranty Trust Co. wrote the followingletter to a person who had inquired concerning the Cuban Canedebentures:

"This company was trustee of the issue, which Issue of bonds was given inexchange in the reorganization of the Cuban Cane Sugar Corporation * * *In the United States District Court of Delaware, a creditor's bill was filedand receivers were appointed for the Cuban Cane Products Co., Inc. In suchreceivership proceeding an order was entered authorizing and directing us, asTrustees of the debenture issue, to file claims in behalf of all bondholders.Such claim was duly filed in either the month of July or August 1st. Althoughmore than eight months have elapsed since the receivership, no steps havebeen taken to organize security holders of Cuban Cane Products Co., Inc. andas far as we know no one has taken steps to protect the interest of the deben-ture holders except by the filing of claim in behalf of debenture holders ashereinabove described.

"On December 6, 1932 this company notified Cuban Cane Products Co., Inc.of its resignation as trustee, and Manufacturers Trust Company of the citywas appointed successor trustee, said appointment having been accepted byManufacturers Trust Company on December 27, 1932." '

Mr. Stetson of Guaranty "assumed" Guaranty resigned "on adviceof counsel", although he did not know the substance of counsel'sadvice.8oS

The banks in 1935 urged upon the court that the costs of reorgani-zation be borne by the old company as well as the new. This would,of course, result in cutting down the distributive share to which thedebenture holders would be entitled. This allocation of expenseswas eventually ordered. In the course of the consideration of thebanks' proposal which resulted in improving their position asmortgagees and owners of the new company, the court remarked:

"If I am authorized or given power to impose on the new company the allow-ance asked for the debenture-holders' protective committee, Sullivan & Crom-well, and the disbursements by that law firm, why cannot all these allowancesbe imposed on the new company?

"Mr. Layton: I think they can, if the Court sees fit to do so. It would seemto me that that would be rather a hardship in a sense upon the creditors whohave seen fit to accept the benefits of the plan and go into the new company.It would seem to me perhaps it might be more equitable, and I am making thisonly In my own notion, that there would be some equitable distribution madeof those expenses.

Ig61., at 498.wlId., at 523-524.80 84., at 525.


93

"The Court: If there is anybody in this situation who has protected himself

adequately, fully, and completely, it is the banks."Mr. Layton: That is.quite true. They have been in the position of senior

lien-holders all through the proceeding."'

The reorganization plan permitted debenture holders to subscribeto stock of the new company at $10 a share. 10 - If they had all sub-scribed, the banks would have been completely bailed out, withinterest. So testified Mr. Hayden before this Commission:

"A. * * * The only other conclusion, and this is what I have alreadymentioned, that Mr. Stetson said at luncheon at the Powhatan on Thursday thathe would be delighted if any fellow came up to him, so far as he was individuallyconcerned, to sell him the stock at $10, and also the fact that to the best of myknowledge and belief there have been some small transactions, and they couldn'thelp being small, at about 10, 1Oy/, or 1014, within the last month.

Q. At a price of 10 or 1014?A. That was the subscription price.Q. At that price the banks would be completely bailed out?A. Without profit, except the interest on the money while it was in."

If a debenture holder did not like this privilege, he would be en-titled to receive in cash $2.50 to $3.00 on a $1,000 bond, his share ofthe price which the bankers, through their new company, bid for theassets at judicial sale. 812 In other words, he could bail out thebankers, sinking new money into a company which they controlled,or accept about 0.3 percent on the face of his bonds.

Very few of the debenture holders invested the additional money BIBand the banks own the property almost entirely. The net result wassuccintly stated in the court proceedings:

"The Court: Practically the $25,000,000 debenture-holders are out?"Mr. Layton: They are practically out."Mr. Crosby: Except a very small percentage." "'

Mr. Hayden testified before this Commission to the same effect:

"Q. Mr. Hayden, from your own acquaintance and association with this in-dustry and your knowledge of the sugar industry, would you say that todaythe five banks that for all practical purposes now own this sugar company-

A. Yes.Q. - have represented in that sugar company an investment which is-A. $7,000,000.Q. $7,000,000?A. Yes." "a

* * * * * * *

"o Id., at 907.mo Id., at 889-890.

B" Id., at 914.n

2 Id., at 909.811 Id., at 898.

.., at 906.Id.. at 912-918.


Q. That is, the five banks are in-A. They are. They own it.Q. -and the old investors-A. - are out.Q. And the old stockholders in the securities of this company-A. - are out.Q. They are out once and for all, completely?A. Except the few that subscribed.Q. Except the few that subscribed?A. Absolutely correct, * * *." no

The point of this history needs no embellishment. The simplicityof the progressive acts by which the banks emerged as owners andthe security holders with a return on their investment amounting tonothing more than a pittance, speaks for itself. It is not here ap-propriate to comment upon the acts of the banks generally. It isnot improbable that if Guaranty Trust and some of its fellow bankshad not controlled the management of the company, they would nothave been allowed progressively to impound its assets. And it isquestionable that this virtually complete disaster to everybody ex-cept the banks would have resulted if the trustee for the debentureholders had taken prompt and vigorous action to protect their inter-ests. An active trustee might well have considered,, in light of allthe circumstances, that it should have opposed the 1929 reorganiza-tion whereby the claims of the banks on the assets of the companywere left intact and the debentures which matured in 1930 were ex-changed for "Participatirfg Debentures" which would not matureuntil 1950, which, in place of a fixed interest obligation of 7 or 8percent, carried a fixed interest rate of but 6 percent beginning1935, 317 and which it was provided, might be subordinated to bankloans up to twelve million dollars in amount.31" It might have feltit necessary to call to the attention of debenture holders the transferof the valuable Violeta Mill from Cuba Cane to Eastern Cuba,which was subsequently mortgaged to raise funds to pay off an out-standing book loan of $10,000,000.s1 It might also have felt it ap-propriate to urge upon the District Court more favorable treatmentfor debenture holders. Whether all or any of these steps would havebeen wise or justified is difficult to say. But it is clear that GuarantyTrust Co., trustee for the debentures, was in no position to make ajudgment in the interests of the debenture holders. It was one of

no id., at 918.81 During the first five years of the life of the new debentures (to 1935) 6 percent

Interest, subject to certain provisions for accumulation, would be payable only if earned.Also, during the entire life of the debentures an additional 3 percent would be paid, ifearned, before any dividends on stock were paid, or at maturity. Id., Commission'sExhibit No. 48, at 3-4.

"s Id., at 290." Infra, at 98-99.


the benefited creditors; and its affiliation with the corporation wassuch that it was committed by the action of the management-which it and other bank creditors dominated. This point can bestbe made by relating the story of an attempt by bondholders to pre-vent the foreclosure sale which we have just described.

One of the participants with Guaranty in the loans to Cuban Canewas Chase National Bank. Chase was also a beneficiary of thesecurity obtained for the bank loans in the manner described. Since1922, Chase had been trustee for $10,000,000 bonds of Eastern Cuba,Cuban Cane's wholly owned subsidiary. 3 2 Two of its officials,Robert I. Barr and Carl Schmidlapp, were successively directors ofboth Cuban Cane and Eastern Cuba.321 Charles Hayden, a directorof Chase 822 was a director of both companies 82 and a dominantfigure throughout their history. In April 1932, when Cuban Canewas placed in receivership, large sums of money were owed to banks,including $4,300,000 to Chase and $2,600,000 to Guaranty. 24

In 1933, Central Hanover started the foreclosure, which we havealready mentioned, of the Cuban Cane mortgage given to secure thecreditor banks, the largest of which was Chase. The sale was setfor January 30, 1934.12- A committee representing the EasternCuba bondholders, for whom Chase was trustee, wrote to the Chaseon January 17, 1934, asking it to take steps, for the protection ofthe bondholders, to prevent the sale by Central Hanover under thebank creditor's mortgage.3 26 To expect any action was absurd. Ineffect, the bondholders were asking the Chase National Bank, theirtrustee, to take steps to prevent a foreclosure sale from which theChase National Bank would principally profit, as creditor of CubanCane.

Chase answered the committee's letter seven days after it was sent(although both Chase and the chairman and counsel of the commit-tee are located in New York City), and six days before the sale tookplace. They said they would be "glad to have your counsel discuss"the matter with Chase's counsel, if the committee (1) showed thatit represented the percentage of bonds specified in the indenture,and (2) deposited with them "satisfactory indemnity for any liabil-ity or expenses to which we may be put". Then, the trustee said,"We will be glad to take such proceedings as we may be advised by

m Id., at 795, Commission's Exhibit No. 35.mId., at 147-148; Poor's Industrials (1929), at 95; id. (1930), at 1725; Moody's

Industrials (1931). at 1316. 1318.8m Op. cit. supra note 131, at 11.

1 Id., at 12-13.R'I., at 498. At or about the time of the appointment of the receivers Chase siezed

some $120,000 on deposit with Chase and applied it against the loan. Id., at 711.SId.. at 795.Id., at 794-796.


our counsel are proper". This reply of Chase, dated January 24,1934, read as follows:

"If you advise 'us that your committee represents the percentage of out-standing bonds of Eastern Cuba Sugar Corporation contemplated by the in-denture and are willing to deposit with us satisfactory indemnity for anyliability or expenses to which we may be put, by acting in accordance withyour request I * * we will be glad to have you indicate through yourcounsel or otherwise what proceedings should be taken and will be glad tohave your counsel discuss the same with our counsel, and we will be gladto take such proceedings as we may be advised by our counsel are proper." 27

Laurence A. Crosby, member of the New York law firm of Sulli-van & Cromwell, and counsel to the Eastern Cuba Committee, fa-vorably compared this reply with the letter written by ManufacturersTrust Company, as successor trustee of the Cuban Cane debenturesissued as the result of the 1929 reorganization, when it was requestedto take similar action:

"Q. But when you come right down to the question of getting them to dosomething, you find them writing a letter saying 'supply us with funds and wewill send our counsel around to talk with your counsel, and if our counseladvises us properly, we will do something'?

A. But they wrote us a great deal better letter than the ManufacturersTrust Company.

Q. It is a longer letter. Is that why it is better?A. It refers to the fact that the counsel in trying-Q. You don't mean by a better letter a more astute letter?A. No, I mean it shows that they knew something about the situation, were

closer in touch with it." 828

Chase's knowledge of the situation did the bondholders no good.Presumably, Chase National Bank as trustee was as closely in toucbwith the situation as Chase National Bank, the creditor. But thetrustee in fact refused to act in the interests of the bondholdersand to the detriment or delay of itself as creditor. Mr. Crosbysaid he did not think this situation resulted in inadequate repre-sentation of the Eastern Cuba debenture holders. His testimonyfollows:

"Q. The dominant Chase interest in that was, in fact, the Central Hanovermortgage, was it not? They were partners, so to speak, with the other bank?

A. They had the larger percentage of the mortgage. You mean Chase'sprimary concern was to collect their part?

Q. Would you say so, as a commercial bank?A. As trustee they had no personal interest in the Eastern Cuba mortgage,

if you are just comparing personal interest with personal interest. Of course,their larger interest was in Cuba Cane. They didn't have any personal interestin Eastern Cuba at all.

Q. Don't you think that is a type of situation which is very apt to give riseto debenture holders and bondholders being inadequately represented?

=7 Id., at 797.Id., at 803-804. For Manufacturers Trust Co. Incident, see supra, at 45 et 8eq.


A. It might. I don't think it did in this case, but it might.Q. You don't think it did in this case?A. No, I don't think so."

"Q. Mr. Crosby, as a practical matter, can you visualize Chase Bank as cor-porate trustee under the Eastern Cuba mortgage taking effective steps to pre-vent the Chase Bank under the Central Hanover mortgage from foreclosing?

A. That is sort of a Pooh-Bah question. I can visualize them doing it.Q. Isn't it a sort of a Pooh-Bah situation?" 82

The conflict of interest of Chase was patent. Chase, or any otherbanking institution in the same situation, as bank creditor, owed anobligation to its depositors and stockholders to take all steps neces-sary to protect and preserve its loan irrespective of the injury whichsuch measures might cause to others who were investors in the sameenterprise. But as trustee for bondholders its duty clearly lay in thedirection of taking prompt and vigorous action to protect the inter-ests of the bondholders. Obviously, Chase, or any other person inthe same situation, could not and cannot effectively serve its twomasters. One of these masters is bound to be neglected for the other.One of them is bound to get all of that loyalty to which both of themhave equal claim. Knowing where Chase's pecuniary interest lay,one cannot be greatly surprised that, when a choice between Chase'stwo masters had to be made in this Eastern Cuba situation, Chaseas bank creditor assumed a dominant and aggressive role, whileChase as trustee for the bondholders did nothing.

It is interesting to note that Mr. Crosby felt that "under the exist-ing system of corporate trusteeships", nothing better than Chase'sinaction could have been expected from any trustee, even thoughit was not a creditor of the corporation:

"Q. Do you think they promised you as much as a corporate trustee who wasnot a bank creditor could have promised you?

A. Yes, I do, under the existing system of corporate trusteeships. Underthe existing system I don't believe you will get any respectable institution inthe United States for a fee of $2,000 to $4,000 to undertake risks and startlawsuits-

Q. I understand, but my point is this: Wouldn't your chance of getting acorporate trusteeship galvanized into action be much less if you make yourcorporate trustee a holder of an adverse mortgage?

A. I don't think so, necessarily. I certainly don't think so in the case of theChase. My experience with the Chase was that they were always very sensi-tive about this situation and wanted to be careful that they were doing whattheir duty as trustee called upon them to do. It was always in their minds.

Q. Always in their minds that they would do what?A. It was always in their minds that they would be particularly careful

to do what a corporate trustee should do under the existing system, in theprotection of the bondholders. I think they felt that the fact that they had thisother interest should make them more careful and more anxious than theordinary trustee would have been. You say they didn't do anything.

"2 Op. cit. supra note 181, at 802-808.


Q. Yes.A. My answer to that is no corporate trustee would have done anything in

that situation."no

The indictment of the whole present system of corporate trustee-ships implicit in Mr. Crosby's testimony is no overstatement. Butcorrection cannot be expected unless and until conflicting positionsare absolutely outlawed. Banks should not be expected or allowedto sacrifice the interests of their stockholders and depositors; on theother hand, they should not be allowed to seize the funds and sacri-fice the interests of investors for whom they have undertaken to actas trustee.

The impact on the security holders of the conflict of interest aris-ing as a result of the trustee being a short term creditor usuallywill be greatest immediately preceding or immediately followingdefault. But such conflict of interest may be detrimental to thesecurity holders on other occasions as well. One such instance maybe the case where the trustee is a bank creditor as well as trustee ofa debenture issue which contains a negative pledge clause. Theissuer of the debentures may be faced with the necessity of incur-ring new long term indebtedness in order to repay its bank loans.To float a new security issue the issuer may feel that, if it complieswith the negative pledge clauses in debentures which are presentlyoutstanding, it may have difficulty in selling the new securities. Ifthe trustee of the debenture issue is likewise one of the short termcreditors to be paid with the proceeds of the new security issue, itcan readily be seen how the self-interest of the trustee may result inits closing its eyes to the avoidance or circumvention of the negativepledge clause. In such situations the debenture holders are apt tofind that their trustee is no vigorous champion of their rights. Howthe facts may shape a situation of this kind was indicated in thehearings before this Commission relative to the Cuba Cane SugarCorporation.

That company in 1920 sold 25 million of debentures, partly toreimburse it for expenditures in acquiring properties. 3 1 Amongthose was the Violeta plantation, directly owned by the Violet SugarCo., all the stock of which Cuba Cane acquired. 3 2 Between 1920and 1922, the Violeta plantation was transferred to the EasternCuba Sugar Co., wholly owned subsidiary of Cuba Cane. 833 Thisproperty thus became one of the assets securing 10 million in mort-gage bonds sold by Eastern Cuba in 1922.1'4 The only security forthe Cuba Cane debentures sold in 1920, for which the Guaranty

m Id., at 804-805.a Id., at 35, 38.aId., at 38, 44, 45.

Id., at 44, 64.3"Id., at 60, 68.


Trust Co., was trustee,885 was a restrictive clause covenanting not tocreate any mortgage or lien on its property except in the acquisitionof properties or in renewals of existing liens.,,, This clause mightwell have been violated, if not technically then certainly in spirit,by the new Eastern Cuba mortgage, because Cuba Cane, throughstock ownership, owned the Violeta in 1920. For protection of theirinterests Cuba Cane debenture holders had to look to the trustee.But the Eastern Cuba bonds were sold in order to repay bank loansincurred by Cuba Cane in 1921. And the eventual issuance of thesebonds had been a condition on which the banks made the loans.88 'And one of the bank creditors which looked to the sale of the bondsfor repayment of its loan was the trustee for the Cuba Cane deben-tures, Guaranty Trust Co.838 Nor could the debenture holders ex-pect any protection of their rights from the management which wasdominated by the interested bank creditors, including their trustee.

Perhaps transactions of this sort can be defended by the manage-merit of a corporation on the ground that they are necessary anddesirable in the interests of corporate operations and for the benefitof stockholders. Perhaps this is a legitimate and determinative re-sponse for the management to make. But it is no defense for thetrustee for bondholders. They have bargained for a particular typeof protection in the assets of the company, and it is the trustee'sbusiness to see that they are not deprived of it. But when the trusteeis closely identified with the management, it is again being subjectedto contradictory demands of loyalty. And here again, the less vocaland less personal interests of bondholders may be sacrificed, and thetrustee is likely to perform only its duty to the management.

It is not rare to find a bank occupying the dual position of trusteeand short term creditor. 78 percent (240 out of 308) of the trusteesreplying to this Commission's questionnaire also functioned as com-mercial banks. About 8 percent (19 out of 240) of these commercialbanks had outstanding short term credits to the issuer of the bondswithin a year prior to default on the bonds.

Other types of affiliations with the management are not infre-quently found. The affiliations disclosed by the returns of corporatetrustees to a questionnaire sent out by this Commission are set forthin Appendix A, Section I, Table 2. In 34 (11 percent) of the in-stances, the directorates of trustee and issuer were interlocked.Other direct management affiliations existed in 4 cases.

Representation of the issuer on the board of the trustee may giverise to an alliance which is dangerous to the security holders repre-

Id., at 42.Id., at 43, 69. 70.

7 Id., at 60. 66, 78.'O Id., Commission's Exhibit Nos. 81, 82.


100

sented by the trustee, since the interests of debtor and creditor arecommonly antithetical. This conflict certainly arises where suchrepresentation gives the issuer control of the trustee. It may like-wise arise where a minority of the board of the trustee is composedof officers or directors of the issuer, 33 9 especially in times of troublewhen the trustee is preparing to take active steps to collect the debt,to enforce the security, to obtain appointment of a receiver, and thelike. The same considerations apply to allowing a director or officerof the issuer to be an executive officer of the trustee. The primaryconcern of the management of a corporation normally will be withstockholders. Accordingly, in the interests of the beneficiaries ofthese trusts it is the part of prudence and safety to eliminate theissuer from the councils of the trustee.

The same considerations apply to situations where the trustee ownsor represents stock or other junior interests of the issuer. It willthen tend to be under constant pressure of antithetical loyalties. Itsloyalty to management may demand a constant drive to maintainthe company as a going concern in the interests of stockholders, eventhough the assets upon which bondholders have a claim are wastedor diverted, as in the Cuban Cane case. The interests of bond-holders, on the other hand, may demand prompt recognition of de-fault and action to foreclose. In cases like the Hoe case, the trusteewould be less likely to withhold news of impending default frombondholders if it were not identified with management, directly orindirectly, through stock ownership or a voting trusteeship of thestock.

On the other hand the trustee should not be disqualified frombeing represented on the board of directors of the issuer. It is fre-quently the part of prudence and wisdom for creditors to be repre-sented on the board of the debtor. 8 " From that vantage point

8w In this connection it is interesting to note that from October 10, 1927 to March 12,1932 (the date of his death) Ivar Kreuger was a director of Lee, Higginson Trust Co.,trustee for the Kreuger-Toll debentures. Op. cit. supra note 14, at 105.

80 In reply to the questionnaire which this Commission sent to corporate trustees,Chase National Bank included in one return the following episode relative to its investi-gation of the allegation that the affairs of a company, which was a "controlled company"of the issuer, were being mismanaged. This reply was responsive to Sec. 4, Item 1 of thequestionnaire, set forth in Appendix A. The return states:

"In Pebruary in 1935 the Trustee was informed that one of the Bondholders' Commit-

tees believed that the affairs of [said company] were being mismanaged and that itsassets were being wasted. The Trustee communicated with said Committee in an en-deavor to ascertain the basis for the Committee's views. After examining such data andreports as the Trustee was able to obtain from said Committee and after repeated confer-ences and discussions with the President of [said company], the Trustee was unable toreach the conclusion that the views of said Committee were well founded; but the Trus-tee, in vie% of the charges made and in view of the fact that it held under the Indenture27,402 shares of common stock of [said company] arranged for the election on July 2,1935, of a representative of the Trustee as a member of the Board of Directors of [saidcompany], and said representative has been and is continuing to attend meetings of theBoard of Directors of [said company] and to study the management problems of saidCorporation and to report currently to the Trustee concerning its affairs and concerningthe management problems from time to time confronting it."


creditors can, through their representative, more adequately protecttheir interests against improvident or fraudulent acts than if theyare debarred from participating in the councils of the debtor. Con-ceivably situations will arise where the best protection which a trus-tee can render its beneficiaries will be by taking part in the delib-erations of the directors of the issuer. It may by that method bebetter able to thwart plans to evade or avoid negative pledgeclauses; to be advised of management policies detrimental to thesecurity holders; to be warned of impending defaults and to knowof actual defaults. Trustees with conflicting interests could well usesuch posts to their own advantage, and to the detriment of the bene-ficiaries of their trusts, as some have done. But if these conflictsare eliminated, genuine service to the security holders could berendered by not only permitting but encouraging this type of affilia-tion. As a matter of fact, since we conclude that the necessaryreform is to make these trustees active trustees, such affiliation mayat times be almost essential if they are to perform the obligationsof that trusteeship. Though such affiliation may not always be nec-essary, it will at least provide a convenient method for the trusteeto perform part of those obligations. Towards that objective thisCommission has already moved in preparing rules and regulationsfor qualification of directors under Sec. 17c of the Public UtilityHolding Company Act of 1935. These rules, though not yet for-mally adopted, are set forth in their tentative form in Appendix Fof this report.

It has not been uncommon to find the trustee identified with theissuer's investment bankers. Particularly was this the case beforethe Banking Act of 1933 required separation of investment andcommercial banking.s4' Section 32 of this Act provides that no"officer, director, or employee" of any corporation, association, part-nership or individual "primarily engaged in the issue, flotation,underwriting, public sale, or distribution * * * of stocks, bonds,or other similar securities, shall serve the same time as an officerdirector, or employee of any member bank * * * ,42 Section20 of the Act, read with Section 2 (b) (to which it refers) extendsthe prohibition to affiliations through stock control. Since theAct is applicable to all banks which are members of the FederalReserve System it automatically eliminates many of these trustee-underwriter affiliations. This is indicated by the fact that ques-tionnaire returns of trustees for 308 issues show that trustees for214 issues (T0 percent) were members of the Federal Reserve Sys-

"' Banking Act of 1933, Secs. 2(b) 20, 32. Secs. 20 and 32 were amended by Sees. 802

and 307 of the Banking Act of 1935.The section provides that the Board of Governors of the Federal Reserve System

may provide exemptions "by general regulations", "in limited classes of cases". SeeRegulation R issued by the Board of Governors pursuant to these provisions.


tem 84 while trustees for 94 issues were non-members. But evenafter the Banking Act of 1933 the question is by no means academic.The Act obviously has no application to individual trustees. Sec-tions 20 and 32 have no application to banks or trust companies thatare not members of the Federal Reserve System. And althoughSection 21 (a) prohibits non-members of the Federal Reserve Sys-tem from engaging in the business of underwriting and at the sametime engaging "to any extent whatever in the business of receivingdeposits subject to check or to repayment upon presentation of apassbook, certificate of deposit, or other evidence of debt, or uponrequest of the depositor: * * *.-, 84 this section does not in termsprevent banks from being affiliated with underwriters through stockownership -or interlocking directorates. Thus the Act apparentlywould not prevent close affiliations between the trustees and under-writers in the 94 issues referred to above where the trustees werenot members of the Federal Reserve System.

The questionnaire returns to this Commission show that in 288cases there was an underwriter; in 267 of these cases the trusteesreported on their affiliations with the underwriter and in 85 cases(32 percent of those reporting) such affiliations did exist. One con-spicuous example in recent years was Lee, Higginson Trust Co.,controlled by Lee, Higginson & Co., which owned an eighty percent. interest of the trust company.8 4

Eight of the partners and one of the employees of Lee, Higgin-son & Co. were directors of the trust company,848 there beingtwenty-one directors.8 4 7 In addition to the fact that Lee, Higgin-son Trust Co. was controlled by Lee, Higginson & Co., the trust com-pany was to a great extent dependent on the latter for a substantialpart of its business.

Francis C. Grey, former President of Lee, Higginson Trust Co.,testified before this Commission:

"Q. Did you look to the banking firm of Lee, Higginson & Company as oneof the sources of your corporate trustee business?

A. Yes, sir.Q. One of your main sources?A. Yes.Q. Do they customarily try to give as much business as they can in the

issuance of corporation issues, in corporations in which they are interested?A. I tiink they tried to. * *" "

s' Of the 308 issues involved, trustees for 238 issues were organized under the statelaws ; trustees for 70 issues were organized under the Federal Banking Act; trustees for240 issues carried on a commercial banking business in addition to their trust functions.

This Section was amended by Banking Act of 1935, Sec. 303." Op. cit. supra note 14. at 103.

8-"Id., at 106.'Id., at 104.

Id., at 111-112.


These affiliations have been even more conspicuous in the realestate .bond field. As we indicated in our report on Committees forthe Holders of Real Estate Bonds it was the common practice forthe trustee under the bond indenture to be an officer, director oraffiliated bank of the house of issue. As we stated in that report:

"Thus in case of 84 Straus issues, secured by properties located in Californiaand in the Pacific northwest and outstanding on February 27, 1931, Strausexecutive officers were acting as trustees for 77 issues, while trustees for only7 issues had no apparent connection with the underwriter * * *. Theextent of the underwriter's control over the trustee is indicated by an exami-nation of 1.37 defaulted issues underwritten by S. W. Straus & Co. of NewYork. In all of these issues we find that a Straus official or the Straus Na-tional Bank & Trust Co. (of New York) acted as either the original or suc-cessor trustee." N9

With such affiliation, it is clear that the trustee shares such con-flicts of interest as the house of issue may have. To the extent thatthe underwriter has an interest in securities which conflict with thosewhich the trustee represents, the trustee is not an independent repre-sentative of his beneficiaries. We have related above how conspicu-ous that conflict of interest was in the real estate bond field. Andas other parts of our report will demonstrate, such ownership orrepresentation by underwriters of other securities of the same issueris by no means peculiar to the real estate bond field.

Furthermore the underwriter may have many reasons for con-cealing defaults when it would be to the best interests of the securityholders to proceed forthwith to foreclosure, receivership, or bank-ruptcy. The underwriter may have junior securities to protect.It may have a market to maintain. It may have ties to the manage-ment which are so strong as to induce it to lull the security holdersinto a false sense of security. It may have a desire to obtain controlover the whole reorganization when it does come and to conceal de-faults until the reorganization stage is set, as in the Hoe case de-scribed above. To the extent that the trustee is closely affiliatedwith the underwriter, the trustee shares the conflicts which ariseout of these adverse interests of the underwriter.

We will set forth in other parts of our report further specificillustrations of such conflicts. It is sufficient here to refer to ourreport on Committees for the Holders of Real Estate Bonds wherewe pointed out how the houses of issue, by virtue of their controlover the trustees, were in control of the disclosure of defaults andmoved into a position of domination over the reorganization process.Failures to make deposits to meet principal maturities as requiredby indentures were sanctioned by the trustees; bonds instead ofcash were received as complying with the indenture provisions

Part III, committees for the Holders of Real Estate Bonds (1936), at 12.


although, as admitted by S. J. T. Straus, there was no power towaive this provision of the indenture. Mr. Straus testified thatthis was one of the methods houses of issue were employing toprevent foreclosures.ss ° The trustees acquiesced in this; nothingelse could reasonably be expected in view of their close affiliationwith the house of issue. Trustees deliberately shut their eyes todefaults in taxes; this, according to Harold Moore, then an officialof American Bond & Mortgage Company, who frequently actedas trustee, was customary.35 1 Some of the results of the affiliationsof trustees with houses of issue are summarized as follows in thereport on Committees for the Holders of Real Estate Bonds:

"The acquiescence of trustees in this program of the bond houses andtheir affiliates made it possible for houses of issue to peg the real estatebond market long after its value had collapsed; It enabled them to maintainthe prestige of no defaults, long after properties ceased to earn their expensesand charges. In addition, it resulted in direct, pecuniary damage to bond-holders because of the resultant failure to impound the rents and profits ofthe property, to which they were entitled upon default. Trust indentures forreal estate bonds generally provide that the trustee is entitled to possessionof the property, on behalf of bondholders, upon default; and along withpossession, it is entitled to receive the rents and profits of the property."

"Because of its hold upon the trustee, therefore, the house of issue was ableto conceal default and postpone action with the result not only that a deceptiveappearance of safety was created, but also that it as equity owner at timesprotected its own investment. Nor does this complete the story. The strategicposition of the bond houses, enabling them to control the announcement ofdefault, served to give them a measure of contol over the reorganizationprocess. If the house of issue wished time to form committees or to setup the reorganization machinery, it need not fear obstructive tactics fromthe trustee. If it desired the trustee to bring foreclosure proceedings, itneed not fear delay or insistence upon technicalities such as furnishing indem-nity or procuring demand by the requisite 25 or more percent of the bonds.On the other hand, the house of issue had little reason to fear that an oppositiongroup would bring suit to foreclose or to collect the principal of the bonds.The trustee would not accommodate a group hostile to the bond house, andit could not be compelled to act unless they massed that percentage of the totalamount of outstanding bonds, as required by the indenture, made demand andfurnished indemnity. And a rival group could hardly do this because the houseof issue possessed the only list of security holders. Without such list, therewould be small hope of organizing a substantial block of holders.,,35

"ld., at 19-20.Wild., at 36.m2 l., at 26-27, 28-29. In First Trust Co. of Lincoln, Neb. v. Ricketts, 75 F. (2d) 809

(C. C. A. 8th, 1934) the house of issue was also trustee or mortgagee. Unknown to thebondholders it made various advances to meet interest payments the mortgagor havingdefaulted. There was no provision in the mortgage that the mortgagee or trustee mightpay such Interest and have a lien therefor. The trustee was adjudicated a bankrupt.Its trustee in bankruptcy asserted that It was entitled to a first lien upon the mortgagedproperty for such advances. The court concluded that the interest coupons presented bythe bondholders to the bankrupt, though not marked "paid" or "cancelled" by It, "werepaid and not purchased, and are not entitled to share with the bonds In the proceeds of a


105

Thus such affiliations of the trustee with the underwriter tend tosubmerge the interests of the security holders and to make themsubordinate to the wishes, desires and selfish interests of the under-writer. The trustee tends to become a pawn in the hands of theunderwriter to serve the latter's ends. The trustee will be eitherunable or unwilling to look at the situation coldly and objectivelywith a single eye to the protection of his beneficiaries. He cannotfor he serves two masters.

Such affiliations are thus pregnant with danger to the securityholders whom the trustee is supposed to represent. Such affiliationsgive rise to even a greater conflict of interest where the underwriterhas been guilty of fraudulent misrepresentations in the sale of thesecurities. If the underwriter obtains control over the reorganiza-tion it obtains a large measure of protection against such claims.As we stated in the report on Committees for the Holders of RealEstate Bonds:

" * * * In the minds of bondholders, default itself creates distrust andsuspicion of the houses which originated and sold the bonds. Not much isrequired to fan this feeling of growing distrust and suspicion into a blazingfire of resentment against the houses of issue which may result in adverse pub-licity, litigation, and damage to any future business. In every default situation,regardless of the guilt or Innocence of the houses of issue, there is present thepossibility that a committee not controlled by the houses may take aggressiveaction of this sort. On the other hand, control of the committee--whetherexerted by placing members of the house of issue directly on the committee orby insuring the selection of men acceptable to the house of issue--means controlover the version of the situation presented to the bondholders through commit-tee circulars, advertisements and answers to inquiries. It also means * * *that if a friendly and cooperative plan of reorganization were worked out, thetrue facts as to the value of the property and the relation of the houses ofissue to it could be kept permanently in their possession and not brought tolight. It also means that there will not be a thorough investigation of possiblecauses of action against the houses of issue nor will there be litigation bythe committees against them.

"In this manner the houses of issue will minimize the risk of their own lia-bility to bondholders. In this manner they will also 'save face'. Through theirmouth piece-the protective committee-they can minimize the seriousness ofthe situation. They can blame mortgagors, depressions, and business cycles.They can divert criticism to those causes. They can, perhaps, completely pre-vent the searching light of publicity being cast on their own misdeeds. Theycan, perhaps, lull bondholders into some sense of security by virtue of the factthat they, the houses of issue, are working assiduously In the cause of the

sale of the mortgage security. Any right which the trustee of the bankrupt may have tolook to the security for reimbursement for interest advanced Is Inferior to the liens of thebondholders." The Court distinguished Ketchum v. Duncan, 96 U. s. 659 (1877), onthe ground that there were "circumstances in that case which would have put the bond-holders upon inquiry that their coupons were being purchased and not paid."

The court condemned the practice of making such secret advances:"Its advancing of interest to its customers ts to be attributed to a desire on its part to

preserve an unimpaired market for its mortgage bonds, rather than to a desire to confera boon upon them by purchasing their interest ooupon.."


Investor. In this manner they can perhaps avoid facing the clamor of bond-holders. By this method of control the bondholders may not get scentof the facts surrounding the issuance and sale of the securities. In this wayperhaps vast majorities of bondholders can be induced to deposit their securi-ties with the house of issue. Once that is accomplished effective control overforeclosure and reorganization has been attained. Minorities are rendered quiteimpotent. They cannot marshal enough support to make up the percentagenecessary under the trust indenture to demand foreclosure or other enforce-ment of the security underlying the bonds by the trustee. Likewise, the trustindenture may prohibit suit on their non-deposited bonds unless the trusteerefuses to act after demand by holders of a specified percentage of bonds.Thus dissenting groups are slowed up and made ineffective, if not completelystilled and rendered impotent.

"Control of the committee may have even broader consequences. We havementioned that bondholders who deposit with the committee under the cus-tomary 'iron clad' deposit agreement which prevailed in this field cannot readilyget back their bonds. No absolute right to withdraw normally exists. With-drawal for all practical purposes lies in the discretion of the committee. Andeven should the committee decide to permit withdrawal, assessments or evenpenalties normally must be paid for the privilege."

* * * * * * *

"In such manner do protective committees controlled or dominated by housesof issue stand in a peculiarly strategic position to protect the house of issueagainst its own misdeeds. In such manner do deposit agreements serve asinsulation for trustees (or their principals) against assertions of fraud, duress,and deception practiced on their beneficiaries."

To obtain such control over the reorganization the underwriternormally needs a friendly or complacent trustee-a trustee who willnot sound a cry of warning to the security holders; a trustee whoby inaction or by compliance with the wishes of the underwriterwill take no steps contrary to the desires of the underwriter. Theunderwriter had such a trustee in the real estate bond field. Hewill be likely to have such a trustee in any field if it is an affiliatedinterest. In such cases the interests of underwriter and securityholder frequently become antithetical. In the same manner theinterests of the affiliated trustee become incompatible with those ofits beneficiaries.

To recapitulate, if the trustee is affiliated with the issuer or withthe underwriting bankers, it is all too likely to be sympathetic withtheir concerns. It is under constant pressure to protect them andtheir interests, instead of conducting itself with an eye single tothe interests of its cestuis. And if it is a creditor of the issuer, thetemptation to sacrifice their interests is redoubled. It is in a positionto salvage its own interests at their expense; whether or not it isaffiliated with management or bankers, it is able to move rapidly

'Part III, Committees for the Holders of Real Estate Bonds (1986) at 85-87, 90.


and effectively to protect its claims, before the interests of securitybolders are safeguarded. And in the reorganization process, if it isaffiliated with management or bankers it is all too likely to accept,without careful scrutiny, plans which they propose, and to aidand abet majorities which they have marshalled while the interestsof minorities go unrepresented. Certainly if trustees are to beexpected to live up to the standards of conduct before and duringreorganization which we have outlined, they cannot be allowed toincur antagonistic duties and loyalties to themselves as creditors orholders or representatives of conflicting securities, or to the man-agement or its bankers.

In conclusion, three reforms are necessary. In the first place, ifthe prestige and good repute of our large commercial banks are tobe maintained, one of two steps must be taken: Either corporatetrusteeships must be divorced from commercial banks and made theexclusive function of trust institutions specializing in the businessof acting as trustee; or a commercial bank acting as trustee forsecurities of a corporation should not be permitted to hold a man-agement, ownership or creditor position in that company or haveany other interest inconsistent with its fiduciary responsibilities.Nothing short of such measures will insure adequate protection tothe banks' depositors and stockholders, and to the investors forwhom they purport to act as trustee. The large number of bankswhich function as corporate trustees without being short-term cred-itors of the issuer demonstrates that this separation of functions ispractical.

In the second place, complete divorce of underwriter and trusteeis essential for the protection of the security holders.

In the third place the trustee must not own or represent securi-ties or interests of a character which conflict in any material respectwith those for which he acts as trustee; nor should the issuer berepresented in the management of the trustee. Such conflicts as wehave described have been subject to practically no control. We havealready referred to the tentative rules and regulations respectingqualifications of directors of public utility holding companies. An-other is found in rules of certain stock exchanges.

The New York Stock Exchange and the New York Curb Ex-change have recognized the problem in a limited way. They specifythat, for the purpose of listing securities, they will not accept astrustee:

"(a) An officer or director of the issuing corporation;(b) A corporation in which an officer of the issuing corporation is an execu-

tve officer."75957"--86----8


108

The full text of the Stock Exchange statement appears in thefootnote.8 54 These provisions represent a recognition of the prob-lem. But they affect only a narrow portion of the total area ofconflicts. Presumably, securities could be listed if the trustee or acompany affiliated with the trustee were in control of the issuer;certainly the trustee could still be trustee under a junior mortgage;or it could own junior or senior securities; or it could be representedon a protective committee; or it could be a short-term creditor of theissuer, with the real danger of the consequences which we haveheretofore described. And, of course, even the elementary principleinsisted upon by the Stock Exchange and the Curb, would not affectthe great bulk of securities sold. Real estate securities are generallynot listed or traded on exchanges. There is no reason, in the absenceof legislation, why companies of the type of S. W. Straus & Co.and American Bond & Mortgage Co. cannot continue to sell securi-ties of which their officers or affiliates are trustees. The Exchangeregulations, furthermore, do not touch any part of the field of thetrustee's duties, responsibilities and conduct. 55 Unless the indenture

8 "The Committee [on Stock List] recommends that a trust company or other financialcorporation be appointed trustee of mortgages, indentures, and deeds of trust; and whena State law requires the appointment of an individual as trustee, a trust company orother financial corporation be appointed as co-trustee.

"Each mortgage, indenture, or deed of trust should be represented by a separate trustee."The Committee will not accept as trustee:(a) An officer or director of the issuing corporation;(b) A corporation in which an officer of the issuing corporation is an executive officer."The trustee shall present a certificate accepting the trust and certifying (1) securities

are issued under the terms of the mortgage or indenture, giving the numbers, denomina-tions and amount authenticated; (2) collateral deposited; (8) disposition of prior obli-gations. For additional issues of bonds, the trustee must certify that (1) increase is inconformity with terms of mortgage or indenture, giving numbers, denominations andamount authenticated; (2) additional collateral deposited; and (3) disposition of priorobligations.

"The company and trustee shall notify the Stock Exchange of the holding, cancellation,or retirement of securities, by redemption, through the operation of sinking fund orotherwise.

"The trustee must notify the Stock Exchange if deposited collateral is changed orremoved, and furnish a list of collateral substituted.

"A change of trustee shall not be made without the approval of the Committee."888 In this connection attention is called to Regulation F of the Board of Governors of

the Federal Reserve System, June 1, 1936, entitled "Trust Powers of National Banks."See. 6 (f) provides: "Every such national bank shall conform to sound principles in theoperation of its trust department." A footnote to this subdivision reads: "The State-ment of Principles of Trust Institutions approved by the Executive Council of the Ameri-can Bankers Association under date of April 11, 1933 is included in the Appendix to thisregulation and is commended to banks operating trust departments." Art. III of thatStatement of Principles provides in part:

"Section 3. Fundamental Duties of Trustee.-It is the duty of a trustee to administera trust solely in the interest of the beneficiaries without permitting the intrusion ofinterests of the trustee or third parties that may in any way conflict with the interestsof the trust; to keep and render accurate accounts with respect to the administration ofthe trust; to acquaint the beneficiaries with all material facts in connection with thetrust; and, in administering the trust, to exercise the care a prudent man familiar with


109

trustee is subjected to pervasive regulation in these respects, investorswill continue to suffer from inadequate representation and protection.

such matters would exercise as trustee of the property of others, adhering to the rule thatthe trustee is primarily a conserver.

"Section 4. Corporate. Trust Bustnes.-In the administration of corporate trusts andagencies the trust institution should render the same fine quality of service as it rendersIn the administration of personal trusts and agencies. Promptness, accuracy, and pro-tection are fundamental requirements of efficient corporate trust service. The terms ofthe trust Instrument should be carried out with scrupulous care and with particularattention to the duties imposed therein upon the trustee for the protection of the securityholders."


SECTION IV

CONCLUSIONS AND RECOMMENDATIONS

We conclude that it is necessary in the public interest and for theprotection of investors (1) that the trustees under these indenturesbe disqualified from acting or serving if they have or acquire con-flicts of interest incompatible or inconsistent with their fiduciaryobligations; and (2) that they be transformed into active trusteeswith the obligation to exercise that degree of care and diligencewhich the law attaches to such high fiduciary position.

This Commission is at present vested only with limited powerswhich can bo exercised to the end of reaching these desired objec-tives. By virtue of the powers vested in it under Section 19 of theSecurities Exchange Act of 1934, it can by appropriate rules andregulations change the listing requirements for securities, on nationalsecurities exchanges or by order alter or supplement the listing rulesof such exchanges, on determination by the Commission that suchchanges are necessary or appropriate for the protection of investors.In light of the conditions which our study has revealed, we proposeto determine the extent to which listing requirements along thelines of the foregoing recommendations can be developed. Thereare, however, two practical limitations of such a program. In thefirst place, such listing requirements would reach only the ratherlimited classes of securities dealt in on such exchanges. In thesecond place, the Commission cannot in justice to exchange tradingset up such strict standards for the indentures and the trusteesacting thereunder as to make it more attractive for issuers to stayoff the exchanges and thus to be able to use any form of trust inden-ture and any trustee desired. Hence, although the Commission canmove towards the objectives of the proposed reforms by exercise ofits powers under Section 19 of the Securities Exchange Act of 1934,that power and method are inadequate for effectuation of the pro-posed reforms.15 Uniform legislation by Congress is accordinglynecessary.

-Under Section 7 of the Public Utility Holding Company Act, however, this Commis-sion has broader powers over the terms and conditions of the issuance or sale of securitiesof registered holding companies and subsidiaries. We propose to determine how far it ispracticable to go in adopting rules and regulations under that Act embodying the fore-going standards in advance of uniform legislation applicable to all types of issuers.See. 7 is applicable to the issuance or sale of securities by a registered holding companyor subsidiary company. It provides for filing by such companies with the Commission of

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Such legislation should be part of an integrated legislative pro-gram dealing with all phases of the reorganization problem. It

should be aimed at refashioning the trust indenture in light of theobjectives which have been discussed.

As in case of the Securities Act of 1933, the point of control shouldbe the public offering of securities. Such legislation should providefor the setting of minimum standards for indentures under whichsecurities are issued and publicly offered and qualifications for thoseundertaking to act as trustees for such security issues. It shouldforbid the use of the mails or any means or instruments of trans-portation or communication in interstate commerce for the sale ofsecurities issued under indentures, unless these indentures and thetrustees thereunder meet the prescribed standards. The protectionof investors will require not only that conflicts of interest of trusteesbe eliminated but also that some safeguards against impecunious andirresponsible trustees be established. This is essential lest the safetyof funds be jeopardized and the administration of these vast trus-teeships fall into irresponsible hands. Towards that end provisionsshould be made that the trustee should be a bank or trust company,organized under state or federal laws, with resources commensuratewith the responsibilities of the proposed trusteeship.

Furthermore, such standards should be sufficiently broad as to pre-scribe the requirements for the fiscal or paying agent under theseindentures. We have pointed out in our report on Committees forthe Holders of Real Estate Bonds certain critical conditions arisingout of these fiscal or paying agencies. We noted there the recklessmanner in which the funds were used or invested; the way in whichcontrol of the fiscal or paying agency by mortgagor and house ofissue led to concealment of defaults; the method by which the earn-ings from these funds were retained by the fiscal or paying agentrather than credited to the bondholders or the mortgagor, as the casemight be. Consequently we conclude that the fiscal or paying agencyshould be divorced from the mortgagor and house of issue and eitherbe placed under the control of the trustee or in the hands of a whollyindependent and responsible bank which is under a duty to notifythe trustee of defaults. Furthermore, the fiscal or paying agencyfunds should be guarded with the same care as trust funds and beinvested pursuant to the same standards. Earnings from these fundsshould not accrue to the fiscal or paying agent; his compensationshould be fixed pursuant to the worth of his services.

a declaration concerning such issuance or sale and prescribes conditions precedent to suchdeclaration becoming effective. In subsection (d) it provides that if such conditionsprecedent are satisfied the Commission shall permit the declaration "to become effectiveunless the Commission finds that * * * (6) the terms and conditions of the issue orsale of the security are detrimental to the public Interest or the interests of investorsor consumers."


Certain exemptions from such regulation doubtless can be providedwhere the character or amount of such security issues are not of truenational concern. Further, it may be advisable to vest in the Com-mission power to provide for exemption of other classes of securitieswhere in light of the small amount of the holdings, the absence ofbroad distribution, or the short maturity of the obligation it wouldnot be necessary in the public interest or for the protection of in-vestors to require these higher standards of trusteeship.

Other parts of the integrated legislative program in the reorgani-zation field which we will submit can be made to buttress such legis-lation. Thus, Federal courts or administrative agencies in passingon the fairness of the plans of reorganization can be required to ex-amine the indentures under which any new securities are to be issuedto ascertain that they comply with these new standards.

Such measures would go far towards curbing the exploitation ofinvestors which has occurred either at the hands of the trustee itselfor at the hands of the reorganization and management groups withthe knowledge, consent, or acquiescence of a complacent and inactivetrustee. The result would be that investors would have an activeguardian of their interests throughout the entire life of the security.There would be carried over into the corporate field the'standards offiduciary relationships which have long obtained in personal trustsand with which these professional trustees have had a long and richexperience. In view of the history of exploitation of investors underpresent trust indentures any less rigid requirement would be inade-quate. There can be no permanency of integrity and confidence inthis field unless those in control of other people's investments areheld to high fiduciary standards of conduct.


APPENDICES

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CONTENTS

APPENDIX APage

Corporate trustee questionnaire and tabulation of data ---------------- 115

APPENDIX B

Representative fees of corporate trustees ------------------------------ 132

APPENDIX C

Bondholders' meetings ---------------------------------------------- 135A. Provisions in trust indentures -------------------------------- 135B. Reorganization by contract ----------------------------------- 143C. Selection of members of protective committees at bondholders'

meetings --------------------------------------------- 151

APPENDIX D

Active participation of indenture trustee in reorganization ------------- 178A. External bonds-City of Barranquilla ------------------------ 178B. Trusteeship of guaranteed mortgage issues in New York -------- 185C. Standards for indentures and indenture trustees enacted in 1936

by the New York State Legislature ------------------------ 191

APPENDIX E

The indenture trustee and the non-depositor----------------------- 205

APPENDIX F

Proposed rules under Section 17 (c) of the Public Utility Holding CompanyAct of 1935 ------------------------------------------------ 215

APPENDIX G

Selected bibliography of materials on trustees under indentures --------- 225

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APPENDIX A

CORPORATE TRUSTEE QUESTIONNAIRE AND TABULATION OF DATA

The following questionnaire was forwarded by this Commissionto a number of banks and trust companies serving as corporatetrustees:

PROTECTIVE CoMMIT=T STUDY

CORPORATE TRUsTEr QUESTIONNAIRE

1. The answers to the following questions should be submitted induplicate and signed in the name of the trustee by a dulyauthorized officer.

2. This questionnaire is to be answered separately for each in-denture securing bonds, notes, debentures, or similar securitiesof any issuer (except foreign and domestic governments orsubdivisions thereof), publicly offered to an amount of $500,000or more (but not equipment trust obligations) ; under which thetrustee has acted and a default in principal, interest or sinkingfund payments has occurred to the knowledge of the trusteesince January 1, 1930, said default not having been cured byperformance of the covenant as specified in the indenture; andwhich indenture has not been discharged of record or otherwisecancelled, released or satisfied.

3. This questionnaire should be answered on plain white paper,similar in size to this form, typewritten, with at least a two inchleft-hand margin and submitted unbound except by clips andremovable staples.

4. This questionnaire must be returned to the Protective CommitteeStudy, Securities and Exchange Commission, Washington, D. C.,on or before August 15, 1935.

5. If any information called for by this questionnaire cannot besupplied without an unreasonable expenditure of time or money,a detailed statement to that effect should be made together withthe full reasons therefor.

6. Additional copies of this form may be had upon request toProtective Committee Study, Securities and Exchange Commis-sion, Washington, D. C.

7. Each question concerning "affiliated interests" should be an-swered separately for each relevant affiliated interest, and eachshould be named.

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Definitions

8. "Trustee" as used in this questionnaire means any corporationacting as trustee or mortgagee, whether singly or otherwise,under any indenture to which this questionnaire relates.

9. "The securities" as used in this questionnaire means those bonds,notes, debentures, or similar securities, issued under the inden-ture to which this questionnaire relates.

10. "Underwriter" as used in this questionnaire includes all origi-nators and underwriters and all members of so-called bankers,underwriters and purchase syndicates.

11. "Person" as used in this questionnaire means an individual, acorporation, a partnership, an association, a joint-stock company,a business trust, an unincorporated organization, or a govern-ment or political subdivision thereof.

12. "Connection" as used in this questionnaire means the prior andpresent relationships as employee, officer, director, stockholder,trustee, partner or attorney at law.

13. "Affiliated interests" as used in this questionnaire means anyperson-(a) Of which the person in question is a holder of voting stock(b) Which he controls, whether by agency, stock ownership, or

otherwise(c) By which he is controlled, whether by agehcy, stock owner-

ship, or otherwise; or(d) Any of whose officers or directors are also officers or

directors of the person in question.14. "Indenture" as used in this questionnaire means any mortgage,

deed of trust, or trust indenture under which the securities areissued.

Name of the Securities:SECTION I

The Trustee

1. Name and address of trustee and any co-trustee2. Name, state of incorporation, principal place of business and

brief description of the nature of business of issuer.3. Principal amount of the securities outstanding on date of

default4. If the issuer was affiliated interest of trustee, nature of

affiliation5. If affiliated interests of issuer were affiliated interests of

trustee, nature of each affiliation6. If any underwriters of the securities were affiliated interests

of trustee, nature thereof


7. If affiliated interests of underwriters were affiliated interests

of trustee, nature thereof8. Selection of trustee by

'(a) Issuer(b) Underwriter(c) Other, specify

9. Connection, if any, of counsel for trustee with underwriter10. Connection, if any, of counsel for trustee with issuer and

with affiliated interests of issuer11. Name and address of paying agent12. Connection of trustee with paying agent13. Trustee was member of Federal Reserve system

Yes No14. (a) Trustee organized under (indicate by citation to statute)

(b) Trustee also acted as commercial bankYes No

15. Relation (in any capacity) of trustee to issuer one year priorto date of default (principal, interest, or sinking fund) underthe indenture(a) as creditor (including claims represented by bonds,

debentures, notes, etc., of the issuer)(b) as debtorspecifying approximate amount and nature of obligation, kindand amount of security held or given and whether the claimsagainst issuer were held for trustee's own account or for itstrust accounts (specifying general nature of trust accounts)

16. Relation (in any capacity) of trustee to issuer three months priorto date of default (principal, interest, or sinking fund) underthe indenture(a) as creditor (including claims represented by bonds, deben-

tures, notes, etc., of the issuer)(b) as debtorspecifying approximate amount and nature of obligation, kindand amount of security held or given and whether the claimsagainst issuer were held for trustee's own account or for itstrust accounts (specifying general nature of trust accounts)

17. Relation (in any capacity) of trustee to issuer on date of default(principal, interest or sinking fund) under the indenture(a) as creditor (including claims represented by bonds, deben-

tures, notes, etc., of the issuer)(b) as debtorspecifying approximate amount and nature of obligation, kindand amount of security held or given and whether the claimsagainst the issuer were held for trustee's own account or for itstrust accounts (specifying general nature of trust accounts)


18. Relation (in any capacity) of trustee to issuer on date of ap-pointment of receiver or bankruptcy trustee for issuer(a) as creditor (including claims represented by bonds, deben-

tures, notes, etc., of the issuer)(b) as debtorspecifying approximate amount and nature of obligations, kindand amount of security held or given and whether the claimsagainst issuer were held for trustee's own account or for itstrust accounts (specifying general nature of trust accounts)

19. Names of lawyers who participated in drafting of the indentureand the names of persons whom they represented in so doing

20. Statement of all purchases of the securities made by the trusteefor the sinking fund or for redemption since one year prior tothe default from all persons connected with the issuer, trustee,or their affiliated interests, specifying the names of such persons,the dates, prices and amounts of such purchases, and whethersuch persons were by lot, on the market or otherwise

21. Statement of total amount of payments made to sinking fundby issuer since one year prior to the default by presentation ofthe securities.

SECTIOr II

Duties and Obligations of Trustee Under Indenture

1. Date and place of execution of indenture2. Express exemption from liability except for wilful misconduct

or gross negligenceYes No

If answer is "no", specify extent of exemption3. Express provision that trustee has no obligation to take any ac-

tion toward the execution or enforcement of the covenants which,in opinion of trustee are likely to involve expense or liability,unless holder or holders of the securities shall furnish trusteeindemnity

Yes NoIf answer is "no", specify the exception

4. Express provision that trustee has no obligation to accelerate ma-turity of the securities on happening of specified defaults unlesson demand by

(fill in exact %)

of the principal amount of the securities then outstandingIf there is an exception, specify

5. a. Express provision that trustee has no obligation to forecloseor to initiate other judicial proceedings or any other action,specified in the indenture, to enforce rights against the prop-


erty under the indenture, on happening of specified defaults,unless on demand by

(fill in exact %)of the principal amount of the securities then outstanding

If there is an exception, specifyb. Express provision that even on such demand, trustee has dis-

cretion as to which such remedy it will pursueYes No

If answer is "no", specify the exceptionc. Express provision that only

(fill in exact %)of the principal amount of the securities outstanding candirect the trustee as to which such remedy shall be pursued

If there is an exception, specify6. Express provision that trustee is vested with exclusive right to

enforce rights against the property under the indentureYes No

If answer is "no", specify exception7. Express provision that in case of default by issuer in payment of

principal when due (whether on due date of the securities oron accelerated maturity) trustee has express right in its ownnamea. To recover judgment for whole amount so due and unpaid

Yes Nob. To recover deficiency judgment

Yes Noc. To file proof of claims for holders of the securities

Yes Nod. To enforce rights under the indenture against the property

Yes NoIf there is an exception, specify

8. Express provision that holders of the securities have no rightto institute any suit for collection of principal or interest unless

(fill in exact %)

in principal amount of the securities outstanding make demandon trustee and trustee refuses or fails to take such action

Yes NoIf there is an exception, specify

9. Express provision that trustee is under obligation to give holdersof the securities notice of default of issuer as respectsa. taxes Yes Nob. Insurance Yes Noc. sinking fund Yes Nod. interest Yes No

If answer is "yes", specify nature of notice


10. Express provision that issuer is under obligation to submit totrustee

NoQuarterlySemi-annualDesignateAnnual

audits or financial statements of the issuer11. If any such audits or financial statements are required to be sub-

mitted, express provision thata. auditors must be acceptable to trustee

Yes Nob. trustee must give holders of the securities notice of the audits

or financial statementsYes No

If answer is "yes", specify nature of noticec. auditors must certify in such audits or financial statements

that no default has occurred during period covered by theaudit

Yes No12. Express provision that trustee is under obligation to submit to

holders of the securitiesQuarterlySemi-annualAnnual DesignateOnly on termination of trustNo I

accounting of the assets held in trust18. Express provision that trustee is under no obligation to see to

any recording, registry or filing of the indentureYes No

14. Holders of the securities agree that no recourse shall be had toany individual liability of incorporators, stockholders, officersor directors of issuer

15. Power is given trustee to acquire the property on any foreclosureor other sale and to hold it for the benefit of all holders of thesecurities

Yes No16. Summary of provisious in indenture which require that trustee

and/or issuer contract with designated persons or with personsto be designated by issuer or trustee or their affiliated interests,for the furnishing or supplying of any service, goods, or prop-erty of any nature, specifying names of such persons, nature ofcontracts, and whether, and in what respect, such persons areaffiliated interests of trustee and/or issuer


17. Express provision that trustee shall not be required to take notice

or be deemed to have notice of any default unless notified in

writing of such default by holders of at least % (fill in exact

percentage) in amount of the securities outstandingYes No

SECToN III

Proceeds of Sale of the Securities

1. Trustee received' proceed.YesNo

2. By terms of indenture trustee under no obligation to see to the

application of proceedsYesNo

If there is an exception, specify3. If trustee received proceeds, specify conditions of release by

trustee4. If trustee did not receive proceeds, specify the supervision or

control exerciseda. by trustee over application of proceedsb. by any other party (except the mortgager) over application

of proceedsSECTION IV

Activities of Trustee

1. Steps taken by trustee on and after default to protect the prop-erty under the indenture, to enforce covenants in indenture or tocollect principal and interest due on the securities, specifyingin each case indemnity furnished and indicating in case of judi-cial proceedings, the name of the court and title and number ofthe cause

2. Statement of which of the foregoing actions were taken withoutindemnity being furnished by holders of the securities or by theissuer

3. Statement of actions refused by the trustee for reason that holdersof the securities or the issuer failed or refused to offer or tenderindemnity

4. Names and addresses of protective or reorganization committeesrepresenting the securities or other securities of the issuer, anyone or more members of which were employees, officers or direc-

tors of the trustee or of affiliated interests of the trustee, indi-cating the nature of the affiliation

5. Nature of participation, if any, of trustee in selection of mem-bers of protective or reorganization committees for the securities


6. Actions brought against trustee by holders of the securitiessince -default, specifying general nature thereof (such as-for anaccounting, for damages on certification, to enjoin foreclosure);title and number of the cause; name of the court; whether pend-ing or disposed of; and if disposed of, the general nature of thedisposition (such as-judgment for trustee; settled for $- ;

accounting granted, specifying sums allowed various parties outof the estate as costs, expenses, or compensation).

7. List of Holders of the Securities held by Trusteea. Sources of and amounts paidb. Number of applications for access toc. Number of applications granted and sums chargedd. Number of applications deniede. Number of instances where trustee mailed literature for appli-

cantsf. Statement of any policy of trustee with respect to lists

8. Relationship of the trustee to the underwriters of the new securi-ties offered in exchange for the securities on reorganization

9. Relationship of the trustee to the new or reorganized companyReplies to the foregoing corporate trustee questionnaire were

received from 53 banks and trust companies located in various citiesthroughout the United States. These institutions represented anaggregate of 424 security issues as trustee. Of these 424 issues 202were real estate securities. The remainder were scattered over awide variety of enterprises including manufacturing, mining, con-struction, shipping, electric light, gas, importing, mortgage compa-nies, railroads, hospitals and schools.

Data extracted from the questionnaire replies are tabulated below.

With certain exceptions, these tables do not repeat the questionnaireinformation contained in the text of the foregoing report.

SECTION I

General Data Concerning the Trustee and Its Affiliations

TABLE 1. Selection of Trustee:Real

Estate Other Total

By issuer --------------------------------- 48 89 137By underwriter -------------------------- 29 35 64By issuer and underwriter ---------------- 15 17 32By paying agent -------------------------- 1 - 1By guarantor ------------------------------ 1 - 1

No answer ------- .....- .......----------- 33 40 73

Total ------------------------------- 127 181 1308I In 308 issues the trustees was the original trustee under the indenture; the remaining

116 issues were represented by successor trustees. As most of the data set forth under

Section I is applicable only to the original trustee, the base used is 808 and not 424 Issues

as in the remaining sections.


123

TABLE 2. Affiliations, Trustee and Issuer:Trustee was paying agent. ------------ 210Trustee was co-paying agent ---------------------------- 39Trustee was commercial depositary ----------------------- 49Interlocking directorates ----------- -------------------- 34Trustee and creditor on bank loans --------------------- 19Each owned stock In the other ------ 1Director of issuer was employee of trustee ----------------- 1Director of trustee was trustee under voting trust agreement

for stock of issuer -------------------- 1Principal stockholder of issuer was a director of trustee ------ 1

Total affiliations ------------------------------- 355Duplications ............... .-- ------ 61

Net affiliations --------------------------------- 294

No affiliations -... .........------------------------------ 14

Total number of Issues involved ------------------- 308

TABLE 3. Affiliation, Trustee and Underwriter:

Trustee was the underwriter ---------Trustee was one of the underwriters ---------Trustee was a stockholder in underwriter-...Interlocking directorates ---------------- Trustee and underwriter were members of the

same banking group -----------------------Trustee was pareat company of underwriter_--Trustee and underwriter merely stated to be

RealEstate

131087

32

Other686

15

Total19181422

2 53 5

atfulaes ------------------.. . .----------- 1 1

Total affiliations ....................- 44 41Inapplicable-no underwriter ---------------- 4 16No answer ---------------------............. 16 5No affiliations ------------------------------- 63 119

Total --------------------------------- 127 181

TABLE 4. Connection, Trustee's Counsel With Underwriter:RealEstate Other

General counsel for underwriter ------------- 22 22Occasional " * " ------ - 3---Inapplicable ---------------------------------- 4 16No answer ---------------------------------- 19 6No connection ------------------------------ 79 137

Total --------------------------------- 127 181

2

852021

182

308

Total443

2025

216

308

T5957"-86-9


124

TABLE 5. Connmction, Trustee's Counsel With Issuer:RealE state Other Total

General counsel for issuer ------------------ 2 6 8Occasional " " - --------- 2 6 8

Miscellaneous connections -- 3 3Inapplicable ------------------------------ 4 4 8No answer -- . . ..----------------------------- 20 5 25

No connection --------------------------- 100 160 260

Total --------------- ------ 127 181 308

TABLE 6. Cownel Drafting Trustee Indenture Represented:

RealEstate Other Total

Issuer ----------------------------------- 19 41 60

Trustee and issuer ------------------------- 19 30 49I ssu e r a n d u n d e rw riter .......... 18 30 4 8

Issuer, underwriter and trustee ---------------- 17 8 25Trustee and underwriter --------------------- 17 7 24

Trustee ----------------------------------- 4 9 13

Underwriter ------------------------------- 4 8 12

Paying agent ------------------------------ 3 - aIssuer and protective committee. 2 - 2Trustee and paying agent --------------------- 2 1 3Issuer and paying agent_ - - 1 - 1Guarantor --------------------------------- 1 - 1Issuer and broker --------------------------- - 1Issuer, paying agent and unidentified company ---- 1 - 1Bondholders committee ----------- ---- - 1 1

No answer -------------------------------- 18 46 64

Total ----------------------------------- 127 181 308

SECrON II

Duties and Obligations of Trustee Under Indenture

TABLE 1. Date of Ewecution of Indenture:

Prior to 1900 ---- ------------------------------------ 91900-1913 -------------------------------------------------- 321914-1920 ------------------------------------------- 101921-1926 ------------------------------------------ 1721927-1930 ------------------------------------------------- 176

1931-date of return ------------------------ - 24

No answer ---------------------------------------- 1

Total ------------------------------------------------ 424


125

TABLE 2. Exculpatory Claue-Trustee Expressly Exempt FromLiability Except for Gross Negligence or Wilful Misconduot:

Yes -------------------- 388

No ------------------------------------------------------ 36

Total --------------------------------------------- 424

TABLE 3. Notice of Default-Trustee Under Express Obligation toGive Security Holder Notice of Default With Respect to Interest,Sinking Fund, Insurance or Taxes:

Yes -------------------- 0No ---------------------.---------------------------- 424

TABLE 4. Accounting Provision:(a) Express provision that trustee must submit periodical

accounts of assets held in trust to security holders-Yes ------------------------------------No ------------------------------------------- 424

(b) Express provision that issuer submit audits or financialstatements to the trustee-

Monthly -------------------------------- 14Quarterly ----------------------------------- 20Semi-Annually ---------------------------------- 26Annually -------------------------------------- 201On request of trustee ---------------------- 27No provision -------------------.. ...------ 168

Total------------------------------ 456

No.-The total exceeds the number of questionnaire replies for the reason that in anumber of instances, the issuer was required to submit more than one report; e. g., bothmonthly and annual reports.

2 In connection with indenture provisions concerning the furnishing of audits, ArthurE. Burke, corporate trust officer of Guaranty Trust Co., testified before this Commissionas follows:

"Q. Does the corporate trustee get periodic statements from the company?A. No, only In those cases where the trust indenture so provides.Q. Do you recall whether the Hoe Trust Indenture so provides?A. I couldn't recall off hand. I'm quite certain it did not so provide, but I wouldn't

want to so testify without examination of it.Q. Did you receive periodic statements from the Company, from the Hoe Company?A. I'm quite certain we did not, because first of all it is rather unusual In a Mort.

gage, a first mortgage Indenture to receive statements of that kind. It is usual only onthe debenture issues."

(Proceedings before the Securities and Exchange Commission In the Matter of R. Hoe& Co.. Inc. (1935) at 421.)


126

TABLE 5. Miscellaneous Powers of Trustee:(a) To acquire property at foreclosure or other sale and hold

for benefit of all bondholders-

Yes ------------ ---------------- 148

No provision. ----------------------------- 276

Total --------------------------------- 424

(b) To file proof of claim for security holders-

Yes ---------------------------------------- 68No provision --------------------------------- 354

No answer ------------------------------------- 2

Total --------------------------------- 424

(c) To recover deficiency judgment--

Yes --------------------- 271No provision -------------------------------- 144

Inapplicable ----------------------------------- 9

Total -- ------------------------- 424

TABLE 6. Empress indenture provision that no recourse be had toindividual liability of incorporators, stockholders, officers, ordirectors of issuer:

Yes -------------------------------------- 237

No ----------------------------------------------------- 187

Total- *--------------------------424

TABLE 7. Empress indenture provision that trustee and/or issuer con-tract with designated person or with person to be designated byissuer, trustee or their affiliated interests for furnishing of serv-ices or goods of any nature.

Yes ----------------------------------------------------- 48

No ----------------------------------------------------- 375

No answer ---------------------------------------------- 1

Total --------------------------------------------- 4243 45 of these were real estate issues underwritten by S. W. Straus & Co. in which a

wholly owned subsidiary of the underwriter was designated to procure insurance on theproperty. One was likewise underwritten by S. W. Straus & Co. in which the insurancewas to be procured through the underwriter. One indenture called for services by a firmof architects, a member of which was an officer of the issuer. In the last of these 48issues, the indenture required the services of a firm of architects, certain members ofwhich were directors of the trustet.


127

SECTON III

Proceeds of Sale of the Securities

TABLE 1. Trustee By Terms of Indenture Under No Obligation ToSee To Application of Proceeds:

Yes 22-------------------No -- --------------------------------------------- 191No answer ----------------------------------------- 11

Total ---------------------------------------- 424

TABLE 2. Trustee By Terms of Indenture Received Proceeds:Yes ----------------------------------------------- 95No ------------------------------------ ----- 300Inapplicable-no sale --------------------------------- 16No answer ----------------- 13

Total --------------------- 424

TABLE 3. Wh-re Trustee By Terms of Indenture Received Proceeds,Conditions of Release:

Certificate of architect, engineer, superintendent of construc-tion, and the like ---------------------- 38

Order of issuer ------------------------------------- 24As per conditions contained in separate disbursement agree-ment -------------------------------------------- 11

Part of proceeds used to retire previous debt, balance to orderof issuer ------------------------------------------ 8

Retire previous Indebtedness ---------------------------- 7On order of the underwriter ----------------------------- 1No answer ------------------------------------------------ 6

Total -- . . . ..---------------------------------------- 95

TABLE 4. In 300 cases where trustee did not receive proceeds:(a) Supervision by trustee over application of proceeds-

Trustee supervised application proceeds ------------ 8No supervision by trustee --------------------- 223No information given as to trustee's supervision ---- 69

Total - . . . ..------------------------------- 300

(b) Supervision by any other party (except mortgagor)-By bankers as per disbursement agreement --------- 7For building costs,. on certificate of architect -----.. 7No information given as to other supervision ------ 278

Total ----------------------.-.--...... 292Supervision by trustee --------------------------- 8

Total .. . .-8- - - - - - - - - -- --- - 0o


128

SECT-ION IV

Activities of Trustees-Actions Against Trustees-Lists

TART 1. Steps taken by trustee on and after default to protectthe property, to enforce indenture covenants, to collect prin-cipal and interest, etc.:

No action taken ---------------------- 116Served notice of default or of event of default on issuer only ---- 71Accelerated maturity only .. -------------------------------- 2Filed proof of claims only ---------------------------------- 11Brought foreclosure proceedings ----------------------------- 46Accelerated maturity and foreclosed --------------------- 9Took possession of property ------------- 21Took possession and foreclosed ------------------------------ 22Instituted or intervened in receivership proceedings -------------- 9

Trustee is receiving the income from the property or has taken stepsto that end ------------------------- 9

Sundry negotiations with security holders looking to extensions,waivers of default, formation of protective committees, or insti-tution of 77B proceedings --------------------------------- 6

Various combinations of the above---------------------------- 69Various miscellaneous activities not included in the above, such as

auditing books of issuer, inspecting mortgaged property, investi-gating status of collateral and causing its transfer, applying tocourt to consider moneys for past due coupons as trust funds,other miscellaneous litigation, causing cancellation of bonds heldby issuer, calling meeting of bondholders, investigating allega-tions of mismanagement of company, etc --------------------- 24

No answer ------------------------------------------ 9

Total --------------------------------------------- 424

TABLE 2. Indemnification Furnished Trustee for Litigation and/orEntering into Possession of Property:

Na0 state-With Without ment reIndem- Indem- Indem-

Action taken nity nity nity TotalForeclosure proceedings ------------------------ 29 22 4 55Litigation' other than foreclosure ------------------ 6 17 1 24Entered into possession of property ---------------- 14 5 2 21Foreclosed and entered into possession -------------- 8 14 - 22Other combination of above --------- --- 14 10 - 24

Totals ---------- 71 68 7 p146' Includes action on the debt and on guarantees, to reduce taxes, to establish priority, etc.

In addition trustees for three Issues received indemnity for selling the property, onefor paying taxes and one for loaning working capital to the issuer.


129

TABLE 2. Indenvniflcation Furnished Trustee, etc.-Continued

RECAPITULATION

Trustee received indemnification ------------------------------ 71Trustee did not receive indemnification ------------------------- 68No statement re indemnification -------------------------------- 7

Total issues where trustee foreclosed and/or entered into possession ---- 146Total issues where trustee took other action ------------------------- 153Total issues where trustee took no action -------------------------- 116No answer ------------------------------ 9

Total all issues ------------------------------------------ 424NoTE :-The questionnaire returns filed by trustees for 415 of the

424 issues indicate that the following six actions requested wererefused on the ground of failure to furnish indemnity:

1. Refused demand to accelerate, sue for principal and interestor institute receivership proceedings.

2. Refused to foreclose on request of less than 10 percent inamount of securities without indemnity.

3. Refused to foreclose.4. Refused to bring action against guarantor.5. Refused demand for accounting.6. Refused to join in cancellation of lease.

TABLE 3. Action Against Trustees by Security Holders:(a) Number of actions against trustees-

Action brought against trustee- - 56 issuesNo action brought against trustee ....--------- 859 issuesNo answer .............-.. ----- -- 9 issues

Total -----------.------------------ 424 issuesNOTr.-75 actions were brought in the 56 issues.

(b) Classification and disposition of 75 actions against trustees-Judg- Judg- i-ment ment missed

No. of for for or Pend-Type of Action Suits plaintiff trustee stayed Ing

Accounting 53 - * 26 7 20To compel distribution of monies ---------- 10 6 - 3 1For removal of trustee -------------------- 4 - 1 1 2Damages for failure of trustee to take

possession ----------------------------- 2To force acceleration of maturity ---------- ITo secure list of security holders ---------- 1To restrain reorganization plan ---------- 1For failure to impound condemnation award- ITo force foreclosure -------------------- 1Unclassified-------------------------- 1

Total

53104

- - - 2- - 1 -

- - - 11 - - -

- - - 1

Total -.-----. .---. - --- 7 27 13 2 i"Judgment for trustee" here means that the accounts of the trustee were approved

with one or two exceptions, where certain items were not allowed. These 26 issues wereall real estate issues. See Appendix A of this Commission's report on Committees forthe Holders of Real Estate Bonds (1936), for a description of numerous accounting actionsbrought against oorporate trustees in New York City.


130

TABLE 4. Participation of trustee in selection mnebera of protectivecomlanttee:

(a) Number of Issues involving trustee's participation-No participation - ------------------------- 284Some participation ---------------------------- 3Inapplicable-no committee....94No answer e ---------------------- 10

Total 424(b) Extent of trustee's participation-

Trustee appointed one committee member ----------- 11Trustee appointed two committee members ...... 5Trustee appointed three committee members --------- 2Trustee appointed all committee members ..... 2Trustee "assisted" in selection ------------....---- 16

Total ---------------------------------- 36

TABLE 5. Lists of Security Holders:(a) Source of names in possession of trustee-

No list ------------------------------------- 193Trustee's records as registrar, coupon-paying agent,

and from original sales records ---------------- 136From list of depositors under deposit agreement, re-

organization plan, extension agreement, etc---. 56Underwriter ------- - - -------- 16Issuer ------ ------------------------------- 3Protective committee 2Former trustee ------------------- 2No answer ---------------------------------- 16

T otal ....... . . . . . ................... . ..- 424(b) Number of applications to trustee for lists-

None ---------------------- 312One to five applications ........................- 99Five to ten applications ------------------------ 3Several-no statement as to number --------------- 1No answer 9- ----------------------------- 9

Total 424(c) Number of applications for lists granted-

None --------------------- --------- 822

One to five applications --------------------- 90Five to ten applications- 3No answer ---------------------------------- 9

Total ------------- 424


131

TABLE 5. List8 of Seouity Holder--Continued.(d) Number of applications for lists denied-

None.-- - -- - - - -- - --- - - - - - - - 405

One to five applications ..------------------------ 9Several-no answer as to number ----------------- 1No answer -...-.-- ..-.--.....---------------- 9

Total -------.--.--.-.....--------- ------ 424

(e) Trustee mailed circular letters to security holders-None -------------------- - ---- 30

One to five times --------..........---------- 31Ten times ---------------------------------------- 1Whenever requested by protective committee -------- 3No answer -------------- -- - 9

Total - -- - --- --------- 24

(f) Policy of trustee with respect to lists--

List available to-

No lists maintained - ------

No uniform policy, each application decided on merits-"Authorized" persons or for "justifiable" uses --------Confidential; not published except on order of court--Issuer, or on order of issuer.--.-----------------Issuer, or to protective committee- -

Security holders for purpose of contacting otherholders-------------------

Protective committee only --------------Where sales list is source, list published only on

consent of purchasers -----------------------------Protective committee only if there is one; otherwise to

holders "entitled"---------- -

No answer ----- .. ....------- -----

lPnfAl

No. of No issuestrus- repre-tees sented19 778 718 1125 404 482 12

1 353 10

53 424


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ANNEx I TO APPENDIX B

List of services as indicated in various corporate trustee schedulesof fees for which charges may be made. Generally the schedulesare not this complete, and two or more of the services may becombined under one fee, although frequently no precise allocationis reflected in the less detailed schedules. Furthermore, these sched-ules usually have provisions that extraordinary and unusual services,or services not contemplated or not stipulated in the schedule requirean additional fee.

1. Certification of temporary and definitive bonds or notes.2. Exchange of temporary bonds or interim receipts for per-

manent bonds of the same denomination.3. Exchange of denominations.4. Conversion of bonds into other securities.5. Custody of collateral.6. Safe-keeping of securities.7. Registration of bonds.8. Purchase of bonds for various funds.9. Calling bonds for redemption.

10. Payment of coupon interest.11. Payment of maturing principal.12. Cancellation of bonds and coupons in lieu of cash or sur-

rendered for cancellation.13. Cremation of bonds and coupons.14. Receiving and disbursing release and insurance proceeds.15. Custody of insurance policies.16. Partial releases.17. Final releases.18. Receiving and disbursing construction funds.19. Periodic recording of chattel mortgage.20. Making periodic reports in connection with the maintenance

of the Sinking Fund.21. Execution of supplemental indentures.22. Execution of satisfaction pieces and other services rendered

in closing the trust.23. Services as fiscal agent.24. Services as withholding agent in connection with coupons

paid upon which income tax is withheld.25. Paying lost securities without presentation.26. Issuing duplicate bonds.

(184)


APPENDIX C

BONDHOLDERS' MEETINGS

A. PROVISIONS IN TRUST INDENTURES

few American indentures make provisions for bondholders'meetings.1 With some slight variations the following provisionsappearing in the trust indenture of Minnesota Northern Power Co.,Montana-Dakota Utilities Co. and Gas Development Company toThe Minnesota Loan and Trust Company and Charles V. Smith,Trustees, securing first mortgage gold bonds, dated April 1, 1930,is a typical illustration of such a provision:

"ARTICLE IX

REGARDING BONDHOLDERS' ACTIONS

* * * * * * *

"(c) From time to time the holders of seventy-five percent (75%) in amountof all of the bonds hereby secured and outstanding, by an instrument orinstruments in writing signed by such holders, or by their votes at a meetingof the bondholders called anl held as provided in paragraph (d) of thisArticle shall have power (1) to assent to and authorize the release of anypart of the property covered by this Indenture, without prejudice to thepowers conferred upon the Trustees and the Companies by Article X hereof;(2) to assent to and authorize any waiver, modification or compromise of therights of the bondholders and of the Trustees against the Companies, or anyone of them, or against any property subject to this Indenture, whether suchrights shall arise under these presents or otherwise; and (3) to assent to andauthorize any modification of the provisions of this Indenture that shall beproposed by the Companies and recommended by the Trustees; and any actionherein authorized to be taken with the assent or authority given as aforesaidof the holders of seventy-five percent (75%) in amount of the bonds herebysecured for the time being outstanding shall be binding upon the holders of all

I See, e. g., the following Indentures: The Pickwick Corporation to Bank of America ofCalifornia, Trustee, dated December 15, 1929; United States Steel Corporation to UnitedStates Trust Company of New York, Trustee, dated April 1, 1903; University City Syndi-cate, Inc., Ltd., to Bank of America National Trust and Savings Association, Trustee,dated September 1, 1930; Minnesota Northern Power Co., Montana-Dakota Utilities Co.and Gas Development Company to The Minnesota Loan and Trust Company, and CharlesV. Smith, Trustees, dated April 1, 1930; Hollywood Knickerbocker, Inc. to Bank of Amer-ica of California, Trustee, dated July 1, 1929; A. F. Gilmore Company to Security Trustand Savings Bank, Trustee, dated April 1, 1927; Montana-Dakota Power Company to TheMinnesota Loan and Trust Company and Charles V. Smith, Trustees, dated April 1, 1926;and Cuban Cane Products Co., Inc. to Guaranty Trust Company of New York, Trustee,dated January 1, 1930.

(135)


136

of the bonds hereby secured, and upon the Trustees, as fully as though such

action were specifically and expressly authorized by the terms of this Inden-ture; provided, always, that the obligations of the Companies to pay theprincipal of said bonds at maturity, with interest thereon as in such bonds

provided, shall continue unimpaired."(d) Meetings of the bondholders for the purposes specified in the preceding

Section, or for any other purpose of this Indenture, may be convened in the

City of Minneapolis, Minnesota, by the Trustee, and shall be called by theTrustee on the request in writing of the holders of one-fourth (14.) in amountof the outstanding bonds, and in the event of the refusal or neglect of the

Trustee, for thirty (30) days after such request has been delivered to the

Trustee, so to call such meeting or meetings of the bondholders, the holders

of one-fourth (%) in amount of the then outstanding bonds may call the same,

and notice of the time, place and purpose of such meeting or meetings shallbe given by six (6) consecutive advertisements in at least one daily newspaperpublished in the City of Minneapolis, State of Minnesota, and also In one daily

newspaper published in the City of Chicago, Illinois, the first of which adver-

tisements shall be not less than thirty (30) days before the date fixed for saidmeeting, and subsequent meetings may be called in such manner as may be

fixed by regulations prescribed or established by the bondholders at such

meeting, and the bondholders may vote at such meetings in person or by

proxy; and such regulations or by-laws in respect of such meetings from time

to time may be established, altered or repealed by the bondholders, acting by

seventy-five percent (75%) in amount, as to them shall seem expedient; anduntil the bondholders shall make such regulations and by-laws, such powers

may be exercised by the Trustee; and the Trustees shall have the right, at or

before any meeting of the bondholders, to require that any act or resolution of

the bondholders affecting the duties of the Trustees, or either of them, shall be

authenticated by the signature of all the persons assenting thereto, as well as

by a minute of the proceedings of the meeting. The presence in person or by

proxy of the holders of not less than seventy-five percent (75%) in amount of

the outstanding bonds hereby secured shall be required' to constitute a quorum

at any meeting of the bondholders, except in the case of a meeting held to

appoint a successor Trustee, as provided in Article XI of this Indenture, for

which purposes the holders of a majority in amount of bonds shall constitute

a quorum. At all meetings called as aforesaid, the Trust Company may require

the persons voting or present at such meetings to establish to the Trust

Company, in such manner as it may require or deem expedient, the fact that

they are holders of bonds in the amount claimed."

Other American trust indentures provide for not less than 51percent or 662% percent in amount of the outstanding bonds to con-stitute a quorum.'

The following is another type of provision with respect to meet-ings of holdholders which appears in a few of the American inden-tures:

See, e. g.: United States Steel Corporation to United States Trust Company of NewYork, Trustee (66% percent) ; Cuban Cane Products Co., Inc. to Guaranty Trust Co. ofNew York, Trustee (51 percent).

'University City Syndicate Inc. Ltd. (a Delaware corporation) to Bank of AmericaNational Trust and Savincs Association, Trustee, dated September 1, 1930.


137

"ARTICLE XIII

CONCERNING THE BONDHOLDERS

"Section 3. From time to time the holders of three-fourths in principal amountof all bonds hereby secured at the time being outstanding, by their votes ata meeting of the bondholders called by the Trustee on such notice as the Trusteeshall deem sufficient, or by an instrument or instruments in writing, signed bysuch bondholders, shall have power with the written approval of the Trusteeand the Company:

(1) To assent to and authorize any modification or compromise of the rightsof the bondholders and of the Trustee against the Company or against anyproperty subject to this mortgage or deed of trust; whether such rights shallarise under this mortgage or deed of trust or otherwise; and

(2) To assent to and authorize any modification of the provisions of thismortgage or deed of trust.

"Any action taken with the assent or authority given as aforesaid shall be-binding upon the holders of all bonds hereby secured, and upon the Trusteeand the Company as fully as though such action was fully and expresslyauthorized by the terms and conditions of this mortgage or deed of trust;provided, however, that the power hereby conferred by this Section shall notinclude the power to impair the lien of this mortgage or deed of trust; andprovided, further, that nothing in this Article contained shall be construedto permit, directly or indirectly, any change of the date or dates for the pay-ment of the principal and/or interest of any of the bonds secured hereby andthen outstanding, as such dates are or may be provided by said bonds and/orthe coupons appertaining thereto. The provisions of this article shall not beconstrued so as to prevent a change in or modification of or amendment to theschedule of release prices in the manner and to the extent provided for inArticle VIII hereof."

Another provision providing for meetings of bondholders is con-tained in the trust indenture securing the debentures of Cuban CaneProducts Co. Inc., to Guaranty Trust Co. of New York, dated Janu-ary 1, 1930.'

It should be noted that generally the American indentures byspecific provision expressly exclude any action at the bondholders'meeting impairing the obligation of the issuer to pay principal andinterest in the manner specified in the indenture.5 Presumably suchchanges could be effected only by unanimous consent of all bond-holders.

'Commission's Exhibit No. 71 introduced at the hearing before this Commission In theMatter of Cuba Cane Sugar Corp. (1935).

1 E. p., The Pickwick Corporation to Bank of America of California, Trustee, datedDecember 15, 1929; University City Syndicate, Inc., Ltd. to Bank of America NationalTrust and Savings Association, Trustee, dated September 1, 1930; Minnesota NorthernPower Co., Montana-Dakota Utilities Co. and Gas Development Company to The Minne-sota Loan and Trust Company, and Charles V. Smith, Trustees, dated April 1, 1930;Hollywood Knickerbocker Inc. to Bank of America of California, Trustee, dated July 1,1929; A. F. Gilmore Company to Security Trust and Savings Bank, Trustee, dated April1, 1926; Montana-Dakota Power Company to The Minnesota Loan and Trust Company andCharles V. Smith, Trustees, dated April 1, 1926.


Canadian trust indentures commonly include provisions for bond-holders' meetings. These provisions arm considerably more elaborateand detailed than those which occasionally occur in indentures in

this country. A trust indenture naming the Montreal Trust Com-pany as Trustee (Price Brothers & Company, Limited, as issuer)contains the following typical provision:

"ARTICLE XIX

MEETINGS OF BONDHOLDERS

"1. The Trustee may at any time, and shall from time to time on being

served with notice signed by the Company or by bondholders representing at

least one-fifth of the principal amount of the Bonds outstanding, convene a

meeting of the bondholders. In the event of the Trustee failing to call and

hold a meeting after being thereunto required by the bondholders as above

set forth, the Company or the requisite number of bondholders may them-

selves call and hold such meeting. Bonds held by the Company or by any

subsidiary, parent or affiliated company, shall not be deemed to be outstanding

bonds for any purpose of this Article, provided, however, that Bonds pledged

or charged by the Company as security for loans or other indebtedness shall

(while so pledged or charged), for all such purposes, be deemed to be out-

standing Bonds and the pledgees thereof or holders of any lien or charge

thereon shall be entitled to sign any notice, attend all meetings of bondholders,

and vote thereat in respect of the Bonds so pledged or charged by the Company

unless such pledgees or holders are not entitled under the terms of the pledge

or charge freely to exercise in their discretion, uncontrolled by the Company,

the right.to vote such Bonds. Every such meeting shall be held at the City

of Montreal, or at such other place as the Trustee may determine."2. At least thirty (80) days' previous notice of such meeting shall be given

to the bondholders, and such notice shall state the time when and the place

where said meeting Is to be held, and shall specify the general nature of the

business to be transacted thereat, and in general terms the subject matter

of any extnaordinary resolution to be submitted thereat."All notices to be sent under this Article XIX to the holder of a registered

Bond or a coupon Bond registered as to principal shall be deemed to be validly

given if sent by registered mail, prepaid, addressed to said bondholder at

his address on the registration books. All notices to be sent hereunder to

bondholders who have not registered their Bonds or their post office addresses

as provided In Section 14 of Article III hereof shall be deemed to be validly

given If advertised in 'The Gazette' or some other newspaper published in the

City of Montreal, approved by the Trustee, and 'The Boston Herald' or some

other newspaper published In the City of Boston, Massachusetts, approved

by the Trustee, and in 'The Times', or some other newspaper published in the

City of London, England, approved by the Trustee, and in such newspapers

published in the Cities of Quebec and Toronto, and In the Borough of Man-

hattan, City of New York, N. Y., respectively, approved by the Trustee, twice

a week in each of three (3) successive weeks. All notices to be sent here-

under to bondholders who have not registered their Bonds but have registered

their post office addresses as provided in Section 14 of Article III hereof

GRegistration Statement of Bowater's Canadian Paper Corporation, Ltd., File 2-792-1,Exhibit H-4, at 95-102.


139

shall be deemed to be validly given if both sent by registered mail, prepaid,addressed to such bondholders at their respective registered address and ad-vertised as above provided. Any notice so advertised or served by post oradvertised and served by post shall be deemed to have been validly given orserved at the expiration of five (5) days after It is posted or first advertisedor posted and first advertised as aforesaid.

"3. At any meeting of the bondholders a quorum shall consist of bondholderspresent in person or by proxy and representing fifty-one (51) percent ofthe principal amount of the Bonds outstanding.

"Some person, who shall be a bondholder or proxy, shall be nominated bythe Trustee to be chairman of the meeting and if no person is so nominated, orif the person so nominated is not present within twenty-five minutes fromthe time fixed for the holding of the meeting, the bondholders present orrepresented shall choose one of their number to be chairman.

"If a quorum of the bondholders shall not be present within half an hourfrom the time fixed for holding any meeting, the meeting on fifteen (15)days' notice given in the manner set forth in Section 2 of this Article may beadjourned from time to time not longer than sixty (60) days in all, untila quorum be in attendance.

"Every question submitted to a meeting, except an extraordinary resolution,and except as herein otherwise provided, shall be decided in the first placeby a majority of the votes given on a show of hands. The chairman shallhave a vote in addition to the vote to which he may be entitled as a bondholder.

"On every extraordinary resolution, and on any other question submittedto a meeting when requested, after a vote by show of hands, by bondholdersrepresenting at least ten thousand (10,000) dollars in the principal amount ofthe Bonds then outstanding, a poll shall be taken. At any meeting of thebondholders, each bondholder shall, on a poll, be entitled to one vote for everyone hundred (100) dollars of Bonds of which he shall be the holder. Votesmay be given In person or by proxy, and a proxy need not be a bondholder.

"No action shall be taken at any meeting of the bondholders affecting therights of the holders of one or more series of Bonds in a manner or to anextent 'differing from that in or to which the rights of holders of any otherseries of Bonds are affected by extraordinary resolution or otherwise, unlesssuch action shall have received the affirmative votes of the holders of at leastseventy-five (75) percent of the principal amount outstanding of the Bondsof each series so affected.

"4. The Trustee may (for the purpose of enabling the bondholders to bepresent and vote at anY meeting without producing their Bonds, and of en-abling them to be present and vote at any such meeting by proxy) make andfrom time to time vary such regulations as it shall think fit for the deposit ofcoupon Bonds with any bank or trust company, and for the issue to the per-sons depositing the same of certificates by such bank Or trust company en-titling the holders thereof to be present and vote at any such meeting andto appoint proxies to represent them and vote for them at any such meetingIn the same way as if the persons so present and voting either personally orby proxy were the actual bearers of the Bonds in respect of which such cer-tificate shall have been issued, and any regulations so made shall if approvedby the Trustee be binding and effective and votes given in accordance there-with shall be valid and shall be counted. Holders of registered Bonds may,by an instrument in writing under their hands, appoint any person as theirproxy to vote at any meeting for them. In such proxy shall be stated the

75957 6----10


140

numbers of the Bonds regarding which they are entitled to vote. Save asherein otherwise expressly provided the only persons who shall be recognizedat any meeting as holders of any Bonds, or as entitled to vote or be present

at the meeting in respect thereof, shall be the persons who produce unreg-istered Bonds at the meeting and the registered bondholders.

"5. The Company and the Trustee, by their respective officers and directors,

and the legal advisers of the Company and the Trustee, may attend any meet-ing of the bondholders but shall have no vote.

"6. In addition to all powers hereinbefore given, a meeting of the bondholders

shall have, subject to the qualification in* Section 3 of this Article contained,the following powers exercisable from time to time, by extraordinary resolu-tion only:

(a) Power to sanction any change or alteration of any provision of thisTrust Deed and any modification or compromise of the rights of the bond-holders against the Company or against its property, whether such rights shall

arise under the provisions of this Trust Deed or otherwise.(b) Power to require the Trustee, on having entered into or taken possession

of the mortgaged premises or any part thereof, to restore the same to theCompany upon such conditions as the bondholders may direct.

(c) Power to sanction any scheme for the reconstruction of the Companyor for the consolidation, amalgamation or merger of the Company with

any other company or for the selling or leasing of the undertaking of the

Company or any part thereof.(d) Power to authorize the Trustee to accept in satisfaction or part satis-

faction for the sale or transfer of all or any part of the mortgaged premisesany shares (whether preference, ordinary, deferred or founders), bonds, de-

bentures, mortgages, debenture stock or any other securities of any companyformed or to be formed.

(e) Power to authorize the distribution in specie of any shares or securities.

(f) Power to require the Trustee to exercise or refrain from exercising any

of the powers conferred upon it by this Trust Deed and to direct the manner

of the exercise of any such powers or to waive any default on the part of

the Company other than the nonpayment of any principal moneys at maturity,

upon such terms as may be decided on.(g) Power to authorize the Trustee to bid at any sale of the mortgaged

premises, or any part thereof, and to tender in payment or part payment

on account of any property so purchased, all or any part of the Bonds then

outstanding, and to give to the Company a valid discharge in respect of the

amount of the Bonds so tendered, and to hold any property so purchased

and any part of the Bonds then outstanding and not so tendered, in trust

for all the holders of the then outstanding Bonds pro rata in proportion to

the amounts held by them respectively before the making of such tender.

"7. The expression 'extraordinary resolution' when used herein means a

resolution passed at a meeting of the bondholders duly convened and held

in accordance with the provisions herein contained, and carried by the

affirmative votes of the holders of not less than seventy-five percent (75%)in principal amount of all outstanding Bonds.

"An extraordinary resolution passed at a meeting of the bondholders held

in accordance with the provisions hereof shall, subject to the requirement

of Section 3 of this Article and the other requirements herein contained, be

binding upon all the bondholders, whether present or absent, and upon each

and every bondholder.


141

"8. At any meeting of the bondholders, in cases where no poll is required

or requested, a declaration made by the Chairman that a resolution has been

carried or carried by any particular majority or lost shall be conclusive evidence

thereof."9. Minutes of all resolutions and proceedings at every such meeting as

aforesaid shall be made and duly entered in books to be from time to time

provided for that purpose by the Trustee at the expense of the Company,

and any such minutes as aforesaid, if signed by the Chairman of the meet-

Ing at which such resolutions were passed or proceedings had, or by the

Chairman of the next succeeding meeting of the bondholders, shall be primafacie evidence of the matters therein stated, and until the contrary is proved,every such meeting in respect of the proceedings of which minutes shall havebeen made, shall be deemed to have been duly held and convened, and allresolutions passed thereat or proceedings had, to have been duly passed andhad."

Although the Canadian indentures generally follow the aboveframework in providing for bondholders meetings, there are vari-ations in certain respects which are worth noting briefly. Thus, thepercentage of bondholders (in amount) required to compel theTrustee to call a meeting seems to vary from 10 percent to 25 per-cent, 7 10 percent being most common.8

The quorum requirements also exhibit considerable variation.Thus, one indenture provided that holders of 25 percent of thebonds outstanding should constitute a quorum,' whereas anotherindenture placed the requirement as high as 662 percent.10 Mosfof the indentures examined required a majority of the bonds out-standing for a quorum, as in the provision set out above. Some ofthe indentures provided for a reduction of quorum requirementsupon adjournment and subsequent reconvening of the meeting. Thefollowing provision from the Deed of Trust and Mortgage dated De-cember 1, 1909, between Canadian Car & Foundry Company, Lim-ited, and the Royal Trust Company, is typical:

"4. If within half-an-hour from the time appointed for any meeting aquorum Is not present, the meeting, if summoned upon the requisition of thebondholders, shall be dissolved, but in any other case the meeting shall standadjourned to the same day in the next week at the same time and place, andIf at such adjourned meeting a quorum as above defined is not present, thebondholders present shall form a quorum. No business shall be transactedat any meeting unless the requisite quorum be present at the commencementof the business."

7 For a provision containing the 10 percent requirement, see Registration Statement ofCanadian Utilities, Limited, File 2-1720-21, Exhibit D, at 110. A 25 percent require.ment appears In the Trust Agreement dated April 15, 1934, between Canadian PacificRailway Company and The Royal Trust Company, Article Six.8E. g., (1) Trust Deed, dated October 1, 1927, from The Shawinigan Water & Power

Company to Montreal Trust Company, and (2) Trust Indenture dated March 22, 1927between International Power Company, Limited, and The Poyal Trust Company.

9 Trust Indenture dated March 22, 1927 between International Power Company, Limited,and The Royal Trust Company.

'Registration Statement of Canadian Utilities, Limited, aupra note 7.


142

The requirements for adoption of an "Extraordinary Resolution"(necessary for drastic readjustment of the rights of security hold-ers) also vary rather widely. Some of the indentures require a speci-fied percentage of the principal amount of bonds outstanding for suchaction, 1 while others require merely a certain percentage (usually75 percent) of the bonds voted at the meeting, provided, of course,a quorum is present.12

'The English indentures contain provisions for security holders'meetings, substantially similar to the Canadian provision set outabove. Thus, the Trust Deed dated February 1, 1934 between Dun-lop Rubber Company, Limited and The Law Debenture Corpora-tion, Limited, securing an issue of First Mortgage Debenture Stock,provides that the Trustees or the Company may, and upon requestof the holders of 10 percent of the debenture stock outstanding, 8allconvene a meeting of the debenture holders. The provisions regard-ing notice and procedure are similar to those appearing in the Cana-dian indentures, with one major difference, viz., the quorum require-ment is considerably lower. It is provided that holders of 10 per-cent of the outstanding debentures shall constitute a quorum fortransaction of all business except adoption of "extraordinary reso-lutions" relating to readjustment of capital structure, etc. And ifless than 10 percent of the debentures are represented, the meetingmay be adjourned and reconvened at which time the debentureholders present will constitute a quorum. For passing an "extraor-dinary resolution", however, that indenture provides:

"19. The quorum for any meeting for passing an extraordinary resolutionshall be a clear majority in value of the holders of the Stock for the timebeing outstanding present in person or by proxy but so that If within half-an-hour from the time appointed for the meeting a clear majority in value ofsuch Stockholders is not present so as to form a quorum the meeting shallstand adjourned for fourteen days and shall accordingly be held on the cor-responding day of the week and at the same time and place as that originallyfixed by the notice convening the meeting and notice of such adjourned meetingshall be given in the manner provided by Clause 44 of the foregoing Deed andsuch notice shall state that the Stockholders present in person or by proxy atthe adjourned meeting will form a quorun and if at such adjourned meetinga quorum as above defined is not present, then those Stockholders who arepresent shall be a quorum and may transact the business for which the meet-ing was originally convened and a resolution passed thereat by a majority con-sisting of not less than three-fourths of the persons voting thereat upon ashow of hands or if a poll is duly demanded then by a majority consisting ofnot less than three-fourths in value of the votes given on such poll shall beconsidered an extraordinary resolution within the meaning of this Schedule."

I '. g., Registration Statement of Bowater's Canadian Paper Corporation, Ltd., supranote 6.

12B. g., Deed of Trust and Mortgage dated December 1, 1909, between Canadian Car &Foundry Company, Limited and The Royal Trust Company.


It should be observed that contrary to the practice in the United

States, the Canadian and British indentures examined do permit

bondholders at a meeting by "extraordinary resolution" to effect

changes or modifications in the obligation of the issuer to pay prin-

cipal and interest; in fact a far-reaching reorganization of the issuer

and its securities can be authorized at such a meeting.

B. REORGANIZATION BY CONTRACT

The type of provision contained in the foregoing indentures pro-

vides the machinery for reorganization by contract through the

vehicle of a bondholders' meeting. But reorganization by contract

may be effected without formality of a meeting merely by providingthat assent of a specified percentage of bondholders is adequate to

change or alter the terms of the bonds or of the indenture.Prior to the depression of the Thirties, provisions in indentures

setting up the machinery to effect a reorganization by contract wereexceedingly rare. As stated in 1927 by one member of the reorgani-zation bar: "Such provisions, while valid, are not frequentlyfound."l1 But such provisions are quite frequently found in newindentures for the reorganized bond issues originally sold by S. W.Straus & Co. These indentures do not provide for a meeting ofbondholders but commonly specify that the indenture may be altered,changed, etc., on assent of a specified percentage of the bondholders.As we stated in our report on Committees for The Holders of RealEstate Bonds:

"While there is a variation in detail, these indentures generally provide

that the trustee upon the written consent of 75 percent in principal amount of

the bonds outstanding and with the consent of the obligor may release thetrust indenture and discharge the obligation of the bonds, in return for cashor securities. Upon surrender of their bonds, the bondholders receive their

pro rata share of the cash together with the securities, if any, constitutingthe consideration for the release of the trust indenture. Other indenturesrecite in more meticulous terms that the consideration for the release of thetrust indenture 'may be money, securities or any other consideration' and'may be less than the principal amount of the bonds outstanding.'

"Language analogous to that described above permits the alteration, elimi-

nation or amendment of any of the terms of the indenture with the consent ofthe obligor and with the consent of 75 percent in principal amount of bondsoutstanding.

"These provisions permit the elimination of the bondholders' lien, the saleof the property, the extension of the maturity of the bonds, the reduction of

Interest, or the consummation of a sweeping plan of reorganization, on a purely

18 Robert T. Swaine writing on the subject of Reorganization of Corporations: Certain

Developments of The Last Decade, in, Some Legal Phases of Corporate Financing, Reor-ganization and Regulation (1927) at 133, 172. In support of the validity of such provi-sions he cites Sage v. Central R. R., 99 U. S. 834, 341 (1878) ; Gates v. Boton d N. Y. Air

ne R. B., 58 Conn. 838, 845-347, 5 AU. 695, 701-702 (1885).


voluntary basis pursuant to a contract which the bondholders are deemed tohave entered into by virtue of their acceptance of the new securities. These

provisions are complementary to the provisions of voting trust agreements

previously described respecting the power of voting trustees to sell, lease,

mortgage, etc., the property. In fact, if bonds as well as voting trust certifi-

cates for stock are issued pursuant to the reorganization plan, the voting

trust provisions must be supplemented by provisions permitting the release

or amendment of the trust indenture which are necessary in order that the

controlling group may be in an effective position to reorganize on a voluntary

basis." "

In the absence of such provision the release or amendment of theindenture could not be obtained without consent of all of the bond-holders or without the aid of a foreclosure or bankruptcy court.15

The matter (in so far as foreclosure is concerned) has been statedby one writer as follows:

"A mortgage bondholder is regarded as a sort of tenant in common of the

security with the other bondholders. Consequently their unanimous con-

sent is required to effect a change in the lien. Failing that, the only recourse

is foreclosure of the mortgage if there has been a default. Herein lies the

fons et origo of the whole procedure of reorganization. The foreclosure sale,

therefore, besides serving the purely formal purpose of removing a lien,

serves also to define the right of the individual bondholder if he chooses to

be paid in cash rather than accept the reorganization plan." 1

Illustration of such principle 7 is to be found in Hollister v.Stewart, s where trustees under the authority of a railroad mortgage"solely, and without judicial intervention, took possession of therailroad, and began to operate it, and eventually joined with thebondholders outside of the plaintiff and a few others in a plan ofreorganization. That contemplated the substitution of three mort-gages for the first mortgage, and some other obligations of the com-pany. One of these mortgages for $400,000 was made a first lien

on all the property of the company. The other two were framed

"4 Part III, Committees for the Holders of Real Estate Bonds (1936), at 226-227.'s Insofar as the bankruptcy power is concerned see Continental Illinois National Bank

& Trust Company of Chicago v. Chicago Rock Island d Pacific Railway Company et al.,

294 U. S. 648, (1935), where the court said of Sec. 77 of the Bankruptcy Act, providing

for reorganizations of railroads: "It follows, from what has now been said, that § 77, in

its general scope and aim, is within the power conferred by the bankruptcy clause of the

Constitution; and we so hold." As stated by the court Sec. 77 provides that "Upon

confirmation of the plan, It is to be binding not only upon corporation and all stockhold-

ers and creditors generally, but upon all secured creditors of each class of which two-thirds

in amount shall have accepted the plan."'aWeiner, Conflicting Functions of the Upset Price In a Corporate Reorganization (1927),

27 Columbia L. Rev. 132, 137, citing, inter alia, Brooks v. Vermont Central R. Co.,

22 Fed. 211 (C. C. D. Vt. 1884) ; Sage v. Central R. R., 99 U. S. 334, 338 (1878) ; Mer-

chants' Loan A Tru8t Co. v. Chicago Rys. Co., 158 Fed. 923 (C. C. A. 7th, 1907) ; In re

Prudential Outfitting Company of Delaware, Inc., 250 Fed. 504 (S. D. N. Y.. 1918)

(bankruptcy)."And see Canada Southern R. R. Co. v. Gebhard, 109 U. S. 527, 535 (1883) where the

court said : "In the absence of statutory authority or some provision in the instrument

which establishes the trust, nothing can be done by a majority, however large, which will

bind a minority without their consent."-111 N. Y. 644, 19 N. E. 782 (1889).


for a reduced rate of interest. To this plan the plaintiff neverassented, but the trustees adopted it, assumed to waive all existingdefaults under the first mortgage, and agreed to waive them in thefuture; applied some part of the proceeds of the land fund to pay-ments of interest and principal of the new preferred motgage; andnotified the plaintiff that they should pay such proceeds indiscrim-inately upon the new bonds as well as the old." 19 The court affirmeda judgment restraining the trustees from proceeding in that mannerand holding the new bonds void as against the plaintiff. The courtsaid:

"That is simply holding the parties to the conditions of the mortgage, andcompelling the trustees to act in accordance with the terms of their trust.The scheme of reorganization could only be made effective in one of twoways-by the consent of all the bondholders, or by a foreclosure cutting offtheir lien, and so enabling a new corporation to make its own mortgages inits own way. The plaintiff had a clear right to stand upon his contract, andthe trustees had no power or authority to compel him to make a new anddifferent one. We are not concerned with his motives, but only with hisrights. Without his consent, the company and the trustees, the other partiesto the contract, could not vary its terms, and divert to new securities thefunds pledged by the mortgage to its payment. The proposition is almost tooplain for argument. Unless railroad syndicates or committees are to be putabove the Constitution, the trustees cannot set aside and change their contractwith plaintiff of their own volition without his consent." "

In a bond issue of any size the obtaining of 100 percent consentswould be a practical impossibility. Accordingly reorganizers wouldbe faced with the necessity of dealing with a dissenting minority,with the consequence that foreclosure proceedings (and later on,77B proceedings) would be necessary. But the necessity for suchproceedings would be in great part eliminated under a trust inden-ture permitting a reasonable percentage of the bondholders to alterthe lien. As we stated in our report on Committees for the Holdersof Real Estate Bonds:

"These provisions, according to their draftsmen, are designed to infuse newreal estate trust indentures with a flexibility not possessed by the traditionalindenture. By virtue of their voluntary features, the expense and delay offoreclosure or other court proceedings are to be avoided. In the last analysis,however, their primary purpose is to bind the minority to the will of themajority. Thus Bernard Nath testified before this Commission:

'We have therefore provided that the trustee under this indenture mayrelease the indenture if there has been obtained and filed with the trusteein writing the consent of 75 percent of the amount of the security holders.So that we hope in that way to avoid the repetition of the non-depositingor non-assenting bondholders.

'We have incorporated provisions that will make the will of 75 percentor more of the bondholders binding on the small minority.'

'OId., at 658, 19 N. E. at 787.2l., at 659-660, 19 N. E. at 789-790.

Part III, Comminttees for the Holders of Real Estate Bonds (1936), at 227.


146

A similar point of view of the utility and value of such provi-sions for reorganization by contract is contained in a paper preparedand read by Andrew J. Dallstream, of the Chicago law firm ofPam & Hurd, before the Law Club of Chicago on February 28,1936. Mr. Dallstream said:

"A difficult problem Is presented in trying to work out definitive provisionsfor effecting by contract right a complete reorganization or readjustmentwithout utilizing a foreclosure, a receivership or a bankruptcy proceeding.By bankruptcy I mean to include proceedings under Section 77B of the Bank-ruptcy Act. Even If such proceedings ultimately are more satisfactory thanat present, it is likely that in more nornal times old viewpoints will returnand it will be extremely difficult for corporations to avail themselves of thebenefits of Section 77B without incurring to a large extent a loss of good willand going concern value and a proceeding of that character will be regardedwith distaste and as involving a great loss of caste, face or prestige.

"Before suggesting definitive provisions for effecting reorganizations byContract, it may be well to briefly argue the advisability of such comprehensiveprovisions.

"In an earlier day our corporation laws governing the conduct of corpora-tions made few provisions for the settlement and adjustment of the rights ofshareholders. There being no provisions for preferred stock, preferred rightswere provided to attach to certain shares through private agreement betweenshareholders until finally express statutory provision was made for shares ofvarious classes having distinct preferences and rights, but no provision wasmade for substantial adjustments between the rights of these securityholders ofthe various classes. The inflexible provisions of the earlier statutes requiredthat the capital of the corporation as originally set up remain intact. Likewisein an earlier day no substantial changes could be made in the corporate pur-poses and there were no provisions authorizing the sale or disposition of allor substantially all of the corporate property or for a merger or consolidation.Practically nothing could be done of any consequence save by unanimous con-sent. These situations were ultimately recognized as requiring relief.

"The legislatures approached suggested amendments to their corporation lawsdesigned to provide a solution of these problems with reluctance and temerity,but with the passing of years most states have enacted modern corporation lawswhich grant to a requisite percentage of the stockholders the power to makepractically any change in the character of the business or in the rights of thesecurityholders, provided the requisite percentage of the stockholders of eachclass affected assent, and provided, always, that the action taken or the changemade pursuant to such assent meets the test of 'common honesty' (which testis an Inherent part of every such statute). Today the conceptions upon whichthese legislative amendments were based are almost universally accepted.

"Our law of mortgages and the established conception of the rights of mort-gagees was settled in periods when the mortgagee was generally an individualor a group of individuals closely associated with each other in a common enter-prise. The modern corporate mortgage provides for the issuance of securitiesdistributed through underwriters and dealers to hundreds or perhaps thousandsof Individual purchasers of widely separated residences. These 'bondholdermortgagees' are united by no common tie, except the term 'Investors.' It isutterly impossible for any substantial number of these securityholders to meetand discuss their common problems. To expect unanimity of thought or actionby these widely scattered securityholders in meeting any situation Is ridiculous.


147

"Often such securities are held by persons under disability. Some are

acquired by persons more interested in their nuisance value than In aiding a

practical solution of the class problem. Many of such securities are held in

the form of non-registered coupon bonds, resulting in many holders being

unknown. To secure the common assent of eighty to ninety percent of such

securityholders is for all practical purposes to have secured the assent of the

class. To assume that the holder of a single bond out of a large issue is entitled

to block a constructive program favored by the overwhelming majority of his

fellow investors, is to cling to a conception of rights which has no application

to the modern methods of issuing and distributing securities."A new conception should give fair warning to each securityholder that he is

required by contract to abide by the honest decision of an adequate percentage

of his fellow bondholders as the representatives of the class. Such a suggestionis no more revolutionary than the suggestion, when it was first advanced, thatpreferred stockholders must abide by the action of the majority of the classof preferred stockholders in matters affecting their interests.

"General agreement as to how liberal should be the provisions carrying suchIdeas into effect cannot be obtained but majority opinion will likely be thatsome specified percentage of the bondholders should have the absolute right bycontract to control the rights of the class of securityholders in any programof readjustment or reorganization, provided the unified action of the holders

of as nearly all of the bonds as is practicable is secured; perhaps 80 to 90percent The fact that Section 77B of the Bankruptcy Act has specified asmaller percentage furnishes no guide for that required to take private actionunder contractual provisions of a trust Indenture. A proceeding under Section77B, unsatisfactory in some particulars though it be, affords the supervisionof a court. To proceed without that safeguard should clearly require a higherpercentage. Recently in drafting indentures under which securities were to beIssued in connection with reorganizations the members of my own firm col-laborating with other counsel drafted such provisions as were designed topermit, if the affairs of the same enterprise again became involved in difficulties,the working out by contractual provisions of the indenture some readjustment,either voluntarily without the aid of a court proceeding, or in connection witha conventional foreclosure or other court proceeding. To date uhe most liberalof these provisions relating to reorganizations which we have drafted are thefollowing:

'Notwithstanding anything hereinbefore or hereafter contained In thisIndenture, the Trustee may at any time in writing approve of any planproposed by any bondholders' committee or group of bondholders, for theamendment in any respect of this Indenture or of the bonds hereby securedor for any waiver of any breach of any of the terms and provisions con-tained In this Indenture or in such bonds, or for any reorganization ofthe mortgaged property, or of the affairs of the Company (whether or notInvolving the organization of new or successor corporation or trust andthe acquisition by such new or successor corporation or trust of themortgaged property or of any interest therein or of any of the outstandingsecurities of the Company), or for any readjustment of the indebtedness

secured by this Indenture, or for any combination of any such acts, pro-ceedings or transactions. Any such plan when so proposed and approvedas aforesaid shall be filed with the Trustee and shall be subject to inspec-tion by the holders of the bonds outstanding hereunder. If any such planshall be assented to by the holders of not less than 80 percent in principalamount of all the bonds hereby secured and then outstanding such plan


148

shall be binding upon the holders of each and all of the bonds hereby

secured, and such holders shall be bound to accept in lieu of such out-

standing bonds new, modified or substitute securities in the manner and

to the extent, if at all, provided by such plan. Any such plan may provide

for a complete recasting of the rights and liabilities of the bondholders

and of the Company in respect of the indebtedness evidenced by said

bonds and of the mortgaged property and, without limiting the generality

of the foregoing language, may provide for any one or more of the fol-lowing: an extension of the time of payment of said bonds or an increase

or reduction of the rate of interest thereon, or the acceptance wholly or

partially in lieu thereof of new bonds, notes or shares of stock, or other

securities of the Company or of any other corporation, association or

trust. Upon any such plan having been so proposed or approved and

assented to as aforesaid, and upon the deposit with the Trustee of the new,

modified or substitute securities and/or other consideration, to which the

holders of the bonds hereby secured shall be entitled under such plan,

the Trustee shall be authorized to release and cancel this Indenture, and

shall thereafter from time to time deliver to each bondholder the new,

modified or substitute securities and/or other consideration to which he

shall be entitled upon surrender by him to the Trustee for cancellation,

stamping or modification, as the circumstances may require of his said

bonds.'Any such plan may be (but need not be) carried out under the discre-

tion of a court of equity or In connection with any judicial proceeding.'Nothing in this Article contained shall be deemed to restrict any reor-

ganization now or hereafter authorized by any applicable Federal or StateLaw upon compliance with the pertinent provisions of such law.'

"I have read these provisions not because they represent necessarily the final

solution, but because they present a picture of an effort made, and a considera-

tion of their terms may result in more widespread consideration by the Bar

generally of the solution of these problems. Provisions of this character

should of course be referred to in the face of the bond and in any circular

making an offer of sale."Even if provisions of the character herein suggested come into general use,

it will be many years before we will have the opportunity of subjecting many

of them to the test of practical operation and the Bar will for some time be

faced with problems incident to the administration of trusts created by in-

dentures which do not contain provisions for either meeting unusual situations

or reorganizations."Only rarely can a permanent readjustment or reorganization be worked

out under existing indentures except through court proceedings, but there

must arise in the future, as in the past, many situations calling for constructive

solutions of the problems affecting the corporate Issuers and the holders of

securities where proceedings under 77B, a foreclosure suit, or a receivership,

are not indicated and would be most likely to result in the impairment of

the value of the very asset which It is most important to preserve." 2

As noted, the foregoing remarks were not restricted to real estate

indentures. As a matter of fact, the problem is no different therethan in industrials, at least so far as fundamental principles areconcerned. The arguments advanaad in favor of such provisions

xDallstream, Administration of Trusts Created Under Corporate Mortgages (1986), at6-10.


149

have merit. But as we stated in our report on Committees for theHolders of Real Estate Bonds:

"It is true, of course, that this philosophy may find a counterpart in the

policy implicit in Section 77B of the Bankruptcy Act, that a plan consented

to by a majority shall be binding upon all holders of the particular class of

securities. But a 77B plan so approved by the majority of security holders

must be scrutinized and confirmed by the federal court. This essential control,

however, is lacking under the procedure set forth in these trust indentures,

since no machinery is provided for the submission of the contemplated action

to Judicial review. This was made clear by Mr. Nath's testimony before this

Commission:

'A. * * * So that changes of this kind can be made and the only way

they can be stopped is the way they should be stopped, that is to say:

If there is any effort to overreach, the courts are always open to any

bondholders or any group or minority bondholders to go into court and

to claim that the whole transaction is improper or fraudulent. But shortof that, it will be possible under these indentures for the changes which Ihave mentioned or even for the release of the entire indenture to be madeif 75 percent of the bondholders affirmatively agree to such change.

Q. And there would be no court supervision, however, Mr. Nath, over

the fairness, short of fraud, of any such plan?A. There would be no court supervision contemplated, and if anybody

thought court supervision was necessary, 77B would always be available

or foreclosures might be available. But this is a need (sic) wherebyin the proper case all expense of litigation can be avoided.'

"But such right as an individual bondholder may have to appeal to a courtof equity to safeguard him against fraud is a poor substitute for scrutiny by

the court of a reorganization plan as a matter of course and as.an integralpart of the reorganization proceedings.

"In this connection it should be noted that upon reorganization, many ofthe new indentures for bond issues underwritten by S. W. Straus & Co. (of

California) provide for a measure of administrative control in respect torelease of the indenture with consent of the holders of 75 percent in principal

amount of bonds outstanding. This is accomplished by the following language:

'This indenture may be released and the bonds satisfied (but only with

the written consent of the Commissioner of Corporations of the State ofCalifornia so long as there is such a Commissioner) upon payment ordelivery to the Co-trustee for the benefit of the holders of all the bondsthen outstanding, of a consideration (which may be money, securities or

any other consideration), which consideration may be less than theprincipal amount of the bonds then outstanding.'

"But these and the other indentures do not provide for similar administra-tive control in connection with the alteration, elimination or amendment ofany of the terms of the trust indentures short of its total release.

"The introduction of these 75 percent clauses may possibly promote moreexpeditious and economical reorganizations. But to allow such plans to be

consummated without supervision is fraught with danger, especially sinceminorities will be bound to the plan to which 75 percent agree.

"Furthermore, the power given to the majority requires as a corollary

more adequate protection to minorities than will prevail under any voluntarysystem of reorganization. Such a group as 75 percent cannot be expected

to serve both assenters and dissenters assiduously. The manner of obtaining


such assents will vary. It Is more than likely that protective committeeswill be formed to marshall these assents. If their operation is at all com-parable to present practices, these majority and dominant groups will notbe adequate protectors of the minorities. At this point the function of thetrustee in protection of the minorities becomes of great importance." "

Hence, although these indentures which provide for reorganizationby contract may solve some of the reorganization difficulties inherentin equity receivership or bankruptcy, it must be admitted that theygive rise to abuses and problems which must be faced if the interestsof security holders are not to be made subordinate to the desires andconveniences of the dominant group. The risk is that if these pro-visions come into vogue and no controls are set up over them, thenext cycle of reorganizations will take place on a voluntary basiswithout supervision of any court or administrative agency. We willdevelop in other parts of our report the dangers and hazards inherentin voluntary reorganizations and make specific recommendations forcontrol over them. Accordingly, we will defer until that time de-tailed consideration of proposals for control and supervision overthese indenture provisions, since they are but one type of voluntaryreorganization procedure.

At this point, however, one further matter should be mentioned.If less than all the bondholders are to be given the power to effectreorganizations by virtue of the contract contained in the indenture,the use of proxies will doubtless be common. In case of indentureswhich provide for bondholders' meetings, it will not be practical toexpect large numbers to attend in person. Rather, if the history ofstockholders' meetings teaches us anything, we may expect that thebulk of bondholders, if they are represented, will be represented byproxy holders. If those proxies come into hands with interestsadverse to those of the bondholders the latter will not only beinadequately represented; they may be exploited in the fashion inwhich protective committees in other situations have exploitedsecurity holders.

If the management or the junior security holders of a corporationcan obtain proxies from bondholders to vote in their place and steadfor changes in the bonds and in the indenture, grave injustices mayresult. The interests of such parties normally will not lie with thebondholders. Similar conflicts of interest may exist as respectsother proxy holders.

The proxy problem in this situation is illustrated by a provisionin the indenture dated January 1, 1928, between InternationalPower & Paper Co. of Newfoundland, Ltd. and The Royal Trust Co.,securing first mortgage bonds Clause 14 of the Fourth Scheduleprovides in part:

I Part iii, Committees for the Holders of Real Estate Bonds (1936), at 227-228.


"And no person shall be appointed a proxy unless he is one of the Bondhold-ers or a Trustee hereof or when the Trustee is a corporation, an officer of suchcorporation, or a Director or an officer of the Company * * *."

In other Canadian indentures the only provision as respects proxyholders is that they need not be bondholders.

The danger of course is that control over the proxy machine wouldgravitate into the hands of those who had the lists of names andaddresses of the bondholders-most commonly the issuers and theunderwriters-and that they would proceed to put on a campaignfor proxies so that the reorganization could be effected in the mannerbest suited to their own objectives. Conflicts of interests arising outof that situation and the resultant inadequate representation of thebondholders create substantially the same problems as do solicitationof deposits or powers of attorney by protective committees. For thatreason we defer further discussion of that problem until later por-tions of our report. But it is clear that the proxy problem in thissituation occupies a prominent place in the program of control overthe newer procedure of reorganization by contract.

C. SELwcrON OF MEMBERS OF PROTECTIVE COMMITTES AT BONDHOLDERS'MEWINGS

In this report we have discussed the affiliations of the trustee withthe committee. In concluding that discussion we said:

"It may however be essential for the trustee to be the focal point for organi-zation of bondholders in times of trouble and for formation of a protectivecommittee. This may mean that the trustee should act as chairman of a bond-holders' meeting where a committee is selected or that it should undertakedirectly to have a committee formed. But further than that its identificationwith the committee should not go."

In the latter connection it is interesting to note the extent to whichthe trustee has participated in the selection of members of protectivecommittees. From the returns to the questionnaire sent by this Com-mission to corporate trustees the following data have been compiled:Partioipation of trustee in selection of member8 of proteotive comnmwttee:

(a) Number of issues involving trustee's participation-No participation ---------------------------------- 284Some participation -------------------------------- 36Inapplicable-no committee ----------------------- 94No answer .....---.-..- .........----------- 10

Total -------------------------------------- 424(b) Extent of trustee's participation-

Trustee appointed one committee member . ------- 11Trustee appointed two committee members ........ 5Trustee appointed three committee members --------- 2Trustee appointed all committee members ------------ 2Trustee "assisted" In selection ------------------ 16

Total -.......----------- ---------------- -- 8


152

If this is a fair sample, the trustee in the past has been relativelyinactive in forming protective committees. Yet trust officers them-selves not infrequently express the view that this is one of the func-tions of the trustee. As one has stated:

"Upon default under a trust deed it.is the trustee's duty to notify all bond-holders of the default as coupons or bonds are presented for payment and atthe same time make a record of the names and addresses of all bondholdersas obtained. If the bonds were originally underwritten or marketed througha bond house or syndicate, the bond house or the originating member of thesyndicate should also be notified as they have no doubt made a study of thesecurity before the bonds were sold and considered the possibilities of realiza-tion in just such an event. The trustee should also make a close study of thesecurity and its options of procedure to realize on the property for the benefitof the bondholders first and the obligor as well. Steps should be taken to havea meeting called of all the bondholders that they may organize for their com-mon protection and appoint a committee authorized to protect their interests,which committee should be clothed with proper authority to act as adviser tothe trustee for as large a number of bondholders as possible.""

But under the newer type of indenture provision which providesfor bondholders meetings, machinery for the selection of committeesunder the aegis of the trustee is afforded. By reason of that ma-chinery the trustee may be able to act more frequently as the focalpoint for organization of bondholders in times of trouble, either bycalling meetings or by acting as chairman of meetings called for thatpurpose.2 5

In this country the members of a protective committee are, onrare occasions, selected at a meeting of security holders called bythe corporate trustee. An illustration of this practice appears in

"A. L. Grutze, Trust Officer, Title & Trust Co., Portland, Oregon, writing in 41 Trust

Companies (1925) 183, 185.25Canadian indentures frequently include such purpose in the indenture provisions

governing these meetings. Thus the indenture dated as of June 1, 1928, from AbitibiPower & Paper Company, Limited, in favor of Montreal Trust Co. and The National CityBank of New York, Trustees, securing first mortgage bonds provides in Art. 45, Clause11(c) :

"Power from time to time to appoint a committee with power and authority (subjectto such limitations, if any, as may be prescribed in the resolution) to exercise, and todirect the Trustees to exercise, on behalf of the Bondholders such of the powers of theBondholders that are exercisable by extraordinary or other resolution as shall be providedin any extraordinary resolution appointing such committee or subsequently from time totime adopted. Any such extraordinary resolution making such appointment may providefor payment of the expenses and disbursements of and compensation to such committee.Such committee shall consist of such number of persons as shall be prescribed in the reso-lution appointing it and the members need not be themselves holders of Bonds. Everysuch committee may elect its chairman and may make regulations respecting its quorum,the calling of its meetings, the filling of vacancies occurring in its number and its pro--2edure generally. Such regulations may provide that the committee may act at a meet-ing at which a quorum is present or may act by minutes signed by the number of mem-bers thereof necessary to constitute a quorum. All acts of any such committee within

the authority delegated to it shall be binding upon all Bondholders ;"


connection with the External Secured Sinking Fund 7 percent GoldBonds of 1928 of the State of Maranhao, Brazil.2 6

The issue in the amount of $1,750,000, of which $1,682,000 wasoutstanding at the time of default, was distributed in 1928 by abanking group headed by Baker, Kellogg & Co. It was secured by a"number of taxes, including the revenues of the water and electriclight and power works, which are collected by an American engineer-ing company.1 2

7 The Bankers Trust Company was designatedtrustee. Because of exchange restrictions imposed by the FederalGovernment of Brazil, the interest payment due on May 1, 1932, andthose subsequently falling due were not met. Defaults occurred insinking fund payments as well. Protests, by both the Bankers TrustCompany and the Ulen Management Company (the American en-gineering concern referred to above) were successful to a limitedextent: deposits to the account of the Bankers Trust Company inthe Bank of Brazil of the amount of Brazilian currency approxi-mately equivalent to the debt service due in dollars were made fromAugust 4, 1932 until March 22, 1934.

On February 5, 1934, the Federal Brazilian Government issueddecree number 23,829 which regulated the payments that were to bemade on external federal, state and municipal loans. This decree,covering the four-year period from April 1, 1934 to March 31, 1938,classified external loans in eight grades.8 Loans in the first gradereceived service in full; in the remaining grades, bond service wasscaled in varying amounts until the eighth grade was reached whichreceived no bond service. The Maranhao loan was placed in theseventh grade with interest payments ranging from 171/2 percent,in the first year, to 321/2 percent in the fourth year of the fullamount of the interest requirement, but with no payments for amorti-zation.

Shortly after the promulgation of the decree Bankers Trust Com-pany, trustee for the loan, decided that the formation of a bond-holders' protective committee would be advisable. Factors whichwere said to have prompted this decision were the trustee's inabilityto obtain a transfer of its deposited funds into dollars, the pro-

" The Information on which the account of this meeting of Maranhao bondholders isbased, except where otherwise indicated, has been obtained from various documents, let-ters and memoranda, copies of which have been furnished this Commission by BankersTrust Company, Baker, Kellogg & Co., Ulen Management company, and the committeeunder consideration.

97 Institute of International Finance, Bulletin No. 49, Dec. 31, 1931, at 25."Foreign Bondholders Protective Council, Inc., Annual Report 1934, introduced as

Commission's Exhibit No. 19 in Proceedings Before the Securities and Exchange Commis-lion In the Matter of Foreign Bondholders Protective Council, Ina (1935), at 36-43.


154

nouncement of the federal decree and the proposal of an officer ofthe obligor state "to withdraw or reduce certain taxes pledged assecurity for the bonds. '2

The trust agreement between the State of Maranhao and theBankers Trust Company, dated April 14, 1928, made provision forthe calling of bondholders' meetings by the trustee in the followingterms:

"Meetings of the bondholders may be convened In The City of New York,State of New York, by the Trustee * * * and shall be called by theTrustee upon request in writing of the State or upon a request In writingsigned by the holders of twenty-five percent (25%) in principal amount ofbonds at the time outstanding. Notice of the time and place and purpose ofsuch meeting or meetings shall be given by the Trustee * * * at theexpense of the State, and shall be published in at least one daily newspaperin the City of New York, for at least four consecutive weeks, the last publica-tion to be not less than twenty days before the date fixed for said meeting.Adjourned and subsequent meetings may be called in such manner as maybe prescribed by the bondholders at any meeting. The bondholders may voteat such meetings in person or by proxy; and regulations or by-laws in respectof such meetings may from time to time be established, altered or repealed bythe bondholders acting by seventy-five percent (75%) in principal amount ofthe bonds outstanding; and until the bondholders shall make such regulationsor by-laws, such powers may be exercised by the Trustee." '

Bankers Trust Company decided to call a meeting of the bond-holders, pursuant to the above provision, "to consider (1) the forma-tion of a Bondholders' Committee, (2) the proposed partial interestpayments under the Presidential Decree No. 23829 and the othermatters affecting their interests." A circular letter, dated May 16,1934, was sent by Bankers Trust Company, as trustee, to all bond-holders whose addresses it had and to members of the underwritingand selling group, announcing a meeting for June 6, 1934. Thisletter is printed as Exhibit A to this Appendix. An advertisementof the meeting inserted in two New York newspapers is printed asExhibit B. Bondholders who could not attend in person were re-quested to sign a printed form of proxy, running to "Mr. Henry W.Lieber, a substantial bondholder, and Mr. George 0. Castell, one of

- See circular letter from Bankers Trust Company to bondholders annexed to thlaappendix as Exhibit A.

3o Art. Seventh, sec. 2. It does not appear whether the trustee adopted regulations orby-laws in respect to the meeting.

Section 1 of the same article provides for the modification of the trust agreement, ex-cept with respect of the obligation of the issues to pay principal and interest, by theaffirmative vote of seventy-five percent (75%) In principal amount of the bonds out-standing at a meeting of bondholders held as provided in the section quoted in the text.It may be, therefore, that the provision for the calling of a meeting was intended onlyfor the purpose of permitting bondholders to vote on an amendment to the agreement.In that event the meeting herein referred to would be an informal one called on theInitiative of the trustee and of Interest from that aspect.


his associates," or if they so desired, to strike these two names andinsert the name of a proxy of their own choice.3' The proxy form isaffixed as Exhibit C.

The meeting, conducted at the offices of the Bankers Trust Com-pany, was poorly attended. Holders of not more than $114,500 ofbonds, 6.8 percent of the $1,682,000 outstanding, appeared in person.Approximately 15 percent of the bonds outstanding were repre-sented at the meeting altogether by their owners or by proxies.

The minutes of the meeting, presided over by Mr. Nohl, a corpo-rate trust officer of the Bankers Trust Company, described the elec-tion of the committee:

"Mr. Nohl then said that the Trustee thought that bondholders should forma protective committee and that the meeting should be turned over to thebondholders. Mr. Frederick [the proxy for a holder of $6000 of bonds] sug-gested that Mr. Kellogg [Vice-President of Baker, Kellogg & Co., the principalunderwriter] head the Committee. Mr. Kellogg hesitated and suggested thatMr. McQueen be named as Temporary Chairman.

"Mr. McQueen took the chair."Mr. Sexton [Vice-President of Baker, Kellogg & Co.] suggested that Messrs.

Kellogg, McQueen and Byfield be named by the bondholders as a Committee.These three, including Mr. E. B. L. Babcock, were nominated, seconded andappointed members of the Committee by the bondholders.

"A resolution was made by Mr. Byfield that the Committee should be limitedto five members-the fifth wnember to be appointed at some later time."

The committee was constituted as follows:

Charles A. McQueen, ChairmanRobert S. ByfieldRalph D. Kellogg

E. C. BabcockLew B. Clark, Secretary

Mr. Kellogg, as noted above, was of the firm of Baker, Kellogg& Co., the principal underwriter of the bonds. Mr. Byfield waspresident, Mr. McQueen and Mr. Clark were vice-presidents ofForeign Bond Associates, Inc., a company engaged in dealing inforeign bonds. The nature of the business of Foreign Bond Asso-

91 In order to permit holders of unregistered bonds and their proxies to attend and votewithout producing their bonds, the trustee required each such holder to exhibit his bondsto a New York City hank or trust company, a member bank or trust company of the Fed-eral Reserve System, a bank or trust company having a correspondent in New York Cityor a member of the New York Stock Exchange, and obtain a certificate (affixed hereto asExhibit D), attesting to his bondholdings. Art. Seventh, sec. 3 of the trust indenturespecifies the obtaining of such certificate and such further proof of bondholdings as thetrustee deems desirable. The bondholder was not, however, required, as in the car.heretofore set forth of the Donnacona Paper Company, Ltd., to leave his bonds on deposituntil the final adjournment of the meeting.

75957 °-36-----11


ciates, Inc. is described in the following quotation from a circularissued along with its prospectus:

"Foreign Bond Associates, Inc. is a cooperative enterprise for holders of

foreign bonds and for investors who appreciate the profit possibilities in foreignbonds. Through it they jointly engage the services of an experienced man-

agement to handle their Investment position In the foreign field. * * *"It is the purpose of the fund to trade actively In foreign bonds of all types,

to take advantage of the wide discrepancies that frequently exist betweenmarket prices and intrinsic values. In other words:

(1) to sell the over-valued bonds and buy the under-valued bonds until the

market has corrected its own discrepancies;(2) to liquidate bonds that have advanced beyond a reasonable point and

to be in a cash position to repurchase them at a time when there has been amarket slump;

(8) in general to trade advantageously in a field where the professional is at

a tremendous advantage and has little enlightened competition."

Mr. Babcock does not appear to have had any previous connectionwith the issue.

Responses to a questionnaire submitted to this Commission by

the committee members indicate the following bond holdings of the

Maranhao issue at the time of the committee's formation. Mr.

McQueen owned $3,000 par amount jointly with Mr. Clark. The

Latin American Bond Fund, administered by McQueen and Clark,

owned $8,000. Mr. Byfield owned nothing personally but a member

of his family owned $1,000. Foreign Bond Associates, Inc., of whichthe three named were officers, owned $15,500. Mr. Kellogg owned

$D,000 and Mr. Babcock $2,000.This committee arrived at a tentative basis of an agreement with

the State of Maranhao striking various compromises with respect to

the points of difference. The agreement, however, never became

effective, because of changes in the political situation in Maranhao

and in the economic situation in Brazil.

The extent to which the foregoing example will prove to be typical

of attempts to bring bondholders together for concerted action can-

not be prophesied. It is clear that inertia of security holders is

great and the difficulty of getting them assembled tremen-

dous. Nevertheless the democratic process in selection of com-

mittees deserves a fair trial. It can be given a fair trial only if

more adequate controls over committees can be established-both as

respects their powers and their responsibilities. Furthermore it can

be given a fair trial only on the condition that qualifications be set

for committee membership so that those representing the security

holders are freed from the tangle of conflicting loyalties. For these

reasons the problems of bondholders meetings for the purpose of

selecting committees is a part of the larger problem of control over

committees. Hence we defer further discussion of it until later

parts of our report.


EXHIBIT A

BANKERS TRUST COMPANY

16 WALL STREET

NEW YORKTRUST DEPARTMENT

MAY 16, 1934.To the Holders of

STATE OF MARANHAO, BRAZIL,EXTERNAL SECURED SINKING FUND

7% GOLD BONDS OF 1928.Notice is hereby given to holders of the above bonds of a meeting

of bondholders to be held at the office of Bankers Trust Company,16 Wall Street, New York City, on June 6, 1934, at 10 o'clock, A. M.This meeting is being called by us as Trustee under the trust agree-ment dated April 14, 1928, under which the bonds were issued. Fromrecords available to us it appears that you at one time wera a holderof State of Maranhao bonds, which are hereinafter referred to asthe bonds, and this notice is being sent to you accordingly. If youare no longer a holder of such bonds and you know the name andaddress of the person to whom you sold the bonds, we will greatlyappreciate your forwarding to him this letter and enclosures, oradvising us of the name and address of the purchaser.

The situation now existing with respect to the bonds is briefly asfollows: the May 1, 1932 and subsequent interest coupons are indefault. No monies have been paid to the sinking fund since Sep-tember, 1931. As security for the payment of the principal andinterest of the bonds, the State of Maranhao pledged and chargedin favor of us as Trustee certain taxes imposed by the State andthe gross revenues of certain utilities in the City of Sao Luiz andsuburb of Anil. The trust agreement requires that as and whensuch taxes and revenues are collected, they shall be deposited to thecredit of the Trustee in a special account in a bank or banks in theState of Maranhao. Under the trust agreement the State is re-quired to pay or cause to be paid to us as Trustee from such revenuesso deposited, and in case such deposit shall not be sufficient, thenfrom its other resources or funds amounts sufficient to pay the inter-est and sinking fund on the bonds. The State has failed to pay usas Trustee any such amount since September, 1931. Under the

(157)


trust agreement Ulen Management Company was appointed theadministrator of the utilities referred to above and was authorized tocollect the revenues and certain taxes therefrom. Ulen Manage-ment Company has administered the utilities and has from time totime deposited the revenues therefrom in milreis, less certain operat-ing and maintenance expenses, etc., in the Bank of Brazil to thecredit of Bankers Trust Company as Trustee. Due, however, to theexchange control exercised by the Brazilian Government, we, asTrustee, have been unable to obtain a transfer of the funds fromBrazil into dollars and these funds consequently remain on depositwith the Bank of Brazil.

Recently, under the provisions of a decree of the Chief of theProvisional Brazilian Government, known as Presidential DecreeNo. 23829 of February 5, 1934, a plan was adopted covering the pay-ment of interest and sinking fund on the external loans of the Federaland State governments and municipalities of Brazil during the periodfrom 1934 to 1938. The several loans have been placed in variousgrades and the decree sets forth the amount of exchange which willbe made available for the payment of interest and sinking fund onloans in each grade. The Maranhao bonds have been placed inGrade 7 and the decree provides that no sinking fund payments inrespect of bonds in Grade 7 will be transferred for the period of theplan but that foreign exchange will be made available for partialinterest payments in the following amounts: 171/2% for 1934-1935,20% for 1935-1936, 221/2% for 1936-1937, 321/% for 1937-1938. Thedecree also provides that the plan will be reviewed not later than theend of September, 1937, when the Brazilian Government proposesto reconsider the future service of all Brazilian external loans.

We have also been informed that the Federal Interventor of theState of Maranhao has recently proposed to withdraw or reducecertain taxes pledged as security for the bonds.

From the foregoing it may be seen that many serious problemsaffect the interests of the bondholders. We have communicated withthe Brazilian State and Federal authorities and agencies; we haveprotested to our State Department in behalf of the bondholders andwe have been in touch with the American Foreign BondholdersProtective Council with regard to these matters and in an effortto have the defaults cured and funds provided for the service of thebonds.

We have recently concluded that the many important questionswhich have arisen in connection with this loan could not be effectivelydealt with by cable and correspondence between the United Statesand Brazil and that it was essential that we send a representative toBrazil to take up with the State and Federal authorities the matters


affecting the bonds, including the proposed partial interest payments

to be made under the decree, and the possible release of exchangeagainst the deposited milreis referred to above. Our representativesailed for Rio de Janeiro on Saturday, May 5, 1934.

No bondholders' committee has been formed nor, so far as weknow, is the formation of a committee contemplated by any of thebondholders. We, as Trustee, feel that the interests of the bond-holders are being affected so vitally by present developments inBrazil, that the bondholders should be apprised of such developmentsas have come to our attention. We also believe that they should beadvised of the necessity of organizing a committee to collaboratewith the Trustee for the protection of their interests. It is alsofelt that in the course of his dealings with the Brazilian authorities,our representative will be greatly aided if the opinion of the bond-holders can be obtaned on questions affecting their interests. Thismeeting is, therefore, being called to enable the bondholders to con-sider (1) the formation of a Bondholders' Committee, (2) the pro-posed partial interest payments under the Presidential Decree No.23829 and the other matters affecting their interests.

It is of the utmost importance that you attend this meeting per-sonally or, if you are unable to do so, that you be represented at themeeting. A form of proxy is enclosed herewith for use in case youcannot attend personally. For the convenience of those bondholderswho may not be able to attend the meeting and may not have avail-able a proxy, we have requested Mr. Henry W. Lieber, a substantialbondholder, and Mr. George 0. Castell, one of his associates, to act asproxies. The proxy has been so drawn that bondholders desiring toname another proxy may do so by ruling out the names of Messrs.Lieber and Castell and inserting in the blank on the proxy the nameof the proxy they desire to appoint.

In order that holders of unregistered bonds and their proxies mayattend and vote without producing their bonds, the principal amountof bonds, for the purposes of the meeting, held by any bondholderand the numbers thereof and the fact of his holding such bonds maybe proved by a certificate executed by any New York City bank ortrust company or any bank or trust company which is a member ofthe Federal Reserve System or has a correspondent in the City ofNew York or by any New York Stock Exchange firm, showing thatat the date therein mentioned the bondholder had exhibited to itthe bonds described in the certificate. A form of certificate isenclosed herewith and each bondholder other than the holder of aregistered bond or bonds must present such certificate, properlyexecuted, at the meeting if he attends personally, or must attach suchcertificate to the proxy, if he is to be represented by proxy. In the


160

case of registered bonds, the ownership thereof shall be proved bythe registry books.

In order that we, as Trustee, may inform you of developments inthis situation you should, if you do not plan to attend the meetingpersonally, promptly confirm to us your holding of State of Maran-hao bonds and the amount and serial numbers thereof and furnishus, as Trustee, the address to which you as a bondholder desire us tosend communications.

Yours very truly,BANKERS TRUST COMPANY, TRUSTEE,

By R. G. PAGE, Vice-President.


EXHIBIT B

MEETINGS AND ELECTIONS

To the Holders of State of Maranhao, Brazil, External Secured Sink-ing Fund 7% Gold Bonds of 1928:

Notice is hereby given that a meeting of bondholders will be heldat the office of Bankers Trust Company, 16 Wall Street, Boroughof Manhattan, New York City, on June 6, 1934, at 10 o'clock A. M.The bondholders' meeting is being called to consider (1) the forma-tion of a Bondholders' Committee; (2) the proposed partial interestpayments under the provisions of the decree of the Chief of the Pro-visional Government of the United States of Brazil, known as Presi-dential Decree No. 23829 of February 5, 1934, and other matters af-fecting the interests of the bondholders.

Bondholders may obtain from Bankers Trust Company, Trustee,at its office, 16 Wall Street, Borough of Manhattan, New York City,copies of circular letter dated May 16, 1934, addressed to bond-holders. In order that bondholders may attend the meeting withouthaving to produce their bonds, a form of certificate to establish theholding of bonds by bondholders may also be obtained.

All bondholders are strongly urged to attend this meeting person-ally or to be represented thereat by proxy.

Dated, May 16, 1934.BANKERS TRUST COMPANY, Trustee,

By R. G. PAGE, Vice President.

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EXHIBIT 0

PROXY

KNow ALL ME By THXSE PRESENTS that the undersigned, ownerand holder of State of Maranhao, Brazil, External Secured SinkingFund 7% Gold Bonds of 1928, does hereby constitute and appointHENRY W. LIEBER, GEORGE 0. CASTELL, or any of them,attorneys, agents, and proxies of the undersigned with full power ofsubstitution for and in the name, place, and stead of the undersignedto attend at the meeting of holders of State of Maranhao, Brazil, Ex-ternal Secured Sinking Fund 7% Gold Bonds of 1928, to be held atthe office of Bankers Trust Company, 16 Wall Street, Borough ofManhattan, New York City, on June 6, 1934, at ten o'clock A. M.,and any and all adjournments thereof, and to vote and act at saidmeeting and at any and all adjournments thereof upon any and allmatters affecting any and all bonds of the undersigned or the under-signed's interest therein and, specifically, without limiting the gen-erality of the foregoing, the formation and selection of a bondhold-ers' committee, the delegation of powers to such committee, consid-eration of the proposed partial interest payments to be made on thebonds in lieu of full interest and sinking fund payments for theyears 1934 to 1938, pursuant to the provisions of the decree of theChief of the Provisional Government of the United States of Brazil,known as Presidential Decree No. 23829 of February 5, 1934, all tothe same extent and as fully and with the same force and effect asthe undersigned as the owner and holder of such bonds might orcould do if the undersigned were personally present at such meet-ing, and the undersigned does hereby ratify and confirm all thatsaid attorneys, agents, and proxies, or any of them and the substi-tute or substitutes of them, or any of them, may do by virtue hereof.

IN WITNESS WHEREOF, the undersigned has caused these presentsto be duly signed and sealed this ------- day of -------------1934.

----------------------- [. s.]

Witness: Address:

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EXHIBIT D

CERTIFICATE AS TO THE HOLDING OFSTATE OF MARANHAO, BRAZIL,

EXTERNAL SECURED SINKING FUND 7%GOLD BONDS OF 1928.

We hereby certify to Bankers Trust Company, as Trustee undertrust agreement dated April 14, 1928, with State of Maranhao, Brazil,

that ----------------------- (hereinafter referred to as the "bond-

holder") has this day exhibited to us $ ----- , principal amount of

STATE OF MARANHAO, BRAZIL, EXTERNAL SECURED SINKING FUND 7%

GOLD BONDS OF 1928, Nos.*-------

This certificate is made at the request of the bondholder, in orderto permit him to attend and vote, either personally or by proxy, atthe meeting of bondholders to be held at the office of Bankers TrustCompany, 16 Wall Street, Borough of Manhattan, New York City,on June 6, 1934, at ten o'clock A. M., in the same manner as if thedepositor were the actual bearer of the bonds in respect of whichthis certificate is made and produced such bonds at such meeting.

The bondholder's signature appears at the foot of this certificate,and we guarantee the genuineness of such signature.

Dated, ---------------- , 1934.

Signature of the bondholder referred to in this certificate.

........................

* NOTE.-It is essential that the numbers of the bonds be given.

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EXHIBIT B

The procedure followed in calling a bondholders' meeting underone Canadian trust indenture is illustrated by a series of documentsused in connection with a meeting of the bondholders of the Donna-cona Paper Company, Limited. These consist of (1) notice of meet-ings, setting out a detailed summary of a plan of readjustment pro-posed by the debtor; (2) copy of instructions with respect to voting;(8) form for request for voting certificate for holders of unregisteredbonds who desire to vote without presenting their bonds at the meet-ing; (4) specimen voting certificate; and (5) specimen proxy.

(1)

Donnacona Paper Company, Limited

(Incorporated under the Quebeo Compani/es' Act)

Notice of Meeting of Holders

of51/z Percent First Mortgage Twenty-Year Sinking Fund

Gold Bonds

NOTIcE is HmRBBY GIVEN that, pursuant to Notice from DonnaconaPaper Company, Limited, (herein called "the Company") to theundersigned Trustee, a Meeting of the holders of the 51/2 percentFirst Mortgage Twenty-Year Sinking Fund Gold Bonds (hereincalled "the Bonds") of the Company issued, secured and outstandingunder Trust Deed of Hypothec, Mortgage and Pledge made beforeClaude Taschereau, N. P., on the 27th February 1928, by the Com-pany in favour of the undersigned Trustee, as amended by Supple-mentary Trust Deed made before R. Meredith, N. P., on November4th, 1932, and added to by a second Supplementary Trust Deed datedthe 31st of January 1933, made before the said R. Meredith, N. P.,by the Company in favour of the undersigned Trustee, (which saidTrust Deed so amended and added to is herein called the "TrustDeed"), will be held in room "A", the RoYAL TRUaST Co. AnnexBuilding, 102 Craig Street West, in the City of Montreal, Canada, onthe fifteenth day of April, 1936, at the hour of 11 o'clock in the fore-noon, for the following purposes:-

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I. To consider, and, if deemed advisable, pass as an extraordinaryresolution or resolutions within the meaning of the Trust Deed, aresolution or resolutions-

A. To sanction, with or without modification, a plan lor the re-organization of the company, such plan having been approvedby resolution of the directors of the Company on the 25th day ofFebruary, 1936, for submission to meetings of holders of theshares and bonds of the Company, the principal features of saidplan being in substance as follows:

I. PLAN

(a) Capital Stock:The increase of the Capital Stock of the Company and the change

of the respective privileges and preferences of the Class A shares andClass B shares as to voting rights and merger, to be effected by arrange-ment approved by the Court under section 41-A of the Quebec Com-panies' Act or in such other manner as Counsel may advise, as follows:

(1) The existing 244,892 shares of no par value, consisting of121,804 Class A shares and 123,088 Class B shares, shall be in-creased by 131,680 Class A shares of no par value with the resultthat the authorized share capital of the company shall consist of876,572 shares of no par value divided into 253,484 Class A sharesand 123,088 Class B shares ;(2) The Class A and Class B shares, as at present, will rank equallyas regards dividends and upon any return of capital and in allother respects, except as to voting rights. The existing prefer-ences and privileges of the Class A and Class B shares, with re-spect to voting rights and merger, will be cancelled, and theClass A shares will carry exclusive voting rights until the twoClasses of shares are merged as hereinafter set forth. On Feb-bruary 1st, 1944, provided the Company shall have fulfilled all itsobligations under the Trust Deed, or, at such time thereafter asthe company shall have fulfilled such obligations, the Class Aand Class B shares shall become merged and the distinction be-tween the two classes of shares shall disappear.

(b) First Mortgage Bonds:(1) The waiver and cancellation of the annual Sinking Fund pay-ment payable under the Trust Deed on February 1st, 1966, togetherwith the four semi-annual interest payments on the Bonds due on thefirst days of August 1934, February 1935, August 1935 and February1936, payable out of net income earned after the first day of February1934 and all accumulations thereof and interest thereon, except to theextent of $65,840.00 interest due, said $65,840.00 to be paid in stockin lieu of cash as hereinafter provided.(2) The issue of the newly authorized 131,680 Class A Common SharesIn the capital stock of the Company, fully paid, to the holders of the


166

outstanding $6,584,000.00 principal amount of First Mortgage Bonds,at the rate of two (2) shares for each $100.00 principal amount ofBonds held by each of them respectively, in payment In lieu of cashof said $65,840, interest due, and in further consideration of the saidholders agreeing to:

(a) The postponement of the maturity date of the bonds fromFebruary 1, 1948 to February 1, 196;(b) The conversion of the Company's obligation to pay intereston the bonds at the rate of 5 percent per annum into an obliga-tion to pay interest from February 1, 1936, to February 1, 1937,at the rate of 3 percent per annum, from February 1, 1937, toFebruary 1, 1938, at the rate of 4 percent per annum and fromFebruary 1, 1938, to maturity at the rate of 4 percent perannum;(c) The conversion of the Company's obligation under the TrustDeed to make sinking fund payments into an obligation to makepayments as follows:-during the years 1937 to 1943 inclusive,subject to the condition that no payment shall be made If thesame would reduce the net working capital of the Company, asdefined in the Trust Deed, below the sum of $1,000,000.00, theCompany, on the first day of February in each year, shall payto the Trustee for the Sinking Fund one third of its net income(as defined in the Trust Deed but before depreciation and de-pletion) for the previous calendar year; during the years 1944to 1955 inclusive, Irrespective of the amount of net workingcapital of the Company, the Company shall, on the first day ofFebruary in each year, pay to the Trustee for the Sinking Funda sum of money equal to two percent (2%) of the aggregateprincipal amount of Bonds, which up to the several dates ofpayment respectively, shall have been certified by the Trustee,together with a further sum equal to the annual interest, at therate of four and a half percent (4 %) per annum, on all Bondstheretofore purchased or redeemed through the operation of thesinking fund. The failure to make any payment as herein pro-vided on its due date shall constitute an event of default underthe provisions of Clause 21 of the Trust Deed.(d)'The conversion of the Company's obligation to pay the prin-cipal and interest of the bonds in gold coin or its equivalent orEnglish Sterling, into an obligation to pay the same in the re-spective legal tenders of the countries where payable under theTrust Deed.

(c) DivAdenads:The cancellation of the present restrictions on the Company's power

to declare dividends, except the following restriction, viz: that theCompany will not declare or pay any dividends on its share Capital

If the net working Capital of the Company, as defined in the Trust


Deed, shall at the time of payment of any dividend, be less than the

sum of $1,000,000.00 after making provision for the payment of such

dividend.II. APPROVAL OF PLAN

The Plan will not become effective and operative unless and until

all necessary resolutions and consents of the bondholders and share-

holders shall have been obtained in form satisfactory to counsel.

III. PROCEDURE

The Company shall have power to adopt procedure, to make suchprovisions to remedy minor omissions, to adjust minor details and

generally to take such steps consistent with the general nature of theplan as in its discretion may be advisable in order to consummatethe plan and to put the same Into effect

IV. EXPENSES

All expenses incidental to the formulation and carrying Into execu-tion of the plan shall be paid by the Company after approval by theBoard of Directors.

B. To sanction all changes and alterations of the provisions ofthe Trust Deed and any modification or compromise of therights of the holders of the First Mortgage Bonds against theCompany, or against its property, which may be involvedunder the plan or necessary in order to carry out the same, andto sanction the execution of all trust deeds, supplementary trustdeeds, agreements and documents of all kinds which may beinvolved in or which may be necessary or advisable for the pur-pose of giving effect to the plan and to any and all modificationsor compromises of the rights of the holders of the First Mort-gage Bonds of the Company against the Company or against itsproperty which may be involved under the plan or necessary tocarry out the same, and in particular but without limiting thegenerality of the foregoing:

(i) The waiver and cancellation of the annual sinkingfund payment due and payable on February 1, 1936, inaccordance with the plan;(ii) The waiver and cancellation of the four semi-annualinterest payments due on the first days of August 1934,February 1935, August 1935 and February 1936, and allaccumulations thereof and interest thereon except to theextent of $65,840.00, in accordance with the plan;(iii) The postponement of the maturity date of the bondsfrom February 1, 194,8 to February 1, 1956, in accordancewith the plan;


(iv) The conversion of the Company's obligation to payinterest at the rate of 51/2 percent into an obligation to payinterest at lower rates, in accordance with the plan;(v) The conversion of the Company's obligation to makepayments for a sinking fund into an obligation to makepayments for the sinking fund in accordance with the plan;(vi) The conversion of the Company's obligation to paythe principal and interest of the bonds in gold coin or itsequivalent or in English Sterling into an obligation to paythe same in legal tender where payable, in accordance withthe plan;

(vii) The cancellation of certain restrictions on the Com-pany's power to declare dividends, in accordance with theplan;

All action taken at the above mentioned meeting and anyadjournment thereof shall be subject to and shall take effect onlyupon the adoption of such resolutions and the giving of suchfurther consents or other approval as may be necessary to makethe Plan -binding upon those whose rights are affected by thePlan.

II. To take such further or other aEction as may be considered advis-able in the premises.III. To adjourn the meeting from time to time for further consid-eration of and action on any of the above mentioned purposes.

Pursuant to the provisions of the Trust Deed and regulationsmade by the Company with the approval of the Trustee underpowers contained therein --

A holder of registered Bonds may attend the meeting personallywithout production of his Bonds, but may, by instrument in writ-ing stating the numbers of his Bonds, appoint a person as proxy toattend and vote for him at such meeting and any adjournmentthereof.

A holder of unregistered Bonds may attend the meeting person-ally and may vote thereat upon production of his Bonds at the meet-ing, but if he desires to attend and vote without production of hisBonds or to vote by proxy he must deposit his Bonds as hereinafterprovided.

A holder of unregistered Bonds desiring to attend and vote at themeeting without production of his Bonds or by proxy must depositsuch Bonds with a recognized bank or trust company or other com-pany or person satisfactory to the Trustee, and obtain from such


depositary a voting certificate in the form prescribed or any other

form satisfactory to the Trustee. The holder named in any such

voting certificate shall be entitled to be present and vote at such

meeting or any adjournment thereof without production of the Bonds

specified therein, or may, by instrument in writing in the form pre-

scribed or other form to the like effect, appoint a proxy to vote and

act for him at such meeting and at any adjournment thereof inrespect of the Bonds specified in such voting certificate. Bondsshall only be so deposited on condition that they will be held ondeposit until after the meeting and any adjournment thereof andthat they will only thereafter be returned by the depositary.

A proxy need not be a Bondholder, but no proxy shall be givenin favour of the Trustee or any of its officers.

Voting certificates and proxies may be presented at the meeting orany adjournment thereof, or, for the convenience of the Bondholders,they may be lodged, prior to the meeting or any adjournment thereof,at any of the below mentioned officers of The Royal Trust Companyor of the Bank of Montreal.

Forms for the deposit of Bonds for voting purposes, forms ofproxy, copies of the reorganization Plan and other informationmay be obtained by Bondholders upon application to any of thefollowing offices of the Royal Trust Company:

105 St. James Street, West .......................--. MoNraw4 P. Q.58 St. Paul Street -- ,-------------------------------------Qu P. Q.59 Yonge StreeL - ----------- o-o IqT.15 Duke StreeL ----------------------------------- HIxrA, N. S.128 Wellington Street ------------------ oTrAwA, ONT.436 Main Street------------------ -.. . . .---------- WnIvnum, MAN.626 Pender Street, West -------------- VAioDuvma, B. (.1 Pall Mall East, S. W. 1 ........................... LONDOn, ENGLAND

or at the following Agencies of the Bank of Montreal:

64 Wall StreeL ....... - Nmw YORK, N. Y.27-29 South La Salle Street ----- C-O-------- --------- CmAo, ILL

Dated at Montreal, P. Q., this 10th day of March 1936.

THE ROYAL TRUST COMPANY, Truete.


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This form must be delivered ENTIRE to a bank, trust company, other company or person satisfactory to the Trustee

Donnacona Paper Company, Limited(Incorporated under the Quebec Companies Act.)

Meeting of Holders of Five and One-Half Per Cent. First Mortgage Twenty-Year Sinking FundGold Bonds, to be held in room "A" The Royal Trust Co. Annex Building, 102 Craig

Street West, Montreal, on the 15th day of April 1936.

Instructions in Regard to Voting and Regulations for VotingUnregistered Bonds without Production thereof or by Proxy.

1. A holder of registered Bonds may attend the meeting personallywithout production of his Bonds, but may, by instrument in writingstating the numbers of his Bonds, appoint a person as proxy toattend and vote for him at such meeting and any adjournmentthereof.

2. A holder of unregistered Bonds may attend the meeting per-sonally and may vote thereat upon production of his Bonds at themeeting, but if he desires to attend and vote without production ofhis Bonds or to vote by proxy he must deposit his Bonds as herein-after provided. . , . - ....

3. A holder of unregistered Bonds desiring to attend and vote atthe meeting without production of his Bonds or by proxy mustdeposit such Bonds with a recognized bank or trust company orother company or person satisfactory to the Trustee, and obtain fromsuch depositary a voting certificate in the form annexed or any otherform satisfactory to the Trustee. The holder named in any suchvoting certificate shall be entitled to be present and vote at suchmeeting or any adjournment thereof without production of theBonds specified therein, or may by instrument in writing in the formprinted on the reverse of the form of voting certificate attachedhereto, or other form to the like effect, appoint a proxy to vote andact for him at such meeting and at any adjournment thereof inrespect of the Bonds specified in such voting certificate. Bondsshall only be so deposited on condition that they will be held on

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deposit until after the meeting and any adjournment thereof andthat they will only thereafter be returned by the depositary.

4. A proxy need not be a bondholder, but no proxy shall be givenin favour of the Trustee or any of its officers.

5. A holder of unregistered Bonds (i. e. bearer Bonds) desiringto obtain a voting certificate must fill in particulars of his Bondson Form "A" overleaf, sign the same and deliver his Bonds with thisentire form to a recognized bank or trust company or other com-pany or person satisfactory to the Trustee, from whom he mustobtain forms "B" and "C" completed and signed. Form "B" ifpresented at the meeting will entitle the holder named therein toattend personally and vote. If the holder named in Form "B"desires to be represented by proxy at the meeting, he must sign theinstrument of proxy endorsed thereon. Form "C" must be retainedby the holder until after the meeting or any adjournments thereofin order to enable him to withdraw his Bonds from deposit.

6. Voting certificates and proxies may be presented at the meetingor any adjournment thereof, or, for the convenience of bondholders,they may be lodged, prior to the meeting or any adjournment thereof,with any of the following offices of The Royal Trust Company,namely:

105 St. James Street, West_. -------------- MONTRNAI P. Q.58 St. Paul Street----------------------- QUEBEo, P. Q.59 Yonge Street ------------------------- TooNTo, ONT.15 Duke Street - ---------- HALIFAX, N. S.128 Wellington Street 0------------------OTAWA, ONT.436 Main Street ------------------------- WINNIP, MAN.626 Pender Street, West ------------------- VANOUVER, B. 0.1 Pall Mall East, S. W. I ------------------ LoNON, ENGLAND.

or at the following Agencies of the Bank of Montreal:64 Wall Street --------- .. ------ -- ----.. NEw YoRK, N. Y.27-29 South La Salle Street .- .------------CmoAeo, IL

Voting certificates and proxies so lodged elsewhere than at Mon-treal will be forwarded to the offices of the Trustee at Montrealbefore the meeting, if time permits, otherwise the Trustee will beadvised by telegram or cable of the lodgment of such proxies, so thatpersons appointed as proxies thereunder may attend and vote at themeeting or at any adjournment thereof as though such voting certifi-cates and proxies had been produced at the meeting.

7. Forms for the deposit of Bonds for voting purposes, forms ofproxy and other information in regard to the meeting may beobtained by the bondholders upon application to any of the abovementioned offices of The Royal Trust Company or of the Bank ofMontreal.

75957'-86-----12


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FORM A -To be lodged with and retained by the bank, trust company, other company or person saifactory to the Trustee

Donnacona Paper Company, Limited(Incorporated uder the Qeboo OompanWe Aot.)

MEETING OF HOLDERS

of

Five and One-Half Per Cent. First Mortgage Twenty-Year Sinking Fund Gold

Bonds, to be held in room "A", The Royal Trust Co. Annex Building,102 Craig Street West, Montreal,

on the 15th day of April 1936.

REQUEST FOR ISSUE OF A VOTING CERTIFICATE

(Fill in name To----------------------------of bank.trust company.other company.or personsatisfactoryto the

Trustee.)

The undersigned, being the holder of $ --------------Five and One-half Per Cent. First Mortgage Twenty-Year Sinking Fund Gold Bonds of Donnacona PaperCompany, Limited, specified below, hereby deposits thesame and requests you to issue a Voting Certificate un-der the conditions specified overleaf.

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173

The Bonds are to be held on deposit until after the

Meeting of the holders of the said Bonds, summoned

for the 15th day of April, 1936, and any adjournmentsthereof have been held.

Distinctive Numbers of BondsPar Valueof Bonds

Total par value of Bonds --------------------- I--------

Dated this ------------- day of ------------ 936

SIGNArRE OF DEPOSITOR

NAME OF DEPosrroR ............

ADDRESS OF D Posrron ...................

Please PrintName andAddress

--------------------------

--------------------------

--------------------------

--------------------------

--------------------------

--------------------------

--------------------------

--------------------------

--------------------------

--------------------------

------------

------------

------------

------------

------------

------------

------------

------------

------------

------------

---------------------------

---------------------------

---------------------------

---------------------------

---------------------------

---------------------------

---------------------------

---------------------------

---------------------------

---------------------------


(4)

1)-Te be signed by the hank, trust company, other company a person satisfactory to the Trustee and delivered to theFORM J" Bondholder.

Donnacona Paper Company, Limited(Incorporated under the Quebec Companies Act.)

Meeting of Holders of Five and One-Half Per Cent. First Mortgage Twenty.Year Sinking Fund Gold Bonds to be held in room "A" The Royal Trust

Co. Annex Building, 102 Craig Street West, Montreal, on the 15thday of April, 1936

VOTING CERTIFICATEFill In tntalamount ofBondsdeposited.- THis is TO CERTF THAT

of ---------------------------- has deposited with theundersigned the Five and One-half Per Cent. FirstMortgage Twenty-Year Sinking Fund Gold Bonds ofDonnacona Paper Company, Limited, as specified below,amounting to an aggregate par value of $-for the purposes of the Meeting of the holders of thesaid Bonds to be held in the City of Montreal on the15th day of April, 1936, at the hour of 11 o'clock a. m.The Bonds will be held on deposit by the undersigneduntil after the said Meeting and any adjournmentsthereof have been held.

Distinctive Numbers of Bonds Par valueof Bonds

---------------------------..-------------------------..-----------

Total par value of Bonds ----------------------.............

Dated this -------------- day of -------------- 1936Signature of DepositaryDepositary's Address

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175

NOTE: The person named in this certificate, if attending the meetingpersonally must bring the certificate with him to the meeting, but ifhe is unable to attend personally, he may lodge it with the form ofproxy on the reverse hereof duly signed, with any of the followingoffices of The Royal Trust Company:-105 St. James Street, West_. MONTREAL, P. Q. 128 Wellington Street-_ OTTAWA, ONT.58 St. Paul Street --------- QUEBEC, P. Q. 436 MaIn Street -------- WINNIPEG, MAN.59 Yonge Street ----------- TORONTO, ONT. 626 Pender Street, West VANCOUVER, B. C.15 Duke Street ------------ HALrAx, N. S. 1 Pall Mall East S. W. 1. LONDON, ENGLAND.

or at the following Agencies of the Bank of Montreal:64 Wall Street-----'--'- NEW YORK, N. Y. 27-29 South La Salle Street.... CHICAGO, ILL.

(Proxy endorsed overleaf)

C -To be sieed by the bank, trust company, olher company or person satisfactory to the Trustee and delivered to theFORM Bondholder.

RECEIPT FOR DEPOSIT OF BONDS

RECEIVED on deposit from ................of$ ------------ par value of Five and One-half Per Cent. FirstMortgage Twenty-Year Sinking Fund Gold Bonds of DonnaconaPaper Corpany, Limited, for which a Voting Certificate has beenissued for the purposes of a Meeting of the Bondholders to be heldon the 15th day of April, 1936.

The Bonds deposited will be returned to the above named depositoragainst surrender hereof after the said Meeting and any adjourn-ments thereof have been held, but not before.

Dated this ------------ day of ------------- 1936.Signature of D epositary ----------------------------------------D epositary's A ddress --------------------------------------------


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Donnacona Paper Company, Limited(1norporatd under the Quebec Compantie Act.)

MEETING OF HOLDERS

of

Five and One-Half Per Cent. First Mortgage Twenty-Year Sinking Fund GoldBonds, to be held in room "A", The Royal Trust Co. Annex Building,

102 Craig Street West, Montreal,on the 15th day of April, 1936.

PROXY IN RESPECT OF UNREGISTERED BONDS(THAT IS, BEARER BONDS)

The undersigned, being the holder of the Bonds specified in thewithin Voting Certificate, hereby appoints ROBERT P. KFRAN, A. S.

P. GLAssco or Hon. GEoR.GE PARENT, K. C., or any of them, or ------...............................................................

the proxies or proxy of the undersigned to attend a meeting of theholders of the said Bonds to be held on the 15th day of April 1936,at the hour of 11 o'clock a. m. and at any adjournment or adjourn-ments thereof, and to vote and act thereat for and on behalf and.in the name of the undersigned in respect of all matters that maycome before he meeting, in the same manner as the undersignedcould do if personally present thereat, with power of substitution,the undersigned hereby ratifying and agreeing to ratify all that thesaid proxies or proxy may lawfully do by virtue hereof.

As WIT=Ess the hand of the undersigned this ------- day of-. 1936

Signature of Bondholder.

IN THE PRESE1NCE OF:Address In full.

Witness.

NoTs: Voting certificates and proxies may be presented at themeeting or any adjournment thereof, or, for the convenience of

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bondholders, they may be lodged prior to the meeting or any adjourn-ment thereof with any of the following offices of The Royal TrustCompany, namely --

105 St. James Street, West --....----.-------. MONThRAL, P. Q.58 St. Paul Street ...........................- QUEBEC, P. Q.59 Yonge Street .-- ............----------. TORONTO, ONT.15 Duke Street ------------------------------- HALIFAX, N. S.128 Wellington Street --------------------- OTTAWA, ONT.

436 Main Street ------------------------- WINNIPEG, MAN.

626 Pender Street, West __VANCOUVER, B. C.1 Pall Mall East, S. W. 1 ------------------ LONDON, ENGLAND.

or at the following Agencies of the Bank of Montreal:64 Wall Street --------------------- NEW YORK, N. Y.27-29 South La Salle Street ---------------- O-- QCIOAGO, ILL.

The persons above mentioned are suggested as proxies, but bond-holders may appoint other persons to act as proxies. A proxy neednot be a bondholder. No proxy should be given in favour of TheRoyal Trust Company, the Trustee, or any of its officers.

To be Signed by the Holder on withdrawing his Bonds from deposit after theMeeting or any adjournments thereof.

The within mentioned Bonds have been re-delivered to me this-------- day of ----------- , 1936

- ------------------------------------Signature.


APPENDIX D

ACTIVE PARTICIPATION OF INDENTURE TRUSTEE INREORGANIZATION

In the foregoing report we concluded that the interests of bond-holders following default require that the trustee assume the obliga-tions of an active trusteeship. We have also pointed out that it maybe essential for the trustee to be the focal point for the organizationof bondholders in, times of trouble and for the formation of a pro-tective committee.

We shall relate herein two illustrations of the trustee assumingactive duties following default; the first involves the external bondsof the City of Barranquilla; the second involves the trustee system

developed in New York for the readjustment of guaranteed mortgagecertificates.

A. EXTERNAL BoNwS-CiTY OF BARRANQUILLA .

The temporary readjustment of the External Sinking Fund, 8percent Gold Bonds of the City of Barranquilla, Colombia, serves asan example of the indenture trustee assuming the initiative upondefault, negotiating a plan of readjustment with the issuer, andthereafter, through a protective committee which it organized, mar-shalling the requisite assents of bondholders to the plan. The domi-

nating figure throughout was the trustee, not the protectivecommittee.

Bonds of the City of Barranquilla were issued in five series (A-E)

during the period June 1, 1925 to December 1, 1929 and sold toAmerican investors in the aggregate amount of $2,500,000.2 Throughthe operation of the sinking fund this amount had been reduced to

$1,780,400 outstanding at time of default.8 The house of issue forthe first four series was Central Trust Company of Illinois; the fifth

1 This Commission, in September of 1935, made a study of the work of the trustee for

the bond issue of the municipality of Barranquilla (in the Republic of Colombia). Ex-

cept as otherwise indicated in the text or footnotes, the information herein contained Is

based on documents furnished this Commission by the trustee and its attorney.2Reply to this Commission's questionnaire by the Protective Committee for the holders

of City of Barranquilla (Republic of Colombia) External Twenty Year Secured 8 percent

Sinking Pund Gold Bonds, Exhibit D (circular letter to bondholders from Central Republic

Company dated August 10, 1932), at 1.'ibid.

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series was sold by its security affiliate, Central-Illinois Company.'

The proceeds of the loan were utilized in the extension and improve-

ment of the municipally owned water works system and for the

development of a sewerage and paving program. In the offering

prospectus, the security for the bonds was described as follows:

"The bonds, which are authorized by the National Government and approved

by the Department of Atlantico and the Municipal Council, are a directobligation of the City, for which its full faith, credit and resources arepledged, and are specifically secured by first mortgage upon the municipallyowned public market, waterworks system and abattoir, and by first lien and

encumbrance upon the gross revenues of such utilities, the proceeds of the realestate tax, the vehicle tax, and the tax upon outside markets."'

Further to protect the loan, an administrative board was created

charged with the duty of collecting the pledged revenues and oper-ating the various municipal enterprises securing the loan.6 Of the

board's three members, one (the chairman with title of Director-General) was nominated by the house of issue; the second and thirdmembers were nominated by Barranquilla's Municipal Council andChamber of Commerce, respectively.7 Central Trust Company ofIllinois was the trustee for all series of this bond issue. It wassucceeded by Central Republic Bank and Trust Co., which in turn,in 1935, was succeeded by the City National Bank and Trust Co., thepresent trustee.

The trust indenture provided that all pledged revenues should bedeposited in a local bank in Barranquilla; therefrom there shouldbe set aside, first, a sufficient amount to service the loan, next, theexpenses of the operation of the properties under the managementof the administrative board and any remaining balance, after set-ting up a reasonable reserve for depreciation of the mortgagedproperties, would be returned to the City. The moneys allocated forbond service were required to be transmitted monthly from thedepositary bank in Barranquilla to the trustee in Chicago.s

All these monthly remittances were duly made to and includingOctober 1, 1931. In October of 1931, the National Government ofColombia issued a decree imposing restrictions on foreign exchangewhich had the effect of preventing departments and municipalitiesfrom sending funds abroad for service on their foreign loans.s

Thereafter the City of Barranquilla was unable to make its monthlyremittances to the trustee. The trustee, out of moneys remitted

'Loan prospectuses, City of Barranquilla External Twenty Year Secured 8 percentSinking Fund GdId Bonds, Series A, B, C, D and E.

5 Loan prospectus, Series E.0 Supra note 4.T

lbid.I Supra note 2, Exhibit G, at 1, 2.OId., at 2.


before the embargo and out of a special reserve fund created againstthe contingency of the failure to transmit funds to the trustee intime to make a given interest payment, was able to continue interestpayments to December 1, 1932 on Series A. B, C, and E, and toJanuary 1, 1933 on series D.10 On and subsequent to these datesno interest has been paid. The default in the remittance of bondservice specified in the trust indenture was not due to any apparentunwillingness or inability on the part of the City of Barranquillato pay, as evidenced by its continuing to make the required depositsin Colombian pesos in the local depositary for the account of thetrustee.11 In fact it was one of the few Colombian municipalitieswhich after the embargos continued to make such deposits.

Under the circumstances described above, the conventional pro-cedure would call for the organization of a protective committee,usually by the house of issue, which would receive deposits of bondsand make an effort to negotiate a settlement with the debtor. Inthe Barranquilla situation, however, Central Republic Bank andTrust Co., the indenture trustee, took the initiative.2 The first prob-lem which it faced concerned the moneys being periodically depositedby the debtor in the local depositary; these were mounting intoa sizeable sum. Upon investigation it felt that such deposits weresubject to the danger of the depositary bank's failure, with conse-quent loss of the funds, and to the likelihood of depreciation of the-fund in terms of dollars because of the downward trend of Colom-bian exchange."3 The money on deposit was subject to furtherhazard. It was feared that the national government might requirethe investment of these funds in its internal bonds; in fact the ad-ministrative board had invested a small portion of its receipts frompledge revenues in such bonds.

The trustee took steps to minimize the loss from possible bankfailure by causing the funds to be deposited in more than one bank.But the other hazards could not be overcome so readily. To con-sider the problems involved, the City of Baranquilla, at the sugges-tion of the trustee, sent the President of its municipal council andthe Director-General of the administrative board to Chicago inApril, 1932. In the negotiations that followed, the trustee was repre-sented by two of its officers. In addition the trustee retained as itsspecial adviser Louis A. Schroeder, then chairman of the board ofthe Central-Illinois Company, an investment affiliate of the trustee. 4

Mr. Schroeder had been vice-president of the Central Trust Com-

10Foreign Bondholders Protective Council, Inc., Annual Report (1935), at 200.

"1Supra note 2, Exhibit G, at 3, 4.1Id., at 2.

/bid./I&


pany of Illinois at the time it had underwritten the first four series(A-D) of the Barranquilla issue, and he then became an officer ofthe security affiliate which underwrote the series (E). It was statedthat he had conducted the negotiations with Barranquilla for theissuance of the loan and had kept in close touch with its statusthereafter. The trustee retained the services of the Chicago law firmof Pam & Hurd and the New York firm of Curtis, Mallet-PrevostColt & Mosle.1s

Representatives of the City requested the trustee to permit theCity to utilize the pledged revenues deposited for municipal pur-poses rather than to permit the moneys to remain idle in the deposi-tary banks, and that payment of maturing interest and principalpayments be extended. The trustee, in view of the hazards sur-rounding the continued accumulation of funds in local pesos, and theimpossibility of converting them into dollars during the durationof the governmental embargo on foreign exchange, was sympatheticto the suggestion. It desired, however, to maintain intact the ad-ministrative board, which had proven of great benefit to the bond-holders, as it feared that if the board were suspended or abolishedit might be impossible, upon the lifting of the embargo, to reestab-lish it as the operator of the mortgaged properties and as collectorof the revenues pledged for the benefit of the bondholders. Thetrustee also desired that the moneys to be withdrawn should be ex-pended in the construction of public works rather than paid over tothe City's general funds and that such improvements as were incomeproducing would become subject to the lien of the trust indenture.

With these objectives in view, representatives of the trustee andthe City agreed to a plan for the use of the moneys that the Citybad deposited and would deposit until October 1, 1933 as bondservice in the depositary banks in Barranquilla. s Such fundsas were withdrawn were to be invested in public works, part of whichwere to be income producing properties."' The plan provided thatthe administrative board would continue to exercise all its powersunder the trust indenture.' s In addition it was charged with theduty of approving the withdrawal from deposit and expenditureof funds pursuant to the plan and to have complete control of allconstruction work entailed.1 s As a further check on payments for

I Ibid.18 Supra note 2, Exhibit E (summary of plan of readjustment). Under the plan, all

deposits allocated to sinking fund payments (but not moneys allocated to interest pay-ments) withdrawn from deposit were requied to be repaid to the depositary for theaccount of the trustee in monthly installments over a period of five years commencingJanuary 1, 1934. The City's obligation to maintain the trustee's special reserve fundwas waived until January 1, 1988.17

1d., Exhibit I."Ibid.26 Ibid.


182

public work, the plan provided that all withdrawals and expendi-tures should be approved by the "Bankers", i. e., Central RepublicCompany.2o All income producing properties constructed with themoneys so withdrawn, together with the revenues from such proper-ties, would become subject to the lien of the indenture as additionalsecurity for the loan.2'1 The trustee waived the requirements of thetrust indenture concerning sinking fund payments and the pay-ments into the trustee's special reserve fund during the period ofthe plan." The bondholders consenting to the plan waived the pay-ment of interest coupons maturing during the period of the plan,but such coupons were to be repaid the bondholders after the termi-nation of the plan.23

After an agreement on the plan was reached with the City ofBarranquilla, the trustee took steps to procure the consents of bond-holders necessary for the consummation of the plan. Under the in-denture 75 percent of the bondholders in amount could amend thetrust indenture in all respects save as to the provisions governing

the payment of principal and interest. For the amendment of suchprovision 100 percent consent of bondholders was required. Inthe light of these provisions the plan had been drafted to providethat the withdrawal and expenditure of sinking fund moneys wouldbe effective to bind all bondholders upon 75 percent consent,2 4 butthat the analogous provisions concerning interest moneys would beeffective only as to those bondholders who had consented to theplan. 5 Hence, the obtaining of 75 percent consent of bondholderswas the goal, although, of course, the procuring of as nearly unani-mous consent as possible was desired.

At this point the trustee gave consideration to the question ofwhether it should itself solicit assents to the plan or whether in

accordance with the conventional practice a protective committeeshould be formed to marshal the assents. The trustee adopted the

latter alternative and proceeded to organize a protective committeeto act in effect as its agency in obtaining assents to the plan.

The committee so organized was composed of Louis H. Schroeder,J. Sanford Otis, and Edward W. Jaeger," all officers or employees of

201 Ibid.A Ibid.22Ibid.

2 Ibid. This involved the suspension of payment on the interest coupons payable

December 1, 1932, June 1, 1932 and December 1, 1933, on the A, B, C and E series and

those payable January 1, 1933, July 1, 1933 and January 1, 1934, on the D series. The

interest payments so suspended were to be repaid to the bondholders in semi-annual in-

stailments over a period of 5 years commencing December 1, 1932, in the case of Series A,

B, C and E, and January .1, 1933, in the case of series D.24Id., Exhibit B.2 Id., Exhibit E, at 4.

Id., Exhibit F-1.


Central Republic Company, the investment affiliate of the trustee.At the time this affiliate was not directly connected with the CentralTrust Company of Illinois, the original underwriter of the bonds,although there had been a substantial continuity of interests and ofpersonnel through various consolidations. In fact, Mr. Schroeder,the chairman, as previously related, had, as an officer of the under-writer, negotiated the loan with the issuer. These facts have abearing on the reasons advanced by the trustee for adopting thecommittee device for solicitation of assents to the plan. It believedthat a committee headed by Mr. Schroeder would inspire the confi-dence of the many bondholders who would depend upon the adviceof recognized investment houses, and thus facilitate the obtainingof assents. Furthermore, the trustee felt that the formation of acommittee by it, with Mr. Schroeder as chairman, might forestall theorganization of an outside committee whose members might notpossess a sufficient understanding of the situation. Further reasonsadvanced by the trustee for the organization of a committee werethat it did not have any facilities for presenting the plan to thebondholders, and that a bondholders' committee was at that timethe orthodox medium for handling the situation.

This committee was constituted under the conventional form ofdeposit agreement and proceeded to solicit the deposit of the threeinterest coupons affected by the plan.2 7 The bondholders were per-mitted to retain their bonds. Deposits of coupons came in ratherslowly; in fact it was not until the summer of 1933 that 75 percent inamount of deposits had been obtained to make the plan fully effec-tive.2 18 In the solicitation of deposits the committee was aided bythe various employees of Central Republic Company, who hadformerly been employed as bond salesmen by the underwriter ofthe issue.

In the meantime, however, the City had formulated the projectsto be constructed with the moneys to be released under the plan.29To supervise the arrangements for the construction program andthe release of funds, Mr. Schroeder and A. J. Dallstream of Pam &Hurd, counsel to the trustee and also to the committee, went toColombia as the trustee's representatives." In the fall of 1933, pesoswere released pursuant to the plan equivalent to $427,000 computedat the rate of exchange at which pesos had been deposited."' These

Id., Exhibit D.Id., Exhibit G, at 2.lI., at 8.Id.. at 4.Id., at S.


184

moneys were utilized in the construction of the following municipalprojects:

Allocation of funde (peso8)Name of Project Releamed in term of U. S. dollars

Paving -------------------------------------------- $50,0 (.0*Stadium ---------------------------------- 90, 000.O0

Public School Buildings ----------------------- 69,848.13Paving and Sewers -------------------------- 70,201.15

*Natatorium .....---------------- 23,809.52

*Water Storage Reservoir --------------------------- 69, 727.92

Sanitation Equipment, etc --------------------- 41,087. 14*Municipal Haymarket ------------------------ 12,326. 14

Total ------------------------------ $427, 000. 00

An (*) marks the income producing properties which togetherwith their revenues became subject to the lien of the trust indenture,as provided in the plan.8 2 The plan provided that all fees andexpenses incident to the plan would be met by the City, but in thefirst instance would be paid out of the balance of the trustee's specialreserve fund.8 The actual expenditures from this fund amountedto $16,324.72." The largest items consisted in attorneys' fees of$9,500."5 The members of the bondholders' committee as such andother employees of the Central Republic Company, except Mr.Schroeder, have received no compensation. Mr. Schroeder's onlycompensation was in the amount of $833.33, covering his trip toBarranquilla in the fall of 1933 as the representative of the trustee.87

The plan had been drafted as a temporary expedient to cover acomparatively short period, as it had been expected that the nationalembargo on foreign exchange would not be of long duration." Theembargo, however, outlived the plan; in fact is still in effect. Afterthe expiration of the plan, the City continued to make deposits inColombian pesos with the result that a large sum again accumu-latedY' The situation which led up to the 1932 plan was repeatedand aggravated by the further depreciation of Colombian pesos interms of U. S. dollars. 1o At the time of the'conclusion of this Com-mission's study of the Barranquilla situation in the fall of 1935, thetrustee had under consideration the taking of various steps for thefurther modification of the trust indenture to effect a readjustmentof the loan.41

a2 bid.s Id., Exhibit E, at 4.

Id., Exhibit C.

w Tbid.- Tbi d

- Id., Exhibit G, at 2.9Id., at 3, 5.

40 Id., at 5-7.41


185

We have described the Barranquilla situation and the steps takenby the indenture trustee not with the view of appraising the meritsof the plan or any action thereunder but as an illustration of thearea of activity of the indenture trustee upon default. It is there-fore not necessary to comment upon the connections of the trusteeand its counsel with the underwriter and the committee. In briefthe trustee in this case took the initiative in negotiating a plan withthe issuer and in the organization of a bondholders' committee asthe medium for the centralization of the interest of the bondholders.There apparently was no thought given to the necessity of receivingdemand by any specified percentage of the bondholders and of ob-taining indemnity against expense or possible liability. It is true,of course, in this case that the trustee was a successor in interest tothe original underwriter of the loan. It is not possible for us toappraise the force of this connection in stirring the trustee intoaction upon default or to determine whether without this connectionit would have moved in the same manner as related above. Never-theless the fact that it did take the action described is fully indica-tive of the feasibility of the trustee becoming on occasion the activerepresentative of the bondholders.

3. TtUSTmEmHIP or GUARANTERD MorTGAoz IssuF n Nrw Yol s

An unusually active type of trusteeship exists in New York State,in connection with the reorganization of issues of guaranteed mort-gage certificates. Under the standardized form declaration of trust,1

used with only minor modifications in dozens of these reorganiza-tions, the trustee purports to be under a higher standard of obliga-tion to the security holders than trustees under other indentures.Furthermore, he has express authorization to perform a broad rangeof acts looking toward future reorganization. This type of trustee-ship has developed out of a situation of unique complexity andpeculiar difficulty.' However, many features of the trusteeship it-

* Statements made herein, unless otherwise stated, are based upon documents fur-nished this Commission by the Title and Mortgage Rehabilitation Bureau of the NewYork State Insurance Department, by the Mortgage Commission of the State of NewYork, and by attorneys who cooperated with these two State agencies in the drafting ofthe standard form declarations of trust discussed herein.

I Quotations and citations herein are to the declaration of trust executed in series F-1of the N. Y. Title & Mortgage Co. This was the first reorganization plan approved pro.viding for the execution of the trust declaration, and all subsequent so-called "trustee"plans for issues reorganized in New York City have been patterned after that in FP-i.Modifications, to fit special circumstances, may give the trustees detailed orders for thereorganization of a particular mortgage, or vary the method of selection of the trustee,the maximum compensation permitted the trustee, etc. These do not effect any change inthe main features of the trust declaration, which remain standardized. Still other modi-fications, again primarily of administrative detail, are used in Buffalo, and in Sullivanand Westchester counties.

Generally, on the problems of guaranteed mortgages in New York State, see Note(1934) 84 Columbia L. Rev. 663; Note (1935) 85 Columbia L. Rev. 874.


186

self seem to have no inherent restriction either to the type of secur-ity or the type of procedure wherein it originated, and it is thereforea suggestive analogy for other trusteeships, particularly in the fieldof real estate securities.

Its background is that of the guaranteed mortgage business inNew York State. The issues involved had been in all cases floatedto the public and guaranteed as to principal and interest by com-panies operating under the New York State banking or insurancelaws.s The Superintendent of Banks or of Insurance, as the casemight be, became statutory receiver of these companies' when theirguaranty funds proved inadequate to meet the collapse of real estateincome early in 1933.5 The companies, under the terms of thecertificates of participation which they had issued to the public,ordinarily combined in themselves the functions of house of issue,trustee, fiscal agent, transfer agent and supervisor of the manage-ment of the mortgage property, which thus gave them a broadreorganization power. The Superintendent, as statutory receiver,8succeeded to these powers, and was aided by the emergency grant ofstatutory power to propose reorganization plans for the issues andof a new procedure whereby to effectuate them.

The trusteeship was developed specifically to handle a type ofsecurity known as "group mortgage series certificates", floated bysome of the guaranty companies. Here the certificates were issuedagainst the combined security of mortgages on more than one pieceof real estate. For example, the issue known as Series F-1 of theNew York Title and Mortgage Company involves 121 separate under-lying mortgages, each with its own problems. One property mightbe in no default whatsoever; another so hopelessly in default andwith such poor prospects that foreclosure would be necessary; an-other might require an extension of maturity and/or a reduction inthe interest rate, etc. Some properties might even require the ex-

$Generally, on the guaranteed mortgage business and its practices, see Alger (More-land Commissioner), Report to the Governor of the State of N. Y. (1934). This reportsummarizes the results of over a year's examination and investigation of the managementand affairs of the guaranty companies under the jurisdiction of the Superintendent ofInsurance. and of his supervision over them.

4L. 1933, c. 191, (Insurance Law, Sec. 400-428). Discussion herein Is restricted tothe practice in companies operating under the Insurance Law. This receivership isknown under the statute as a "rehabilitation" or "liquidation" proceeding. Most of thecompanies were first taken over for rehabilitation, later changed to liquidation when itwas found that they were hopelessly insolvent. See Van Schalck, The Administrationof the Delinquent Title and Mortgage Guaranty Companies (1935), at 19, 44.

9 Op. cit. supra note 3, at 18 et seq.6 Insurance Law, See. 402(1).IL. 1933, c. 745, known as the Schackno Act. This statute has been several times

amended. It is now implemented by L. 1935, c. 19, known as the Mortgage Commis-sion Act, which works a substantial change In the administration of the guaranty com-pantes and their certificates and adds an alternative reorganization procedure but doesnot effect any change In the declarations of trust used in this field.


penditure of substantial new money before they could be reorganizedexcept on a forced sale basis.' Thus they might have to be reorgan-ized at different times and under different procedures. To avoid thecumbersome process of obtaining consents from the security holderseach time a reorganization of one of the underlying mortgages wasnegotiated, it was necessary to handle the reorganization of groupseries in two stages. In the first stage, a centralized authority hadto be set up, with power to undertake on behalf of the securityholders the detailed separate reorganizations which would consti-tute the second stage. The device of a certificate holders' corpora-tion, the first type of centralized authority used, was abandoned infavor of that of a trustee for the holders.'

The essentials of this trusteeship seem to have originated with thejudge in charge of the statutory receivership proceedings for severalof the larger companies, who was of the opinion that the emergencystatute granting reorganization powers to the Superintendent incharge of these companies was unconstitutional,l ° and was desirousof evolving a substitute reorganization procedure. On the theorythat the guaranty companies were the holders of powers in trustwho had been found delinquent in their trust, and for whom substi-tutes could therefore be appointed by an equity court, he proposedto appoint trustees for each issue, in whom the guaranty company'sbroad reorganization powers could be vested, subject to court con-trol over management, reorganization of the underlying mortgages,and fees.1 The appellate courts did not discourage this type oftrusteeship but held that it was improper to found it upon equityjurisdiction to substitute trustees.12 At about the same time theysustained the constitutionality of the emergency reorganizationstatute in a case involving a certificate holders' corporation. 8 Ac-cordingly, the trusteeship was engrafted upon the statutory pro-

'The outstanding example of this occurs in Series C-z, also of the New York Title andMortgage Co., which includes mortgages on an abandoned brewery and a half-completedhotel. No income is available from the properties themselves. The guaranty companyand the Superintendent both lacked the power to place a lien on them for new money.7. Schackno Act. Seec., 4(b, c). The Mortgage Commission now has the power to raise

money in this manner. Mortgage Commission Act, Sec. 5(3) (b, d). Wolff v. MortgageCommission, Moore v. Barker, both in the N. Y. Court of Appeals, April 15, 1936.

9Rodwin and Jurow, Rehabilitation and the Reorganization of Guaranteed Mortgages(1936), at 16.

10 People v. N. Y. Title d Mortgage Co., 150 Misc. 467, 270 N. Y. Supp. 450 (Sup. Ct.1934).

" People v. N. Y. Title d Mortgage Co. (Heilbronner) 150 Misc. 89, 269 N. Y. Supp. 83(Sup. Ct. 1934). People v. N. Y. Title d Mortgage Co. 150 Misc. 488, 270 N. Y. Supp.473 (Sup. Ct. 1934).

12 On the ground that the Schackno Act procedure was exclusive and that the certifi-cates did not create powers In trust, the Heilbronner case, supra note 11, appointing sub-stituting trustees, was reversed In 241 App. Div. 351, 272 N. Y. Supp. 553 (1st Dept. 1984).

1SMatter of People (Title d Mortgoge Guaranty Co. of Buffalo), 264 N. Y. 69, 190 N. E.153 (1934). See also Abrams v. Van Schatck. 298 U. S. 18a. W., 522 (1934).

75957*-36-----1s


cedure in place of a corporation, thus evolving the present form of"trustee" plan. All group series issues reorganized to date in NewYork City have used this plan, and it has been applied in a con-siderable number of issues where only one mortgage constitutes theunderlying security.

The original statutory procedure is somewhat similar to that underSection 77B of the Bankruptcy Act. Reorganization of an issue iseffectuated by court approval of a plan of reorganization, plus con-sent by holders of two-thirds of the issue, which binds all holders.1

4

The trust indenture is made part of the plan of reorganization. Aunique feature of the standard plan is that it provides for the selec-tion of the trustee in accordance with the wishes of the holders asascertained by ballot, either by court appointment or by nominationand election by the holders. The plan provides for transferring fromthe State officials who have been administering them to the trustee,all properties and rights which are security for the issue. This mayinclude title to properties on which foreclosure has already beentaken, or possession of mortgage deeds, rights of action againstvarious persons, and always the right of action against the guarantycompany on the guaranty. Depending on the status of the property,the trustee's function with respect to it at the time he enters uponthe trust may vary all the way from collection and distribution ofinterest on an undefaulted underlying mortgage to active manage-ment of a property on which foreclosure has taken place. Subsequentchanges in the status of the property may make necessary the as-sumption of a changed relation to it. The trust declaration andthe reorganization plan accordingly give the trustee powers notpossessed by the guaranty company, in order to facilitate his taskshould he be called on either at once or later to manage the prop-erty.15 The security holders retain their old certificates, generallystamped with a notation that they are subject to the reorganizationplan. The creation of the trusteeship is thus the first stage of re-organization of the issue, the reorganization of the underlying prop-erty or properties being the second stage. The court retains a residualjurisdiction over the trustee, and the declaration of trust permits thetrustee to perform practically all types of second-stage reorganiza-tions merely upon court approval, normally ex parte unless the courtshall require notice to holders, and without further consents fromthe holders.

1 Schackno Act, Sees. 6, 8. There are alternative procedures under the Mortgage Com-mission Act, but since Schackno Act procedure is more usual, these need not be considered.The reorganization plans offered under Mortgage Commission Act, Sec. 7, do not differfrom those under the Schackno Act, and we are informed that no reorganization planshave been offered under Mortgage Commission Act, See. 10.

4 Cf. supra note 8.


These broad powers of the trustee are in the first place subjected

to what appears to be an unusually high standard of general duty

to the trust. A striking feature of this standard form declaration

of trust is the form of the exculpatory clause, which, unlike the

ordinary form under which the trustee is liable only for gross

negligence or willful misconduct, provides that the trustee is liable

for mere negligence.'8 Whether this rise in the level of the trustee's

obligation is real or illusory will, however, depend in practice on

whether the clauses making the trustee liable for negligence are

nullified by other clauses exempting him from liability for action

taken upon professional advice.1"He is specifically granted a considerable number of powers looking

toward reorganization. He is permitted to undertake on his own

motion all normal managerial and ministerial acts required in the

ordinary course of administration of real estate property, 8 and inaddition he has the power to extend an underlying mortgage ormortgages for a limited period, 9 and the power to foreclose andbuy in on behalf of all certificateholders at foreclosure sale. 20 Cer-tain more drastic powers both in the operation of the properties andin their reorganization are exercised only upon court approval,secured ex parte unless the court in its discretion directs that noticebe given the certificateholders. These powers include the extensionof an underlying mortgage or mortgages for more than the limitedperiod specified, reducing or deferring interest on a mortgage, bor-rowing money, selling trust assets, appointing agents, payingreorganization fees and expenses. 21

The trustee is under no specific duty to undertake any of theseacts. He is merely empowered to perform them. But the wholeintention of the declaration of trust is toward activity rather thanpassivity on his part. The declaration of trust significantly omitsthe common clause permitting the trustee to refuse to act unlessrequested by a specified percentage of the security holders and un-

15F-1 Trust Declaration, XIII-a: "* * * provided however, that nothing in this

declaration of trust contained shall exempt any trustee from liability arising out of hisown willful misconduct, bad faith or negligence." Id., XIII-d: "The trustee[s] shall notbe liable for any error of judgment or for any loss arising out of any act or omission inthe execution of this trust so long as they act [he acts] in good faith and without neg-ligence."1 F-i Trust Declaration, XIII-e: "The trusteefs] may consult with legal counsel,

engineers, accountants, appraisers and surveyors, and any act or omission to act underthis declaration of trust or in connection with the execution of this trust, taken, suf-fered, or omitted in good faith by the trustee[s] in accordance with the opinion of anysuch counsel, engineers, accountants, appraisers or surveyors, shall be conclusive on thecertificate holders and the trustee shall be fully protected in respect thereof.

iF-1 Trust Indenture, VIII-a-n.19 F-1 Trust Declaration, XIII-h. The period is three years in F-i, in some issues

five years.1OF-i Trust Declaration, VIII-m.F-1 Trust Declaration, VIII-o-x.


less the request is accompanied by an offer of indemnity. Instead,the trustee is given an inducement to act, by virtue of the fact thathe is granted no fixed compensation. The declaration provides onlyan upper limit for his compensation, normally one-half of one per-cent of the face amount of the outstanding certificates, chargedagainst the trust estate. In the larger issues, this upper limit iscut to as low as one-quarter of one percent. This nevertheless per-mits of a substantial maximum compensation: thus, on the $27,-000,000 plus outstanding in F-i, the trustee, at one-fourth of onepercent, might get a fee of almost $70,000 a year. This is an upperlimit only. The court fixes the fee, and to obtain any fee at all thetrustee must demonstrate to the court, at a hearing held on noticeto all- certificate holders, that "upon the basis of time, effort andaccomplishment" he deserves compensation.2 The net effect of theseprovisions is to give the trustee a scope for the exercise of initiativeand a reward for exercising it. Certain features of this trusteeshipare obviously capable of transplantation into other types of trustindentures.

Both individuals and banks have accepted appointment or electionas trustees. Among the banks in New York City which have exe-cuted such trust declarations are: Brooklyn Trust Co., ContinentalBank & Trust Co., City Bank Farmers Trust Co. and CommercialNational Bank & Trust Co.

2 F-1 Trust Declaration, II.


C. STANDARDS FOR INDENTURES AND INDENTURE TRUSTEES ENAOTED IN 193M BY

THE NEw Yoi K STATE LEGISTATU 1

State of New York

Nos. 2197, 2779, 2934, 3023 *Int. 1880

IN ASSEMBLYMarch 11, 1936

Introduced by Mr. STREIT-read once and referred to the Com-mittee on Judiciary-committee discharged, bill amended, orderedreprinted as amended and recommitted to said committee-com-mittee discharged, bill amended, ordered reprinted as amendedand recommitted to said committee - reported by the Com-mittee on Rules with amendments, ordered reprinted and placedon special order of second and third reading

AN ACTTo amend the real property law, in relation to certain trust

mortgages and interests therein and the appointment,agreements, acts and proceedings of persons adminis-tering. or holding the same for the protection of theowners and holders thereof

The People of the State of New York, represented in Senate andAssembly, do enact as follows:1 Section 1. Chapter fifty-two of the laws of nineteen hundred2 nine, entitled "An act relating to real property, constituting3 chapter fifty of the consolidated laws," is hereby amended by4 inserting therein a new article, to be article four-a, to read as5 follows:

ExprzANATioN.-Matter in 4talica Is new; matter in brackets [ ] is old law to beomitted.

I L. 1936, c. 900, amending L. 1909, c. 52; Real Property Law, Art. 4-A.

(191)


192

1 ARTICLE 4-A

2 TRUST INDENTURES AND INTERESTS THEREIN

3 Section 124. Purpose and application of article.

4 125. Definitions.

5 126. Trust indentures.

6 127. Limitation of liability of trustees prohibited.

7 128. Restrictions on trustees.

8 129. Minimum bid of trustee at sale on foreclosure to be

9 fixed by court.

10 130. Deposit agreements.

11 130-a. Restrictions on committees.

12 130-b. Managing agents and management companies.

13 130-c. Voting trustees and voting trust agreements.

14 130-d. Fees and allowances.

15 130-e. Removal of trustees, committees or depositaries.

16 130-f. Actions for accounting by minority groups; expenses

17 thereof.

18 130-g. Violations and penalties.

19 130-h. Construction of article.

20 130-i. Duty of county clerks.

21 130-j. Separability.

22 130-k. Right to appeal.

23 § 124. Purpose and application of article. It is the purpose

24 of the legislature, in enacting this article, to provide for the regu-

25 lation and supervision of the appointment, creation, agreements,

26 acts, conduct, practices and proceedings of trustees, bondholders'


193

1 protective committees, depositaries, management companies, voting

2 trustees and other persons administering, holding in custody or

3 otherwise concerned with -real estate and interests therein to

4 the end that such interests will be properly conserved, administered

5 and ultimately liquidated in the public interest. This article,

6 except as otherwise expressly provided, shall apply, to the extent

7 that the state has power to provide therefor, to all mortgage

8 investments, as hereinafter defined, where the property constituting

9 the underlying security therefor, or any part thereof, is located

10 within the state or where the trustee, committee, depositary, man-

11 agement company, voting trustee or other person administering,

12 holding in custody, or otherwise concerned with such investments

13 has an office for the transaction of business with respect thereto

14 within the state or has obtained authority to do business in this

15 state.

16 § 125. Definitions. As used in this article, unless the context

17 requires otherwise:

18 1. "Mortgage investments" shall mean and include any and all

19 shares and interests, heretofore or hereafter acquired, in an issuo

20 of bonds, notes or other evidence of indebtedness of individuals,

21 partnerships, associations or corporations, held by more than one

22 person and secured by a mortgage or mortgages upon real property,

23 or by a deed or deeds of trust, trust indenture or indentures or

24 other evidence of interest in real property, the payment of which

25 is not guaranteed by any title and mortgage guaranty corporation

26 or investment company and shall include certificates of deposit

27 issued by or on behalf of a bondholders' protective committee or


194

1 similar group and also any bonds, notes or other evidences of

2 indebtedness taken in lieu of such real property by foreclosure

3 or otherwise, provided, however, that it shall not include industrial

4 securities. The term "industrial securities" shall be construed to

5 mean the bonds, debentures, notes or other evidences of indebted-

6 ness of individuals, partnerships, associations or corporations not

7 engaged in the business of owning, improving or operating real

8 property but whose ownership of such real property shall be merely

9 incidental to the operation and conduct of its business and which

10 real property shall be used as incidental and additional security

11 for such bonds, notes, debentures or other evidences of indebtedness.

12 2. "Bondholder" shall mean and include any person, firm, asso-

13 ciation or corporation owning or holding a mortgage investment.

14 3. "Trustee" shall mean and include any person, firm, associa-

15 tion or corporation named, appointed or designated as such in any

16 deed of trust, trust indenture or other similar instrument or any

17 successor of such trustee.

18 4. "Committee" shall mean and include a person or group of

19 persons, however known or designated, appointed by agreement,

20 assignment, proxy, consent, authorization, power of attorney, or

21 other similar instrument to act as an agency to receive and hold

22 mortgage investments deposited by bondholders and to administer

23 or do any act in respect to the same for the bondholders.

24 5. "Deposit agreement" shall include any agreement, assign-

25 ment, proxy, consent, authorization, power of attorney or other

26 similar instrument whereby a mortgage investment is deposited

27 with or assigned to a committee.


195

1 6. "Depositary" shall mean and include any person, firm, associa-

2 tion or corporation designated in any trust indenture, deed of

3 trust, or deposit agreement as the custodian or depositary of

4 mortgage investments.

5 7. "Property" shall mean and include all of the real property

6 or any incidental personal property constituting the underlying

7 security for mortgage investments.

8 8. "Court," unless some other court has jurisdiction over the

9 property or a plan of reorganization therefor, shall mean the

10 supreme court of the state of New York in the county in which

11 the property or the major portion thereof is located, or, if the

12 property be located outside the state, in the county of the state in

13 which the committee, trustee or other person dealing with the

14 mortgage investment has or proposes to have his principal office

15 for the transaction of business with respect to such mortgage

16 investment

17 § 126. Trust indentures. No trustee shall hereafter accept a

18 trust under any trust indenture or mortgage within the contempla-

19 tion of this article or act as trustee thereunder unless the instru-

20 ment creating the trust shall contain the following provisions,

21 among others, which confer upon him the following powers and

22 impose upon him the following duties:

23 1. To receive and collect directly and without the intervention

24 or assistance of any fiscal agent or other intermediary all payments

25 of moneys required to be made and paid under such instrument

26 and to disburse the same pursuant to the terms thereof.

27 2. To act as tax withholding agent, and to receive, collect and


196

1 pay the necessary tax and hold the surplus, if any, in trust for

2 the rightful owner thereof.

3 3. In the event of a default in the payment or deposit of inter-

4 est, amortization, sinking fund requirements, taxes, assessments or

5 principal, (without any request from the bondholders or any of

6 them) with due diligence, prudence and care and in his discretion:

7 (a) to take such action as may be necessary or proper to sequester

8 the rents and income of the property;

9 (b) to procure from the owner of the property an assignment

10 of rents and/or a consent to enter into possession of the property

11 and to collect the rents therefrom; or

12 (c) to apply to the court for the appointment of a receiver of

13 the rents and income of the property;

14 (d) to declare due and payable forthwith any principal amount

15 remaining due and unpaid and commence an action of foreclosure;

16 (e) to apply the moneys received as rents and income from the

17 property as well as moneys received by the trustee from any

18 receiver appointed for such property in his discretion, to the main-

19 tenance and operation of such property, the payment of taxes,

20 water rents and assessments levied thereon and any arrears thereof,

21 to the payment of underlying liens, and to the creation and main-

22 tenance of a reserve or sinking fund, and after the commencement

23 of an action to foreclose the mortgage on such property, to

24 distribute ratably among the bondholders any moneys remaining in

25 his hands;

26 (f) to render annually to bondholders, after the occurrence of a

27 default, unless such default be previously cured, a summarized


197

1 statement of income and expenditures in connection with the

2 property.

3 4. To permit the obligor or other person in possession or control

4 of the property, or his successors in interest, to be free to select

5 the insurance broker or agent through whom any insurance of

6 any kind is to be placed or written on any property affected or

7 covered by a mortgage held by such trustee.

8 § 127. Restrictions on trustees. 1. No trustee shall accept a

9 trust or act as trustee under a trust mortgage affecting any

10 property in which he or any of the officers or directors of

11 the trustee shall have, directly or indirectly, any financial interest.

12 2. No trustee nor any officer or director of a trustee, nor

13 any employee of any company which is a subsidiary of, con-

14 trolled by or affiliated with the trustee shall, either directly

15 or indirectly, act as insurance broker or agent in connection

16. with the placing or writing of any insurance of any kind on

17 any property affected or covered by a mortgage held by

18 such trustee under a trust indenture, deed of trust, or other

19 similar instrument, nor shall such trustee be an officer, director.

20 partner or employee of or otherwise connected with or have any

21 financial interest in, directly or indirectly, in any firm, agency,

22 business, association or corporation that shall act as broker or

23 agent in connection with the placing or writing of such insurance;

24 nor shall any trustee or any officer, director or employee of the

25 trustee be an officer, director, partner or an employee of or have

26 any financial interest in any firm, agency, association or corpora-


1 tion engaged by such trustee as his or its representative or agent

2 in the management or supervision of, or the collection of rents

3 and income from any property affected or covered by the mortgage

4 held by the trustee under a trust indenture, deed of trust, or other

5 similar instrument.

6 3. No trustee shall accept any trust or act as trustee under any

7 other trust indenture covering or affecting the same property.

8 4. No owner or, mortgagor of any property covered by a trust

9 indenture, deed of trust, or other similar instrument and no officer,

10 director, stockholder or employee of such owner or mortgagor shall

11 accept a trust or act as trustee with respect to such property.

12 5. The provisions of this section shall only apply to trust

13 indentures or mortgages hereafter entered into.

14 § 128. Minimum bid of trustee at sale on foreclosure to be fixed

15 by court. Notwithstanding any inconsistent provision of law, on

16 application for judgment of foreclosure and sale in an action

17 brought to foreclose a trust indenture, deed of trust or mortgage

18 upon real property, except where a plan of reorganization shall have

19 been consented to by one hundred per centum of all the bond-

20 holders or where a minimum and maximum sum at which the

21 trustee shall bid for the property has been set forth in a plan

22 of reorganization and approved by the court in a proceeding for

23 the reorganization of the property covered by trust indenture

24 under sections one hundred and twenty-one and one hundred and

25 twenty-two of this chapter the court shall determine what is a fair

26 upset price below which the property shall not be sold and the

27 judgment directing the foreclosure and sale shall fix the minimum


199

1 price which the trustee or his agent or nominee shall bid for the

2 property.

3 § 129. No deposit agreement shall be valid or binding which does

4 not set forth the following provisions for the protection of the

5 bondholders:

6 (a) That the fees of the members of the committee, the assignee

7 or the other person or persons to whom the deposit agreement was

8 given, as the case may be, shall be reasonable and subject to the

9 approval of the court.

10 (b) That the deposit agreement may not be amended without

11 the approval of the court.

12 (c) That the mortgage investments deposited thereunder may

13 not be sold, pledged or otherwise disposed of without the unanimous

14 consent of the depositing bondholders or, in lieu thereof, the

15 approval of the court.

16 (d) No deposit agreement shall be valid or binding or confer

17 any rights whatever upon any member of a committee, assignee or

18 other person to whom the agreement was given, who has any finan-

19 cial interest directly or indirectly in the depositary named or to

20 be named by such committee, assignee or other person, and no

21 person shall act for a bondholder or a deposit agreement who has

22 such an interest.

23 § 130-a. Restrictions on committees. No sale of mortgage invest-

24 ments by a committee shall be valid unless the fairness of the price

25 received at such sale shall have first been approved by the court

26 except that where an action to foreclose a mortgage on the prop-

27 erty is pending, the application to pass upon the fairness of such


200

1 price shall be determined by the court in which such action is

2 pending. The hearing upon such application shall be held at such

3 time and place and upon such notice to the depositing bondholders

4 as the court shall direct.

5 § 130-b. Managing agents and management companies. 1. A per-

6 son, firm, association or corporation appointed, designated or

7 employed to manage, supervise, lease, collect rents or to act in

8 any other way with respect to the operation and maintenance of

9 property shall be required to give a surety bond, approved by the

10 court as to form and sufficiency, in a sum equivalent to at least

11 the gross rental or income of the property for the three months

12 immediately preceding the appointment, designation or employment,

13 running to the trustee, if employed by the trustee before or after

14 a default has occurred and before a reorganization has been effected

15 and thereafter to the person or corporation acquiring the title to

16 the property, for the benefit of the bondholders, conditioned upon

17 the faithful performance of his or its duties and the due accounting

18 for all moneys received by him or it during the course of his or

19 its employment.

20 2. No trustee or committee shall employ as a managing agent any

21 management company or corporation any of whose officers, directors

22 or stockholders are also officers, directors or employees of the trustee

23 or members or employees of the committee.

24 3. No voting trustee, officer or director of a corporation acquiring

25 the title to property in or through a reorganization of such prop-

26 erty and no corporation of which he shall be an officer, director

27 or stockholder, shall be employed as a managing agent for the


201

1 reorganized property except with the approval of the persons own-

2 ing or holding at least fifty-one per centum of the securities issued

3 by the reorganized company.

4 § 130-c. Voting trustees and voting trust agreements. 1. No trus-

5 tee or member of a committee or the attorney of such trustee or

6 committee or any employee of either shall be eligible to become a

7 voting trustee or an officer or director of a corporation to be formed

8 or used under a plan of reorganization to acquire title to prop-

9 erty previously administered by such trustee or committee unless

10 the facts with respect to their previous connection with the prop-

11 erty are disclosed to the court and the affirmative approval of the

12 holders of at least fifty-one per centum of the mortgage invest-

13 ments is obtained or unless a plan of reorganization approved

14 by the court in proceedings under section one hundred and

t5 twenty-two of this chapter shall so provide.

16 2. No agreement appointing trustees to vote the stock of any

17 corporation formed or used under a plan of reorganization of prop-

18 erty shall be valid for a longer term than five years and unless

19 it has been submitted to and approved by the court and no trustees

20 appointed by such agreement shall continue to act thereunder after

21 the expiration of its term, unless and until a new or an extension

22 agreement has been entered into and received the affirmative

23 approval of the holders of at least fifty-one per centum of the

24 stock.

25 3. No salary or other compensation shall be paid to any voting

26 trustee or any officer or director of a corporation formed or used

27 to acquire the title to property in or through reorganization unless

28 the same has been approved by the court.


202

1 § 130-d. Fees and allowances. In the event of a default in a

2 trust indenture necessitating the sequestration of the rents and

3 income of the property covered thereby and where the trustee or

4 committee or other person or persons representing the bondholders

5 is or are lawfully in possession of the property and they or their

6 attorneys, if any, shall have rendered services in connection with

7 the property at any time after default, no fees or allowances shall

8 be paid for such services unless and until affidavits showing the

9 value thereof have been presented to the court or a justice thereof

10 and such court or justice has approved the same and such fees and

11 allowances, if approved, shall be paid in such manner and at such

12 times as the court or justice shall direct.

13 § 130-e. Removal of trustees, committees or depositaries. A trus-

14 tee, committee or any member thereof and a depositary may be

15 removed by the court for cause shown upon the application of any

16 person aggrieved by the act or omission to act of such trustee,

17 committee, member or depositary after such notice and opportunity

18 to be heard in his or its defense as the court shall direct.

19 § 130-f. Actions for accounting by minority groups; expenses

20 thereof. In any special proceeding or action brought by or on

21 behalf of any minority bondholder or group of minority bond-

22 holders, or any person or group of persons not holding at least

23 fifty-one per centum of the stock or bonds of the mortgage issue,

24 but claiming an interest in the trust property, for a judicial

25 accounting, the court may take into consideration the informa-

26 tion as to income and disbursements theretofore furnished to

27 bondholders, the merits and good faith of the proceeding or


203

1 action, and whether the accounting will be of value to the bond-

2 holders, as well as the cost of such accounting, and the court may

3 require that the petitioner or plaintiff furnish a surety company

4 bond to indemnify the estate against the expenses of the accounting,

5 including fees of the referee to take the accounting, stenographic

6 fees, and the expenses of the trustee, and may direct that, if it

7 should appear that the accounting result in any practical benefit

8 to all the bondholders, the court should then in its discretion,

9 release the indemnity, and that if no such benefit accrue, the

10 petitioner or plaintiff and his attorney should receive no compensa-

11 tion, and the trust fund should be reimbursed for the expenses

12 saddled upon it by reason thereof.

13 § 130-g. Violations and penalties. The wilful violation of any

14 provision of this article, except section one hundred and twenty-six

15 unless elsewhere otherwise defined, shall constitute a misdemeanor

16 and shall be punishable, unless elsewhere otherwise prescribed, by

17 a fine of not exceeding one thousand dollars or by imprisonment

18 for not exceeding one year or by both such fine and imprisonment.

19 § 130-h. Construction of article. This article shall be construed

20 liberally to effectuate its purpose. The enumeration by this article

21 of specific powers and duties in trust indentures and other instru-

22 ments shall not preclude or prevent the use, exercise or enjoyment

23 of additional powers and duties under or pursuant to such instru-

24 ments or excuse the failure to exercise or perform such other powers

25 or duties. Nothing contained in this article shall be construed to

26 repeal any other provision of law except in so far as it is

27 irreconcilably in conflict with a provision of this article in which

28 event the latter shall control.75957--36-----14


204

1 § 130-i. Separability. If any of the provisions of this article or

2 the application thereof to any person or circumstance be held

3 invalid, such invalidity shall not affect or impair other provisions

4 or applications to other circumstances which can be given effect

5 without the invalid provision or application, and to this end the

6 provisions of this article are declared to'be separable.

7 § 130-j. Right to appeal. Any person aggrieved by any deter-

8 mination hereunder shall have such right of appeal as is granted to

9 a party to a special proceeding. All proceedings and appeals here-

10 under shall be entitled to such preference as is granted in respect

11 to plans of reorganization under the provisions of section one hun-

12 dred and twenty-two of this chapter.

13 § 2. This act shall take effect immediately.


APPENDIX E

THE INDENTURE TRUSTEE AND THE NON-DEPOSITOR

The story of the Kreuger & Toll reorganization affords another

example of counsel representing at one and the same time the com-nittee and the indenture trustee. Upon Kreuger's suicide in March1932, the houses of issue organized a protective committee for the 5percent secured debentures of the Kreuger & Toll Company, headedby Colonel Grayson M.-P. Murphy. All the remaining members butone were partners or officers of houses of issue. The law firm ofSullivan & Cromwell was counsel to this committee.1 Within abouttwo weeks after the organization of the Murphy Committee, an in-dependent committee was formed with Bainbridge Colby as chair-man and with Samuel Untermyer and Siegfried Hartman as coun-sel. The Colby Committee and its counsel, Samuel Untermyer,vigorously assailed the Kreuger & Toll bankers and the MurphyCommittee by circular letter, advertisement and press release.2 TheMurphy Committee countered these charges against the bankerswith claims of constructive work. The conflict continued until lateJune or early July, 1932. During this time the interests of thedebenture holders suffered, as neither committee was able to obtainsufficient deposits to speak authoritatively in the situation.' Finally,however, a "treaty of peace" was agreed to, the two committees andtheir counsel undertaking to work in cooperation.4 The banker mem-bers resigned from the Murphy Committee and were succeeded bymen with no previous connection with the issuance of the Kreuger& Toll debentures., Certain factors influencing the reconciliationof the opposing groups have a direct bearing on the indenturetrustee.

The existence of the strife between the two committees rendereddifficult the taking of effective steps by the corporate trustee forthe protection of debenture holders. The original trustee was theLee, Higginson Trust Co. It went into liquidation on May 24, 1932and sought to resign as trustee.6 As the rights of the debenture

'Proceedings before the Securities and Exchange Commission In the Matter of Kreuger& Toll Ce. (1935), at 167, Commission's Exhibit No. 12.

2 Id., at 286 et seq.'Id., Commission's Exhibit No. 88, at 5.Id., at 563.

OId., Commission's Exhibit No. 12.* ld., at 138, 139.

(205)


holders to the specific security obviously had to be worked outthrough the corporate trustee under the indenture,7 the early ap-pointment of a successor trustee was imperative. But legal andpractical difficulties stood in the way. Under the indenture thepower to appoint a successor trustee (which was required to be aNew York bank) was vested in a majority of the debenture holders,but pending such action the company could fill the vacancy. Amajority of the debenture holders, however, could not be mobilizedin time to act and the company was in bankruptcy in Sweden. Inlieu of acting pursuant to the trust indenture, the suggestion wasmade by counsel to the Murphy Committee of petitioning a Massa-chusetts court for the appointment of a successor trustee.' Thequestion of whether the Massachusetts court might appoint an out-of-state bank was uncertain. Vigorous opposition might weigh thescales against the granting of the petition. In fact, according to theadvice of Thomas N. Perkins, counsel to Lee, Higginson Trust Co.,it was impracticable to bring about the designation of a successortrustee without Mr. Untermyer's collaboration.

And Mr. Untermyer's cooperation was necessary for other reasons.Counsel to the Murphy Committee found each trust company whichwas sounded out unwilling to accept the appointment as successortrustee due to its reluctance to "(a) to identify itself in the publicmind with the K. & T. situation, and (b) to subject itself to attackand criticism from Mr. Untermyer, assuming he were obstructive,as he surely would be if the new appointment were sought to bebrought about otherwise than as a measure of cooperation with hiscommittee." 10

Still other factors suggested to Sullivan & Cromwell the neces-sity of cooperation with Mr. Untermyer in the appointment of a suc-cesssor trustee. These are indicated in the following cablegram totheir Paris office expressing concern that the readjustment of theKreuger & Toll secured debentures might pass to other hands:

"Ladycourt, Paris.

* * * COURT HAS FURTHER ADJOURNED BANKRUPTCY PETITION HEAR-

INGS TO SEE WHETHER SOME BASIS CAN BE FOUND FOR COOPERATIONBETWEEN UNTERMYERS AND OUR COMMITTEES STOP UNTERMYER PRESSINGPROCEEDING PRIMARILY TO SECURE SOME OFFICIAL REPRESENTATIVE OFAMERICAN CREDITORS ARGUING THAT THE CONTROVERSY BETWEEN TWOEXISTING COMMITTEES CREATES SITUATION WHERE SOME NEUTRAL ANDOFFICIAL REPRESENTATIVE NECESSARY IN ORDER EFFECTIVELY PROTECTRIGHTS SWEDEN STOP AM DISPOSED IN PRINCIPLE ENDEAVOR SEEK SOMEBASIS COOPERATION AS OTHERWISE FEAR CONSTRUCTIVE HANDLING OFTHESE MATTERS WILL PASS INTO HANDS OF COUNSEL FOR BANKRUPTCTRECEIVER OR TRUST COMPANY WHICH MAYBE NAMED AS SUCCESSOR TRUS-

7 Id., Commission's Exhibit No. 88, at 1.I Id., Commission's Exhibit No. 88, at 1, 2.0Id., Commission's Exhibit No. 88, at 2.

10 Ibid.


TEE AND BOTH OF WHOM IN PRESENCE OF OPPOSING COMMITTEES WOULDFEEL NECESSITY TO ADOPT NEUTRAL ATTITUDE AND ASSUME PRIMARY

RESPONSIBILITY.DULLES." n

Following the reconciliation between the two committees and theircounsel, Marine Midland Trust Company was selected as successortrustee, and appointed by the Supreme Judicial Court of Massachu-setts. 12 James G. Blaine, president of the trust company, testifiedthat Eustace Seligman, a partner of Sullivan & Cromwell, anda director of the trust company and a member of its executive com-mittee; suggested to him that the bank act.1 Sullivan & Crom-well were general counsel to Marine Midland. 4 Mr. Blaine testifiedthat he would not have been willing to accept unless he knew thatall parties concerned had harmonized their differences. 5

As part of the arrangement for the appointment of Marine Mid-land it was agreed that both Sullivan & Cromwell, counsel to theMurphy Committee, and Mr. Untermyer and Mr. Hartman, counselto the Colby Committee, should act as counsel to the successor trus-tee.' 6 The fees which these counsel subsequently received from thesuccessor trustee have not been unsubstantial. For a period feespaid these two sets of counsel for "general services" or for "serv-ices" were identical in amount and closely synchronized in point oftime. This appears from the following schedule prepared from theformal accountings filed by the successor trustee and approved bythe court:

To Sullivan and Cromrell- To Messrs. Untermyer and HartmanSept. 28, 1932 For general Sept. 28, 1932 For services__- $5, 000

services ----------------- $5, 000 Feb. 15, 1933 For services -- 12, 500Feb. 8, 1933 For general serv- Aug. 18, 1933 For services.-- 10, 000

ices -------------------- 12, 500 Feb. 19, 1935 For services_-- 15, 000July 24, 1933 For general serv-

ices -------------------- 10, 000 Total --------------- $42, 500Jan. 19, 1935 For general serv-

ices -------------------- 15,000

Total -------------- $42,500

On July 13, 1935, Mr. Hartman alone received $15,000; there wasno corresponding payment to Sullivan & Cromwell. In addition tothe foregoing payments for general services Sullivan & Cromwellhave received an aggregate of $83,300 fees for services to the trustee

1 Id., Commission's Exhibit No. 85.

Id., Commission's Exhibit No. 12, Ex. D 5.

Id., at 837."Id., at 843.

Ibid.'e Id., at 846-849.


208

in a number of special matters.17 Witnesses examined on this matterat the hearing before this Commission denied that the price for thewithdrawal of the opposition of the Colby Committee to the MurphyCommittee was the appointment of Mr. Untermyer and Mr. Hart-man as counsel to the successor trustee for the debenture holders.-8

The fact remains, however, that such appointment and the fees whichfollowed were a direct result of their strategic position in the ap-pointment of a successor trustee.

The successor trustee adopted the practice of submitting an ac-counting to the Supreme Court of New York showing the assets of thetrust and the trustee's receipts and disbursements during the period ofthe account, and petitioning the Court for approval of its accounts.'9

Two such accounts have been filed. These set forth payments madeto Sullivan & Cromwell and to Mr. Untermyer and Mr. Hartmanas counsel to the trustee. The Murphy and Colby Committees, inconnection with these accounting actions, apparently recognized theconflict which exists when a protective committee and the indenturetrustee are represented by the same counsel. The committees evi-dently thought their own counsel were disqualified from scrutinizingthe fees which they had received from the trustees. Accordinglyeach committee retained separate counsel for the occasion; in thecase of the first accounting action, the Murphy Committee was rep-resented by Elrich, Royall, Wheeler & Walter, and the Colby Com-mittee by Moses & Singer. Each received a fee of $2,500, whichwas paid from the trust estate.2"

An analogous situation arose early in the reorganization. Shortlyafter the formation of the Murphy Committee, the indenture trustee,at that time Lee, Higginson Trust Co., retained Sullivan & Cromwellas its counsel to represent it in America and Sweden in connectionwith various special matters. 21 This firm was representing the Mur-

17 Grayson M. P. Murphy et al., Registration Statement, Securities and Exchange Com-

mission, File 2-2083-1-3, Exhibits L, K, M, N.Is Op. cit. supra note 1, at 591, 855.1Supra note 17. As to such accounting actions, Baldwin Maull, Vice President of the

Marine Midland Trust Co., has stated:"The assumption of duties of an extraordinary character In this way may involve the

trustee in activities of such a nature as to create a very definite possibility of liabilityto bondholders. The trustee can bring an accounting action in the equity courts of theproper state In which It can account for its administration of the trust and secure aconfirmation that its acts have been proper, in order to assure itself that no such latentliabilities will later appear. Such actions can be brought from time to time as may seemnecessary. It Is believed that actions of this kind have the same protective value for thetrustee for bondholders as does the accounting action under a testamentary trust for atestamentary trustee. The same parties would be involved in an accounting action ofthis kind as in the action described above to expand the powers of the trustee, and a groupof bondholders can be joined in the same way as representative of all bondholders. Thetrustee must be equally careful that notice is giveno to all known bondholders." Maull,Elastic Powers of a Trustee for Bondholders, 61 Trust Companies 17, at 22 (1985).

2 Op. cit. supra note 1, Commission's Exhibit No. 142.Id., at 489, 490.


209

phy Committee at the same time in respect to certain of these mat-ters.12 In regard to the allocation of the expenses between the pro-tective committee and the trustee, Mr. Dulles cabled his partner inStockholm:SHARP,

GRANDHOTEL,STOCKHOLM

* * * ROPESGRAY PLAN CABLE YOU AUTHORITY RETAIN SCHOENMEYER ONBEHALF LEEHIGTRUST CO TO STUDY UNDER YOUR DIRECTION STATUS GEN-UINENESS SECURITY ITS FREEDOM FROM LIENS AND WHETHER HELD ASBONAFIDE HOLDER WITHOUT NOTICE SO AS TO BE FREE FROM DEBTORSSETOFFS COUNTERCLAIMS STOP IMPORTANT EXPENSES BE CHARGEDAGAINST TRUSTCO SO FAR AS PROPER SO THAT THEY WILL BE BORNE BYALL DEBENTUREHOLDERS STOP DOUBTFUL HOW MANY WILL BE DEPOSITEDWITH OUR COMMITTEE AS UNTERMYER AND OTHERS PLAN OPPOSITION COM-MITTEES HOSTILE TO BANKERS AND DOUBTLESS WILL RECEIVE SUBSTAN-TIAL SUPPORT STOP THEREFORE MUST MINIMIZE OUR COMMITTEESEXPENSES

DULLES"'M

The foregoing telegram is illustrative of another situation inwhich the interests of the committee and the non-depositors clash.Where legal services are rendered jointly by one counsel to the com-mittee and the indenture trustee, the committee will desire that asgreat a portion of the joint expenses as possible be allocated to thetrustee. In this way, the burden of expense on the depositors islessened. The indenture trustee who is represented by the counselto the committee can hardly pass an independent detached judg-ment on the allocation. In this case, Mr. Dulles, presumably inrecognition of the conflict, submitted his firm's bill for legal servicesto the trustee's regular counsel, Ropes, Grey, Boyden & Perkinsfor scrutiny.14 It is inevitable that where counsel to the committeeand the trustee are identical, the question of the proper allocationof expense between the committee and the trustee will frequentlyarise. A duplication of work is involved if outside counsel are calledin to pass on the fairness of the allocation. And such counsel with-out considerable investigation are not likely to be in a position togive an informed opinion.

The two committees recently promulgated a joint plan of reor-ganization which has not yet been consummated. In brief, this planprovides, inter alia, for the organization of a new corporation toacquire at foreclosure sale the collateral pledged under the trustindenture and to hold it for the benefit of the participants in theplan. All shares of the new company (except directors' qualifyingshares) will be issued to the committees. This company will haveabsolute discretion in determining the amount of its bid for the

It., at 490, 499-504.- Id., Commission's Exhibit No. 81.2Id., at 498. The bill was entered as an item in the Intermediate Accounting of the

Marine Midland Trust Company as successor trustee, 8upra note 17, Exhibit K.


pledged collateral at the foreclosure sale.25 It is not likely that thebid at the sale will be conditioned by outside competitive bidding,as the plan states:

"Many of the securities included in the bond collateral are in default and/orsubject to moratory or other laws affecting the terms of payment of principal,interest, or sinking funds on the securities. As will be appreciated, the bondcollateral does not have a readily marketable character especially underexisting conditions. There is a grave likelihood that no'outside bids will bereceived at the foreclosure sale except at sacrifice prices." "o

These provisions of the plan are of great significance to the non-depositors. For it is the bid price at the sale which will determineand control their realization upon the collateral pledged under theindenture, the most important asset of the trust estate. The planmakes clear that only depositors with the committee may receivethe benefits specified therein.27 It is not yet known what oppor-tunity will be given to non-depositors to participate in the planby deposits of their debentures after the foreclosure sale has beenheld. Some indication, however, that such opportunity will not beafforded appears from the statement in the plan that:

"June 15, 1986 has been fixed as the last day on which holders of undepositedSecured Debentures may adhere to this Plan.-Extensions of such time may,in the discretion of the respective Committees, be made by them but onlysubject to such terms and conditions, generally or in specific cases, as theymay determine. It is the present intention of the Committees not to grantan extension of time to holders of undeposited Secured Debentures exceptwhere special circumstances may be affirmatively shown to exist for failureto deposit their Secured Debentures on time and then only subject to suchterms and conditions as the respective Committees may prescribe." 2

Moreover, the plan does not with certainty advance to the non-depositors such protection as is afforded by the fixing of an upsetprice by the court, as it states that "it is not known whether or notthe court will place an upset price on the collateral." 29 This doubthas evidently been resolved; in the foreclosure action broughtby Marine Midland as successor trustee and now pending beforethe New York Supreme Court, a reference has been made toa referee to set an upset price. The interest of the majorityobviously lies in the acquisition of the collateral at foreclosure saleat the lowest price possible. The interests of the non-depositorsrequire the fixing of a fair upset price and every reasonable oppor-tunity to determine whether they will elect to participate in the plan

i Supra note 17, Plan of Readjustment and Prospectus, at 8. Bainbridge Colby et L.,Registration Statement, Securities and Exchange Commission File 2-2084-1-1, Plan ofReadjustment and Prospectus, at 8.

Id., at 6.mId., at 17.

Id., at 16, 17.Id., at 6.


211

or take their pro rata share of the bid price at the foreclosure sale.A trustee affiliated with the committees by the tie of common counselor otherwise would obviously have difficulty in performing thisfunction in protection of the minority. As previously related,Sullivan & Cromwell, counsel to the Murphy Committee, aregeneral counsel to the Marine Midland Trust Co., and a partnerof the firm is a director of the trust company and a member of itsexecutive committee. Moreover, this firm has participated in theforeclosure action. As indicated by a statement in the trustee'saccounting, Sullivan & Cromwell ot January 19, 1933, received$6,000 in full "for services re: foreclosure", so The attorney ofrecord for the trust company in the foreclosure action is SiegfriedHartman. As previously related, he was one of counsel to theColby Committee. He resigned as such counsel in November, 1934. 1

According to the plan proposed jointly by the Murphy and ColbyCommittees,"2 his compensation for services which he rendered ascounsel to the Colby Committee will be paid by the new companyspecified in the plan.sa

Supra note 17, Exhibit M.Op. c t. supra note 1, at 718.

*2 Grayson M. P. Murphy et al., supra.note 17, Amendment to Registration Statement,at 28. Bainbridge Colby et al., supra note 249, Amendment to Registration Statement,at 25.

81 The Registration Statement of the Murphy Committee (supra note 17) states that thenew company to be formed is to assume the expenses incident to the preparation andconsummation of the plan of readjustment. (Amendment, Registration Statement, at 28.)These are estimated to total $250,000 itemized as follows:

Out-of-pocket expenses -------------------------------------- $120, 000Counsel fees:

Sullivan & Cromwell ----------------------------------- 75, 000Guggenheimer & Untermyer ------------------------------ 50, 000Other Counsel ------------------------------------------ 5,000

Total------------------------------------------------$250,000

Three of the houses of issue, Lee, Higginson & Co., Guaranty Company of New Yorkand The City Company of New York had previously contributed $20,000 toward the ex-penses of the Murphy Committee. The new company is to assume the balance of thefees and expenses of both protective committees dating from April 8, 1932, estimated ata total of $875,000. The total of estimated fees and expenses of $895,000 Is itemized asfollows :

Out-of-pocket expenses, Murphy Committee -------------------- $205, 000Out-of-pocket expenses, Colby Committee ---------------------- 20, 000Compensation, members of Murphy Committee ................. 100, 000Compensation, members of Colby Committee ------------------- 65, 000Counsel Fees, Sullivan & Cromwell --------------------------- 340, 000Counsel Fees, Samuel Untermyer, Siegfried Hartman, Guggen-

heimer & Untermyer -------------------------------------- 165,000

Total---------------------------------------------$.... 00

The Registration Statement states (Plan and Prospectus, at 10) that "upon the condi-tion that the Plan, which the two committees are recommending to the Secured Debenture-holders, is approved and accepted by the Secured Debentureholders generally" the bank-ers have arranged to contribute the additional sum of $675,000 to the New Company to


212

The adoption of the procedure of foreclosing and transferringthe collateral to a new corporation, so that it, rather than the trustee,would liquidate the collateral, has certain obvious advantages fromthe viewpoint of committees and their counsel. In the first place

such procedure has the advantage of perfecting the deficiency claimforthwith. In the second place, to participate in the benefits of theplan bondholders would have to deposit with the committees. Theirbonds, when deposited, become subject to the committees' liens forfees and expenses. The committees and their counsel are thus af-forded greater assurance of being paid. The extent, if any, to whichthe latter was a motivating factor in adopting this procedure is only

a matter of conjecture. But it is of interest that if the trustee wasable to exercise its broad powers under the indenture, liquidationwould redound to the benefit of all of the bondholders, rather thanto the benefit of only the assenting bondholders as under the plan.Among these powers of the trustee in this case were the following:

"Section 3. If one or more of the events of default shall happen, the Trustee

personally, or by its agents or attorneys and when necessary or desirable

acting through or with the aid of the proper Swedish authorities, and in its

discretion"(a) May sell, subject to the then prior liens, if any, existing thereon, to

the highest bidder, the Deposited Property and all right, title and interest,

claim and demand therein and right of redemption thereof, which sale or

sales shall be made at public auction at such place, which may be within

or without the State of New York or within or without the Kingdom of

Sweden, and at such time and upon such terms as the Trustee may fix and

briefly specify in the notice of sale to be given as herein provided or as maybe required by the applicable law;

* * * * * * *

"Section 5. In the event of any sale whether made under the power of

sale herein granted or pursuant to judicial proceeding, the Deposited Property

may be sold either in one parcel as an entirety or in several parcels, and if

in several parcels in such parcels as the Trustee may determine and as it

shall deem most advantageous for the holders of the Secured Debentures.

"Section 6. Notice of any sale pursuant to any provision of this Agreement

shall state the time and place when and where the same is to be held and

shall contain a brief general description of the property to be sold and shall

be sufficiently given if published once in each week for four successive calendar

weeks prior to the sale in a newspaper of general circulation published in the

English language in the Borough of Manhattan, City and State of New York,

and in a newspaper of general circulation published in the English language

in London, England, and in a newspaper of general circulation published in the

Swedish language in the City of Stockholm, Sweden, but such publications need

not be simultaneous.

meet the protective committees' expenses. The three banking houses contribute as fol-lows (Registration Statement, Exhibit C-3):

Lee, Higginson & Co ----------------------------------------- $75, 000Guaranty Co. of New York ----------------------------------- 800,000The City Company of New York------------------------------ 800, 000


213

"Section 7. The Trustee may adjourn from time to time any sale made byit under the provisions of this Agreement by announcement at the time andplace appointed for the sale or adjourned sale or sales, and without furthernotice or publication it may make the sale at the time and place to whichthe sale shall be so adjourned.

"Section 8. Upon the completion of any sale or sales under this Agreement,the Trustee shall deliver to the purchaser the securities, bonds, stock notes,obligations and other property sold with good and sufficient transfers. TheTrustee and its successors are hereby appointed the true and lawful attorneysirrevocable of the Company in its name and stead to make all necessary con-veyances, assignments and transfers of 'the property thus sold and for thatpurpose it may execute all necessary instruments of transfer and may sub-stitute one or more persons with like power, the Company hereby ratifyingand confirming all that its said attorney or said substitute or substitutes shalllawfully do by virtue hereof.

"Any such sale or sales made under this Agreement, whether under thepower of sale herein granted or pursuant to judicial proceedings, shall operateto divest all right, title, interest, claim and demand whatsoever either at lawor in equity of the Company of, in and to the property so sold and shall be aperpetual bar both at law or in equity against the Company, its successors andassigns and against any and all persons claiming or purporting to claim theproperty sold or any part thereof from, through or under the Company, itssuccessors or assigns.

"Section 9. The receipt of the Trustee for the purchase money paid at anysuch sale shall be a sufficient discharge therefor to any purchaser of theproperty or any part thereof sold as aforesaid; and no purchaser or his repre-sentatives or assigns after paying said purchase money and receiving saidreceipt shall be bound to see to the application of said purchase money uponor for any trust or purpose of this Agreement or in any manner whatsoeverbe answerable for any loss, misapplication or non-application of any such purchase money or any part thereof, or be bound to inquire as to the authorization, necessity, expediency or regularity of any such sale.

"Section 10. In case of a sale whether made under the power of sale hereingranted or pursuant to judicial proceedings, the principal of the Secured De-bentures If not previously due shall immediately thereupon become due andpayable, anything in the Secured Debentures or in this Agreement to the con-trary notwithstanding.

"Section 11. The purchase money, proceeds or avails of any such sale whetherunder the power of sale herein granted or pursuant to judicial proceedings,together with any other sums that then may be held by the Trustee 'under anyof the provisions of this Agreement as part of the Deposited Property or theproceeds thereof, or otherwise, except any funds held in trust for the paymentor redemption of any Secured Debentures or for the payment of any couponswhich shall have been called for redemption pursuant to Article IV or V hereofor which shall then have matured shall be applied as follows:

'First: To the payment of the costs and expenses of sale, including a reason-able compensation to the Trustee, the Fiscal Agent and the Depositary, theiragents, attorneys and counsel, and to all expenses, liabilities and advancesmade or incurred by the Trustee, Fiscal Agent or Depositary hereunder, and tothe payment of all taxes, assessments or liens superior to the lien of thisAgreement except the superior liens and any taxes, assessments or othercharges subject to which the property shall have been sold.


214

'Second: To the payment of the whole amount then owing and unpaid uponthe Secured Debentures for principal, premium, if any, and interest, withinterest at the rate of six percent. (6%) per annum on the overdue principal,premium, if any, and instalments of interest. In case said moneys shall beInsufficient to pay in full the whole amount so due and unpaid upon the Se-cured Debentures, then to the payment of said principal, premium and interest,without preference or priority of principal or premium over interest or of inter-est or premium over principal or of principal or Interest over premium or ofany instalment of interest over any other instalment of interest, ratably to theaggregate of such principal, premium and interest, subject, however, to theprovisions of Section 1 of this Article X.

"Third: The surplus, if any, to the Company, its successors or assigns or towhomsoever may be lawfully entitled to receive the same or as a court of com-petent jurisdiction may direct.'

"Section l2 * * * The Trustee shall be entitled to recover judgmentand/or to file and prove such claim as aforesaid either before or after orduring the pendency of any proceedings for the enforcement of this Agreement;and the right of the Trustee to recover said judgment and/or to file and provesuch claim shall not be affected by any sale hereunder or by the exercise ofany other right, power or remedy for the enforcement of the provisions ofthis Agreement; and in case of a sale of the Deposited Property and of theapplication of the proceeds of sale to the payment of the debt hereby secured,the Trustee in its own name and as Trustee of an express trust shall be en-titled to enforce payment of and receive all amounts then remaining due andunpaid by the Company under this Agreement for the benefit of the holde :sof the Secured Debentures and shall be entitled to recover judgment for theentire amount so due and unpaid, with interest as aforesaid. No recovery ofany such judgment by the Trustee, and no levy of any execution upon anysuch judgment upon the Deposited Property or upon any other property, andno filing and proving of any claim shall in any manner or to any extent affector Impair the lien of this Agreement upon the Deposited Property or any partthereof, or any rights, powers or remedies of the Trustee hereunder or anylien, rights, powers or remedies of the holders of the Secured Debentures, butsaid lien, rights, powers or remedies of tie Trustee and of said holders shallcontinue unimpaired as before. In case of any receivership, insolvency orbankruptcy proceedings affecting the Company or its property the Trustee shallbe entitled to file -and prove a claim for the entire amount due and payableby the Company under this Agreement at the date of the institution of suchproceedings and for any additional amount which may become due and pay-able by the Company hereunder after such date, without regard to or deduc-

tion for any amount which may have been or which may thereafter be re-ceived, collected or realized by the Trustee or the holders of Secured De-bentures from or out of the Deposited Property or any part thereof or fromor out of the proceeds thereof or any part thereof.

"Any moneys collected by the Trustee under this Section 12 shall be appliedby the Trustee in the same manner and in the same order of precedence as ishereinbefore provided in Section 11 of this Article in respect of the purchasemoneys, proceeds or avails of any sale of the Deposited Property made by theTrustee.""

4 Op. cit. supra note 1, Commission's Exhibit No. 16, Art. X, See. 3, 5-12 inel. Of.our discussion of liquidation trusts in our report on Committees for the Holders of RealEstate Bonds (1936), c. V.


APPENDIX F

PROPOSED RULES UNDER SECTION 17 (c) OF THE PUBLIC UTILITYHOLDING COMPANY ACT OF 1935

RuLE 17C-1. Definitions of Terms Used in Section 17 (c) andRules Thereulnder.

(a) As used in Section 17 (c) of the Public Utility Holding Com-pany Act of 1935 and in the rules and regulations thereunder:

(1) "executive officer" means the Chairman of the Board of Directors, theChairman of the Executive Committee, the President, every Vice-President, theCashier, Secretary, Treasurer, and Trust Officer of a financial institution, and,in addition, every other officer who participates In the management thereof,regardless of whether he has an official title or whether his title contains adesignation of assistant, and regardless of whether he is serving without salaryor other compensation; but such term does not include a director or memberof a committee who is not also an executive officer within the foregoing def-inition; in the case of a partnership, "executive officer" includes a partnerthereof;

(2) "director" means any director of a corporation or any individual whoperforms similar functions in respect of any company, including a partner inrespect of a partnership, a trustee of a mutual savings bank, and a trusteeof a voting trust (but such a voting trustee shall not be deemed an officer ofsuch trust);

(3) "investment banker" means a person engaged In business as an under-writer or a dealer as those terms are defined in the Securities Act of 1933, butdoes not include a bank, trust company, banking association, or banking firmwhich cannot lawfully underwrite or participate in the marketing of securitiesof a public-utility or holding -company.

(b) As used in the rules and regulations under Section 17 (c),unless the context otherwise requires:

(1) "company" means a registered holding company or subsidiary companythereof;

(2) "financial institution" means a bank, trust company, investment banker,banking association or banking firm, or any corporation (other than a regis-tered holding company or subsidiary company thereof) a majority of whosestock, having the unrestricted right to vote for the election of directors, is ownedby a financial institution;

(3) "financial connection": a person shall be deemed to have a "financialconnection" if, and only if, he is an executive officer, director, partner, ap-pointee, or representatiye of a financial institution.

RULE 17C-2. Offieers or Directors Exempted by Federal PowerCommission. A public-utility company as defined by the FederalPower Act, which is also a registered holding company or sub-

(215)


216

sidiary company thereof, may have as an officer or director, orboth, a person who has been authorized by order of the FederalPower Commission pursuant to the provisions of Section 305 (b) ofsaid Act to hold such position, if such person has a financial con-nection (as defined in Rule 17C-1) which, in the absence of suchorder, would make it unlawful under said Section 305 (b) for him tohold such position, and if such person has no other financial con-nections other than those permitted by this or by any other ruleunder Section 17 (c).

RULE 17C-3. Officers and Directors Approved by a FederalCourt. A registered holding company or subsidiary companythereof may have as an officer or director, or both, a person whohas a financial connection (as defined in Rule 17C-1), if a courtof the United States, in connection with a reorganization of suchcompany or of a predecessor thereof, has specifically directed orapproved of the election or appointment of such person as a directoror officer of such company: Provided, That such person shall not,by virtue of this Rule, be eligible for such position for a period ofmore than three years after such direction or approval was lastgiven by such court. If any such court, in connection with such aproceeding, shall have designated or approved of the appointmentof any person as a voting trustee under a voting trust agreementprovided for by such a plan of reorganization, such person shall beeligible to hold such office either for the term prescribed by suchvoting trust agreement or for a period of three years after suchdesignation or approval, whichever term shall be the longer, and anysuch person shall also, for a period of three years after such desig-nation or approval, be eligible as an officer or director, or both, ofthe issuer of any stock which is held in such voting trust. Theprovisions of this Rule shall cease to be applicable with respect toany such person if, after such designation or approval, he shall ac-quire any new financial connection other than such as are permittedby rules under Section 17 (c). As long as a company is permittedby virtue of this Rule to have a person as an officer or director, anysubsidiary company thereof which is engaged in the business ofperforming services or construction for, or selling goods to, associatecompanies and all of whose outstanding voting securities (exceptthe minimum number of shares required to qualify directors foroffice) are owned by such company, may also have such person as anofficer or director.

RuI 17C-4. Ovyners of Secwrities. Subject to the provisions ofRule 17C-9, a registered holding company or subsidiary companythereof may have as an officer or director, or both,


(1) any person who is both the owner of record and the owner of the entirebeneficial interest in 10 per cent or more of the outstanding voting securitiesof such company, regardless of such person's financial connections; and

(2) any person who Is an executive officer, director, partner, appointee, orrepresentative of a financial institution and who has no financial connections(as defined in Rule 17C-1) other than those permitted by this or by any otherrule under Section 17 (c), if such financial institution, directly or indirectly,owns, controls, or holds with power to vote, more than 50 per cent of the out-standing voting securities of such company;

but no such company shall have any such person as an officer if suchperson is also an executive officer of such financial institution. Aslong as a company is permitted by this Rule to have a person as anofficer or director any subsidiary company thereof may also havesuch person as an officer or director.

RuiL 17C-5. Federal Financial Institutions, Savings Banks, andSimilar Institutions. A registered holding company or subsidiarycompany thereof may have as an officer or director, or both, a personwho is an executive officer, director, partner, appointee, or repre-sentative of a financial institution and who has no financial connec-tions (as defined in Rule 17C-1) other than those permitted by thisor by any other Rule under Section 17 (c), if such financialinstitution is

(1) a bank or banking association which is organized under any laws ofthe United States other than the laws providing for the organization of nationalbanking associations; or

(2) a mutual savings bank organized as such under the laws of a State; or(3) a financial institution other than an investment banker, which does not

accept deposits or of which not more than 15 per cent of the total deposits atthe end of the last calendar year were payable on demand without a contractualright on the part of such financial institution to restrict the time of with-drawal; provided, that such financial institution neither, directly or indi-rectly, controls nor is controlled by or under common control with any invest-ment banker or any financial institution which accepts deposits, except afinancial institution described in this Rule.

RULE 17C-6. Limitations on Number of Directors and OfficersHaving Financial Connections. Notwithstanding any provision ofany rule under Section 17 (c), not more than one-third of the di-rectors of any registered holding company or subsidiary companythereof shall at any time after August 26, 1936, be persons who areexecutive officers, directors, partners, appointees, or representativesof any bank, trust company, investment banker, banking associa-tion or banking firm, except that this provision shall not be appli-cable to any persons who are eligible to such positions pursuant tothe provisions of Rule 17C-2, 17C-3, 17C-4, or 17C-5.

RULE 17C-7. Inmtitutions Having Speciied Loaning Capacity, orLocated in Territory Served. Subject to the provisions of Rule17C--9, a registered holding company or subsidiary company thereof


may have as an officer or director, or both, a person who is an execu-tive officer, director, or partner (but not an appointee or representa-tive) of any financial institution other than an investment banker, ifsuch person has no financial connections (as defined in Rule 1IC-1)other than those permitted by this or by any other rule under Section17 (c) ; provided that one of the following conditions is satisfied:

(1) such financial institution at the end of the last calendar year did not

have authority, under the laws applicable to its operations, to lend to any

one borrower on an unsecured basis an amount in excess of $200,000 or, if

there was no such limitation on its lending power, did not have capital and

surplus (including partners' balances) in excess of $2,000,000; or(2) 70 percent or more of the gross revenues (on a consolidated basis)

which such company and all subsidiary companies thereof, if any, derived from

their operations as public-utility companies during the last calendar yearwere derived by such company from its own operations as a public-utilitycompany; and the residence of such officer or director and the principal office or

.a branch of such financial institution are situated in the territory served by

such company or within 100 miles of the principal operating office which such

company maintains in such territory;

but no such company shall have any such person as an officer ifsuch person is also an executive officer of such financial institution.Any company which is permitted by this Rule to have a personas an officer or director during any calendar year may continue tohave him as such during the first three months of the next calendaryear.

RuL 17C-8. Financial Institutions Having an Interest in theCompany. Subject to the provisions of Rule 17C-9, a registeredholding company or subsidiary company thereof may have as anofficer or director, or both, a person who is an appointee or repre-sentative (who may also be an executive officer, director, or partner)of any financial institution other than an investment banker, if suchperson has no financial connections (as defined in Rule 17C-1) otherthan those permitted by this or any other Rule under Section 17 (c);provided that one of the following conditions is satisfied:

(1) such financial institutions holds as collateral security for a debt which

is and has been for 30 days or more in default in payment of principal

or interest, or owns, as a result of the liquidation (by a reorganization or

otherwise) of a bona fide debt owing to such financial institution or to a

predecessor thereof, securities issued or assumed by such company having a

principal amount or par or stated value (or, if no par or stated value, a

liquidating value) amounting in the aggregate to 2 per cent or more of the

total assets of such company; provided that such financial institution either

is not a trustee under any trust indenture or similar agreement with respect

to any class of securities issued or assumed by such company or, if it is such

a trustee it is not, in its own right, a creditor of such company or the owner

of any securities issued or assumed by such company other than of the class

issued under such trust indenture or agreement; or


219

(2) such financial Institution has acquired ownership, in Its own right, Ina manner otherwise than as specified In subparagraph (1) above, of securitiesissued or assumed by such company having a principal amount or par or statedvalue (or, if no par or stated value, a liquidating value) amounting to 2 percent or more of the total assets of such company; and such company is indefault in payment of interest or principal on any issue of funded indebtedness,or is in receivership or bankruptcy, or is In arrears as to dividends on a classof stock entitled to cumulative preferred dividends, which stock such financialinstitutions owns in an amount having a par or stated value (or, if no paror stated value, a liquidating value) amounting to 2 per cent or more of thetotal assets of such company; provided that such financial institution eitheris not a trustee under any trust indenture or similar agreement with respectto any class of securities issued or assumed by such company, or, if it is sucha trustee, it is not, in Its own right, a creditor of such company or the ownerof any securities issued or assumed by such company other than of the classissued under such trust indenture or agreement; or

(3) such company is and has been for 30 days or more in default in paymentof principal or interest on a debt owing by it to such financial institution,or to a group including such financial institution and one or more other lenderswho have designated such financial institution as the one to act on behalfof the group in connection with such indebtedness; provided that such debtamounts to 2 per cent or more of the total assets of such company or thatthe amount loaned by such financial Institution or the amount of its par-ticipation in any such joint loan amounts to either $500,000 or more or 70per cent or more of the maximum amount which, as of the close of the lastcalendar year prior to the date when such loan was made, such financialinstitution, under the laws applicable to its operations, had authority to lendto any one borrower, or, if there was no such limitation on its lending power,to 7 per cent or more of its capital and surplus (including partners' balances)as of the close of such year; and providing further that such financial insti-tution is not a trustee under a trust indenture or similar agreement withrespect to any class of securities issued or assumed by such company; or

(4) such financial Institution is trustee under one, and not more than one,trust indenture or similar agreement with respect to securities issued orassumed by such company; provided that neither such financial Institution norany company which, directly or indirectly, controls, is controlled by, or isunder common control with, such financial institution is, in its own right, acreditor of such company or the owner of any securities issued or assumedby such company other than those issued under such trust indenture or agree-ment; or

(5) such financial institution is executor, administrator, guardian, trustee,or other fiduciary and, in one or more such capacities, holds securities Issuedor assumed by such company, having a principal amount, or par or stated value(or, if no par or stated value, a liquidating value) amounting in the aggre-gate to 2 per cent or more of the total assets of such company; and such com-pany is in default in payment of interest or principal on any issue of fundedindebtedness, or is in receivership or bankruptcy, or is in arrears as to divi-dends on a class of stock entitled to cumulative preferred dividends, whichstock such financial institution holds In an amount having a par or statedvalue (or, if no par or stated value, a liquidating value) amounting to 2 percent or more of the total assets of such company:

but no such company shall have any such person as an officer if suchperson is also an executive officer of such financial institution. For

75957 -36- 15


purposes of this Rule the total assets of a company shall not be con-solidated and shall be computed as of the end of the last calendaryear, except that during the first three months of any year they shallbe computed either as of the end of the last calendar year or theyear before that, whichever would permit such company to havesuch person as an officer or director.

RuLE 17C-9. Filing of Statenents with Respect to CertainRules. Any registered holding company or subsidiary companythereof which has as an officer or director any person who has anyfinancial connection which would make it unlawful for him to holdsuch position except for Rules 17C-4, 17C-7, or 170-8 shall, on orbefore August 26, 1936 (or if such person is not then such an officeror director, within 30 days after he becomes such), file with theCommission a statement signed by such person, setting forth thefacts by virtue of which it is deemed that such rule or rules areapplicable. Similar statements shall also be filed within 30 dayssubsequent to each annual meeting of such company thereafter whilesuch person remains an officer or director and continues such finan-cial connection. A company having several such officers or directorsmay file a single statement signed by all of them. No form is pre-scribed for such statement. One original only need be filed, but, ifacknowledgment is desired, a duplicate should also be filed.

RuLE, 17G-10. Investment Bankers. A registered holding companyor subsidiary company thereof may have as director, but not as anofficer, a person who is an executive officer, director, partner,appointee, or representative of an investment banker, and who hasno financial connections (as defined in Rule 170-1) other than thosepermitted by this or by any other rule under Section 17 (c); pro-vided, that, while such person is a director of such company and fora period of six months after he ceases to be such, neither such com-pany nor any associate company thereof shall enter into any financialtransactions with such investment banker.

RuLE 17C-11. Independent Officers or Directors. (a) A registeredholding company or subsidiary company thereof may have as anofficer or director, or both, a person who is a director (other thana partner) of a financial institution and has no other financial connec-tions (as defined in Rule 17C-1) other than those permitted by thisRule; provided, that

(1) such person Is not an executive officer, partner, appointee, or repre-

sentative of such financial institution; and

(2) such person was an officer or director of such company on June 1,1936; and

(3) such person has no financial connections other than those which he

held on June 1, 1936; and(4) such person is not an officer or director of any other such company which

is not a member of the same holding company system; and


(5) such company shall have filed or caused to be filed with the Commis-sion a statement on Form U-17-3 as adopted June 30, 1936, signed by suchofficer or director and setting forth the information therein specified.

(b) Not more than two persons who are officers or directors of anysuch company shall be persons who are eligible to such position onlyby virtue of this Rule.

(c) This Rule shall expire not later than January 1, 1938.Acting pursuant to the authority granted by the Public Utility

Holding Company Act of 1935, particularly Section 3 (d) thereof,and finding such action necessary and appropriate in the publicinterest and for the protection of investors and consumers, and notcontrary to the purposes of said Act, the Securities and ExchangeCommission hereby amends Rule 3D-5 to read as follows:

Ru-Lm 3D-5. Exemption of certain on-u7Tilty subidiaries. (a)Any subsidiary company of a registered holding company, whichsubsidiary company is not (1) a public-utility or holding company,(2) an investment company or investment trust, including anycompany or trust which is a medium of investment in securities forthe benefit of such holding company or its employees or officers, (3)a company engaged in the business of performing services or construc-tion for, or selling goods to, associate public-utility companies, or (4)a company controlling, directly or indirectly, any company specifiedin (1), (2), or (3) above, shall be exempt from the obligations, duties,and liabilities imposed upon such company as a subsidiary companyby any provision of the Act, except as otherwise provided in para-graphs (c) and (d) of this Rule.

(b) Any subsidiary company exempted under paragraph (a) ofthis Rule shall not be deemed a subsidiary company within the mean-ing of the provisions of Section 11 (f) and (g).

(c) The exemption provided from Section 9 (a) (1) by para-graph (a) of this Rule shall not be applicable to (1) any acquisi-tion of securities of, or any interest in the business of, any companydescribed in Clause (1), (2), (3), or (4) of paragraph (a) of thisRule, (2) any acquisition which will result in such subsidiary com-pany becoming a company described in Clause (1), (2), (3), or (4)of paragraph (a) of this Rule, or (3) any acquisition where theaggregate amount of the gross consideration to be paid by suchsubsidiary company, on account of the transaction in question, or onaccount of such transaction and one or more other transactionsrelating to the same subject matter, will exceed $200,000.

(d) The exemption provided by paragraph (a) of this Rule shallnot be applicable to Sections 12 and 13, nor to Section 15, insofaras any rule, regulation, or order under Section 15 may be expresslyapplicable to subsidiary companies exempted by this Rule.


FORM U-17-3


WASHINGTON, D. 0.

Statement to be Signed by Officer or Director with Respect toWhom Exemption is Claimed Pursuant to Rule 17C-11 from theProvisions of Section 17 (c) of the Public Utility Holding CompanyAct of 1935.

Name of officer or director:(Type or print)

1. On June 1, 1936, the undersigned was and he now is an officeror director of the following registered holding companies or sub-sidiary companies thereof, all of which are in the same holdingcompany system:

Name of Company Positions and Titles

2. The undersigned is not an officer or director of any registeredholding company or subsidiary company thereof other than thecompanies mentioned under Item 1 above.

3. The undersigned now holds the following positions as director(but not as a partner or an executive officer, appointee, or repre-sentative) of a financial institution, as defined in paragraph (b) (2)of Rule 17C-1, which is set out in the Instructions for this Form, andhe was also a director of each such institution on June 1, 1936:

Name Address

4. The undersigned is not an executive officer, director, partner,appointee, or representative of any financial institution other thanthose mentioned under Item 3 above.

5. The undersigned has not accepted any of the positions men-tioned under Item 1 above at the request of any financial institutionor of any officer or director thereof or person known to be a repre-sentative thereof; and he is under no obligation, direct or indirect,to represent the interest of any such financial institution whenacting as a director or officer of any company described under saidItem 1 above.

(Signature)

Subscribed and sworn to before me, a --------------------------(Title of Officer)

this ------- day of ------------- ,193

[OFFICIAL SEAL]

My Commission expires(If acknowledgment is desired, file this form in dupl4cate.)


IYSTRUCTIONS

Section 17 (c) of the Public Utility Holding Company Act of1935 makes it unlawful for a registered holding company or sub-sidiary company thereof to have as an officer or director a personwho has certain financial connections, except in cases permitted byrules of the Commission. The Securities and Exchange Commissionhas adopted rules, including Rule 17C-11, permitting such companiesto have such persons as officers or directors under certain specifiedconditions.

Section 17 (c) provides as follows:"(c) After one year from the date of the enactment of this title,

no registered holding company or any subsidiary company thereofshall have, as an officer or director thereof, any executive officer,director, partner, appointee, or representative of any bank, trustcompany, investment banker, or banking association or firm, or anyexecutive officer, director, partner, appointee, or representative ofany corporation a majority of whose stock, having the unrestrictedright to vote for the election of directors, is owned by any bank,trust company, investment banker, or banking association or firm,except in such cases as rules and regulations prescribed by the Com-mission may permit as not adversely affecting the public interestor the interest of investors or consumers.)7

Rule 17C-11 provides as follows:"(a) A registered holding company or subsidiary company there-

of may have as an officer or director, or both, a person who is adirector (other than a partner) of a financial institution and has noother financial connections (as defined in Rule 17C-1) other thanthose permitted by this Rule; provided that

(1) such person is not an executive officer, partner, appointee,or representative of such financial institution; and

(2) such person was an officer or director of such company onJune 1, 1936; and

(3) such person has no financial connections other than thosewhich he held on June 1, 1936; and

(4) such person is not an officer or director of any other suchcompany which is not a member of the same holding com-pany system; and

(5) such company shall have filed or caused to be filed withthe Commission a statement on Form U-17-3 as adoptedJune 30, 1936, signed by such officer or director and settingforth the information therein specified.


"(b) Not more than two persons who are officers or directors ofany such company shall be persons who are eligible to such positiononly by virtue of this Rule.

"(c) This Rule shall expire not later than January 1, 1938."

DEFINITIONS

The term "financial institution" is defined by paragraph (b) (2)of Rule 17C-1 as follows:

"'Financial institution' means a bank, trust company, invest-ment banker, banking association or banking firm, or any corpo-ration (other than a registered holding company or subsidiarycompany thereof) a majority of whose stock, having the unre-stricted right to vote for the election of directors, is owned bya financial institution."

Definitions of other terms used in this form will be found in theSection of the Public Utility Holding Company Act of 1935 or theRule of the Commission indicated below:

"registered holding company", Section 2 (a) (12);"subsidiary company", Section 2 (a) (8);"holding company system", Section 2 (a) (9);"executive officer", Rule 17C-1;"director", Rule 17C-1.


APPENDIX G

SELECTED BIBLIOGRAPHY OF MATERIALS ON TRUSTEES UNDERINDENTURES

ARTICLES AND REPORTS

Banks, The Powers and Duties of a Trust Company When Actingas Trustee Under a Corporate Mortgage, 15 Bankers Law Journal79 (1898).

Carey and Brabner-Smith, Studies in Realty Mortgage Foreclosures:III Receiverships, 27 Illinois Law Review, 717 (1933).

Carey, Brabner-Smith and Sullivan, Studies in Realty MortgageForeclosures: IV Reorganization, 27 Illinois Law Review 849(1933).

Dallstream, Administration of Trusts under Corporate Mortgages(A paper prepared and read before the Law Club of Chicago onFebruary 28, 1936).

Draper, A Historical Introduction to the Corporate Mortgage, 2Rocky Mountain Law Review 71 (1930).

Green, Examination of Trust Deed or Mortgage to Secure BondIssue, 45 Trust Companies 137 (1927).

Grinnell and Kearns, Corporate Trusteeship and 77B, 61 Trust Com-panies 111 (1935).

Grutze, Modernizing Trust Indenture to Secure Bonds, 61 TrustCompanies 137 (1935).

Grutze, The Trustee's Duties and Liabilities Under Corporate BondIssues After the Bonds Have Been Certified and Delivered, 41Trust Companies 183 (1925).

Hartman, Active Versus Passive Corporate Trusteeship-EnlargedObligations to Both Mortgagor and Noteholders, 62 Trust Com-panies 259 (1936).

Katz, The Protection of Minority Bondholders in Foreclosure andReceiverships, 3 U. of Chicago Law Review 517 (1936).

Leesman, Corporate Trusteeships and Receivership, 28 Illinois LawReview 238 (1933).

Lester, The Effect of Corporate Mortgage Provisions ConditioningRight of Trustee to Act on Default, 4 Rocky Mountain LawReview 163 (1932).

Littleton, Administration Problems Under Corporate Trusteeship,56 Trust Companies 335 (1933).

(225),


Littleton, Bonds, Mortgages, Equipment-Some AdministrativeProblems Under Corporate Trusteeship, 126 Bankers Magazine554 (1933).

Lowenthal, Wall Street and the Investor, 1934-When Is a TrusteeNot a Trustee? 169 Harper's Magazine 707 (1934).

Maull, Elastic Powers of a Trustee for Bondholders, 61 Trust Com-panies 17 (1935).

Mecham, Dangerous Practice of Making Funds Under CorporateBond Issues Payable to Other Than Corporate Trustee, 45 TrustCompanies 621 (1927).

Miller, Modifications and Additions to Trust Indentures SecuringBond Issues, 61 Trust Companies 437 (1935).

Payne, Exculpatory Clauses in Corporate Mortgages and OtherInstruments, 19 Cornell Law Quarterly 171 (1934).

Pirtle, Clarifying Trustee Functions Under Corporate Mortgages-Defining Duties of Trustee, Depository and Agent, 48 TrustCompanies 225 (1929).

Porter, Duty of a Trustee Under a Bond Issue to Bid for the Bond-holders at a Foreclosure Sale, 61 Trust Companies 561 (1935).

Porter, Legal Status of Bondholders' Committees-Application ofRules Governing Trustee, 62 Trust Companies 35 (1936).

Posner, Liability of the Trustee Under the Corporate Indenture, 42Harvard Law Review 198 (1928).

Poss, The Responsible Role of the Trustee Under Corporate Mort-gages, 51 Trust Companies 623 (1930).

Read, Duties and Liabilities of Trustee in Releasing a Trust DeedGiven to Secure a Bond Issue Before Maturity and in the Substi-tution of Security, 45 Trust Companies 191 (1927).

Smith, A Forgotten Chapter in the Early History of the CorporateTrust Deed, 61 American Law Review 900 (1927).

Stanton, Problems of Trustees in Connection with Bond Issues, 55Trust Companies 529 (1932).

State of New York. Report on the Joint Legislative Committee toInvestigate Bondholders' Committees, Stockholders' Committees,Creditors' Committees, Certificate Holders' Committees, Corpora-tions, Trustees and Fiduciaries, Legislative Document (1936),No. 66.

Stevens, Insurance or Bond Coverage for Liabilities of TrusteesUnder Corporate Indentures, 53 Trust Companies 23 (1931).

Theis, Pitfalls for the Corporate Trustee, 125 Bankers Magazine 47(1932).

Utter, Problems of Trustees Under Defaulted Bond Issues, 56Trust Companies 653 (1933).


Walker, Vital Considerations in Acceptance and Performance ofTrusteeship Under Corporate Mortgages, 45 Trust Companies321 (1927).

NOTES AND COMMENTS

Corporate Trustee--Responsibility for Negligence in CertifyingBonds, 40 Yale Law Journal 138 (1930).

Duty of Corporate Trustee to Record Mortgage Securing Bonds, 29Michigan Law Review 1078 (1931).

Duty of Trustee Claiming Lien for Advances to Notify Bondholdersof Advances, 47 Harvard Law Review 882 (1934).

Immunity Clauses in Corporate Trust Indentures, 33 Columbia LawReview 97 (1933).

Liability of Corporate Trustee for Failure to Record, 40 Yale LawJournal 1110 (1931).

Liability of Corporate Trustee for False Representations that TrustDeed Had Been Recorded, 20 Virginia Law Review 477 (1934).

Liability of Corporate Trustee for Negligence in Certifying Bonds,15 Minnesota Law Review 477 (1931).

Liability of Officers of Corporate Trustee for Breach of Trust, 34Michigan Law Review 867 (1936).

Proof in Bankruptcy by a Trustee for Bondholders, 46 Harvard LawReview 309 (1932).

Restrictive Provisions in Trust Indentures Against Actions by In-dividual Bondholders, 41 Yale Law Journal 312 (1931).

Revision of Corporate Mortgages, 51 Trust Companies 601 (1930).Right of Mortgage Trustee to File Claims for Bondholders, 36 Yale

Law Journal 884 (1927).Right of Trustee Under Corporate Trust Agreement to File Claims,

33 Columbia Law Review 1249 (1933).Right of Trustee Under Mortgage to File Claims with Receiver, 40

Harvard Law Review 910 (1927).The Corporate Mortgage Trustee-A Mere Spectator at Foreclosure

Sale, 7 Rocky Mountain Law Review 282 (1935).The "No Recourse" Clause in Corporate Bonds and Indentures, 34

Columbia Law Review 107 (1934).The Rights and Remedies of the Bondholders Under Corporate

Bonds and Indentures, 27 Columbia La-v Review 443, Id., at 579.Unwarranted Liability Imposed Upon Trustee of Corporate Mort-

gage, 42 Trust Companies 657 (1926).


Documents

Trustees Under Indentures