SECURITIES AND EXCHANGE COMMISSION 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 investigation of the work, activities, personnel and functions of protective and reorganization committees pursuant to Section 211 of the Securities Exchange Act of 1934, for several reasons. In the first place, the trustee (which normally is a commercial bank)1 holds title to the property which is conveyed by the issuer as security for its bonds, debentures or notes. The indenture under which the security is held and pursuant to which the bonds, debentures or notes are issued commonly vests in the trustee broad discretionary powers which it may exercise for the protection of the beneficiaries of this trust. Throughout the life of the trust many occasions will arise for exercise of these powers. Commonly these occasions will increase in frequency as the period of reorganization draws near or arrives. In considering, then, the problem of designing a reorganization system which will afford to investors maximum protection against exploitation at the hands of the reorganizing group, a study of the functions which the trustee in the past has performed and of the functions which it might properly perform becomes of paramount importance. In the second place, the trustee has a direct and intimate bearing on the functioning of and occasion for protective committees. As we develop herein, trust indentures almost universally provide that 1"Generally, the earliest mortgages ran to a single individual as trustee, although in the case of the New York and Erie Railroad Company from the beginning there were two or more individual trustees. Subsequently it became the general practice to name two or three individuals as trustees. Still later, the individual trustee was superseded customarily by a corporate trustee, and in recent years, to meet the requirements of State statutes calling for a resident trustee, a natural person and citizen of the State oftentimes is joined with a corporate trustee to which, however, is assigned exclusively all active duties prior to default." Stetson et al., Some Legal Phases of Corporate Finance, 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 bond field 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 infra, at 99. the security holders can force the trustee to take specified action, such as foreclosure, only if a designated percentage of them makes demand on the trustee (with adequate tender of funds to indemnify the trustee) and the trustee refuses to act. Furthermore, these indentures frequently provide that the security holders themselves can take certain action, such as suing on the securities, only if a designated percentage makes demand on the trustee (with similar tender of indemnity) and the trustee refuses to act. Hence in case of bonds, debentures, notes or similar securities, formation of a protective committee may be necessary in order to obtain the necessary amount of the securities to make such demands on the trustee and thus mature the right of these security holders themselves to proceed or to force the trustee to do so. The relevancy of a study of the trustee to a study of protective and reorganization committees is thus apparent. Our study of the trustee paralleled our study of protective and reorganization committees. In the reorganizations which we investigated and presented at public hearings the activities of the trustee were explored. Trust officers and their counsel were examined, both as respects their relation to the various committees and as regards their action or non-action prior to and after default. A questionnaire was prepared and sent to 53 leading corporate trustees throughout the country, these being chosen at random with due regard to geographical distribution. This questionnaire is included as Appendix A to this report. 424 returns from this questionnaire were received. The results have been incorporated in this report. Furthermore, we have drawn to some extent from reports and investigations of other governmental agencies, from decisions of the courts, and from other sources' for illustrative material bearing on the problem of the necessary and proper functions of the trustee both before and after default. The current interest in this field is attested by the fact that special committees of the American Bankers Association and of the Investment Bankers Association have recently been appointed to study the 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 and their individual interest in the issue is likely to be small. The trustee, on the other hand, is usually a single bank. By virtue of the broad discretionary powers vested in it under the typical trust indenture it is in a position to take immediate action in a variety of ways to protect or enforce the security underlying the bonds, de 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. Theoretically, 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 possible 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 have retained no effective control over the issuer's performance of its obligations in respect of them. Such control has been surrendered to or assumed by the trustee. It has been invested with power to certify securities; to supervise the deposit and the withdrawal of collateral and application of funds; to take action upon default; and, in short, to do everything upon which the protection and enforcement of the security of a bondholder depends. Both in law and in practice, this reliance of the security holder upon the trustee for protection of his investment is complete. It is a matter of common knowledge that purchasers of securities seldom examine the terms of the trust indenture, although they are legally bound by its terms. Even if they did examine the indenture, the significance of its elaborate provisions would appear only to specialists. In some instances, indeed, it is so drafted that vital provisions apparently escape the notice of highly trained investment agencies." Reliance for adequacy of the security underlying the bonds, notes or debentures, is placed by the investor upon the reputation of the issuer, 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 security holders under the terms of the indenture. Upon the public distribution of bonds, debentures or notes, secured by an indenture, the name of a prominent institution which will act as trustee is eagerly sought. The addition of the name of such an institution to the prospectus is not without advertising value to the distributor. Likewise it is not without significance to the prospective 'See, e. g., Hazzard v. Chase National Bank of City of N. Y., N. Y. Law Journal, April 15, 1936, at 1905. • Ibid. 'Ibid. 'In the Hazzard case, supra note 3, 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 securities by the size, prestige and financial strength of the trustee. As stated by the United States Supreme Court over fifty years ago: "The salability of railroad bonds depends in no inconsiderable degree upon the character of the persons who are selected to manage the trust. If these persons are of well-known integrity and pecuniary ability, the bonds are more readily sold than if this were not the case."' This statement applies equally to other securities, regardless of the business of the issuer. But an examination of the provisions of modern trust indentures and their administration by trustees will show that this reliance is unfounded. It will show that typically the trustees do not exercise the elaborate powers which are the bondholders' only protection; that they have taken virtually all of the powers designed to protect the bondholders, but have rejected any duty to exercise them; and that they have shorn themselves of all responsibilities which normally trusteeship imports. The "so-called trustee" which is left is merely a clerical agency and a formal instrument which can be used by the bondholders when and if enough of them combine as specified in the indenture. The trustees themselves hold no exalted view of their own functions under these indentures. Leonard J. Clark, trust officer of The Pennsylvania Company for Insurances on Lives and Granting Annuities, a trust institution of long standing, testified in a hearing before 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." Knapp 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 Atl. 871 (1921); Posner, Liability of the Trustee under the Corporate Indenture (1928) 42 Harv. L. Rev. 198, 199, 239. Judge Rosenman's phrase. Supra note 3. Proceedings 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 mechanical functions? 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. (1935), at 873. It is readily admitted by these trustees that they are a species different 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. Furthermore, under the modern trust indenture it alone is capable of effective action. The individual security holder is impotent when acting alone and can get together with his fellow security holders only at great labor and expense. It is likewise true that the common understanding of the lay investor is that the trustee is his alter ego in safeguarding his rights. On these facts the trustee should not be allowed, through indenture provisions never seen by the beneficiary, and which would not be understood if they were seen, to whittle away at the number of his express duties until they are practically non-existent, and to surround itself with exculpatory clauses which leave it harmless, despite inactivity or negligence. Bankers, lawyers and courts who have contributed to the evolution. of the trustee under these indentures have given almost exclusive consideration and weight to the intent of the parties to the indenture. Accordingly, it has been assumed that the trustee could take or refuse to take practically any right or duty, power or privilege, which was agreeable to him and the issuer. It has also been assumed that this contract between trustee and issuer is binding on security holders on the theory that they acquire only such rights as the contract which these parties have made gives them. That is to say, the supposition is that the indenture evidences the intent of the security holders whose loans it secures. But that mutuality of intent which is assumed is in fact non-existent. To the extent that the indenture is the product of the borrower, the underwriter or the trustee, only their respective intents are reflected therein. It is no refutation of this to 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 bargain for special provisions. Nor can prospective buyers normally unite in anticipation of an issue, to exact desired terms. Inequality of bargaining power between investor and issuer is inherent in the very technique of security distribution. Yet the courts in their treatment of the trust indenture have proceeded on the same basis as the draftsmen and have concluded that the indenture is a contract which binds the security holders even though they had no part in its making. The attitude of the courts is well expressed in the following excerpt from a case which treated the provisions of a trust indenture |