as binding on the security holders in the same manner as if they themselves had negotiated the contract at arm's length: 46 While it is true that such bonds are sold broadcast to large numbers of people, they are generally distributed originally to bankers or brokers in large blocks, and in such cases it is the custom of the latter to familiarize themselves with the mortgage and its provisions. The final purchasers are their customers, and look to, and depend upon, these distributors, and not upon the obligors. The case is not, therefore, one where the obligor deals directly with a numerous class, not accustomed to look carefully at the details of the bargain, and where the detailed provisions of the contract are submerged by the urgency of the demand. It may well be that these distributors do not pay such attention to the details as they should, yet the matter is one in 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 can hardly be put in the class of those not responsible for the clear meaning of the instruments on which he buys; at least, if it is so, we have no means of knowing it, and the matter must await some legislative determination." 10 It is in this condition that the courts have left the problems of the trust indenture. Accordingly the solution becomes one for "legislative determination." The basic problem is to refashion the trust indenture for the purpose of according greater protection to investors. That entails prescribing certain minimum standard specifications for the conduct of trustee and issuer thereunder. As in the case of other contracts involving persons not capable nor in a position to protect themselves, the contents of the trust indenture can no longer be left to the conventions of the issuer, the trustee or the underwriter. This means that a more proper balance between the interests of investors and requirements of issuers can be had only by enlarging the definition of the trustee's duties in those cases where its failure to take swift and positive action leaves the investors without effective protection of their interests. The contrary desires of issuer, trustee and underwriter must be made to bow to the insistent demands of investors and of the public interest in such cases. An examination of critical conditions which prevail in this field and of crucial provisions of trust indentures which have been employed against the interests of investors will illuminate the nature of the legislative problem. What follows will not be exhaustive of all provisions of the trust indenture. But the discussion of a few of the major points will be exemplary of the quality and degree of reform which is essential. 10 Babbitt v. Read, 236 Fed. 42 (C. C. A. 2d, 1916), sustaining the validity of an immunity clause in the trust indenture which provided, inter alia, that the stockholders were not to be liable to the bondholders for watered stock. As to the frequency of such immunity clauses in trust indentures, see Appendix A, infra. SECTION II PROTECTION OF THE INVESTORS' POSITION A. ACCEPTANCE OF THE TRUST A good deal of the fault for inadequate protection of investors may be traced to passivity on the part of the trustees at the time when the indenture is drafted. An examination of what transpires behind the scenes when the trust indenture is being drafted emphasizes that one of the real and vital functions of the trustee in protection of investors is to be performed at this point. The trustee of a corporate issue is usually selected by the issuer or the underwriter, or by agreement of both. As a general matter, the trustee does not participate in drafting the indenture. Counsel for the underwriting bankers or the issuer, or both, commonly draft the indenture which is presented to the trustee for its acceptance. In response to the questionnaire sent to a number of institutions acting as corporate trustees," this Commission received information showing the parties represented by counsel who drafted 244 indentures. Excluding 10 miscellaneous cases, the returns show that in 25 percent (60) of the instances, counsel drafting the indenture represented the issuer only; in 20 percent (48), the issuer and underwriter; in 5 percent (12), the underwriter alone. In 20 percent (49) of the cases, both issuer and trustee were reported as represented by counsel 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 paying agent. So, according to reports of the corporate trustees themselves, their counsel drafted the indentures in 16 cases and participated in the drafting in 98 of the 244 cases. But even in this limited number of cases the trustee's participation may well have been nominal. It may have been limited to the provisions relating to the powers, duties and 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 the fairness and adequacy of the provisions of the indenture as they affect security holders. On the contrary, L. J. Clark, trust officer of The Pennsylvania Company for Insurances on Lives and Granting "A copy of this questionnaire appears in Appendix A to this report. Annuities, has testified before this Commission that it is not the duty of a trustee to act as a check on the bankers and the issuer before it accepts a trust: "Q. You would say it has no duty, for example, to make any independent investigation of the company which is contemplating the issuance of new securities? A. No. Q. And a corporate trustee has no duties to investigate the financial condition 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 attention by the bondholders? A. I do. Q. And you believe a corporate trustee has no duty to exercise any supervision over the management, whether within the terms of the trust or beyond the terms of the trust indenture, unless required to do so by a specified number 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 company issuing the securities? A. No." 12 Typically, the trustee will obtain an opinion of its counsel before it assumes a trusteeship. But this opinion ordinarily will not certify to the adequacy of the indenture provisions to protect security holders; it will state, as a general matter, only that the issue has been validly authorized, that the indenture is "in proper form for execution by the Trustee" and the securities are "in proper form for authentication." 13 The primary purpose of counsel's opinion, according to Francis C. Grey, formerly president of Lee, Higginson Trust Co., is to insure that the trustee is adequately protected. He testified as follows at a hearing before this Commission: "Q. I am trying to develop, Mr. Grey, just what provisions counsel, your counsel, would be interested in. Would your counsel examine the agreement with a purpose of ascertaining whether the agreement adequately protected security 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. 12 Proceedings before the Securities and Exchange Commission In the Matter of The Baldwin Locomotive Works (1935), at 333-334. Cf. Theis, Pitfalls for the Corporate Trustee, 125 Bankers Mag. 47 (1932). 13 See opinion of counsel to the trustee, in Proceedings before the Securities and Exchange Commission In the Matter of The Baldwin Locomotive Works (1935), Commis sion's Exhibit No. 80, Q. Then the counsel examined the agreement in order to insure adequate protection of the corporate trustee and not of the security holders? A. Yes, I would suppose so, sir." “Q. Do you recall whether you ever specifically instructed your counsel to examine a trust indenture in order to ascertain whether the security holders. would be properly protected thereunder? "A. I don't recall ever having so instructed them."" Trustees who approach indentures from this point of view certainly cannot be relied upon to see that they contain provisions which afford purchasers adequate security and safety. There is nothing in the law requiring them to do so. And if they insisted that indentures contain provisions for the protection of bondholders, it may be guessed that the business which they obtain from issuers and bankers would decline. Others less sensitive to the requirements of the public interest and of investors would get the business. They are, in other words, interested parties, and their interests do not lie with the bondholders. They are too often interested in retaining the good-will and patronage of the issuers and bankers.15 Nor do the underwriting bankers afford adequate protection to security holders against emasculating and oppressive provisions in indentures. They, like the trustees, are financially interested in acceding to the wishes of the issuer. They are also interested in selling the securities and retaining the good-will of their customers. Since security holders generally are not discriminating in appraising the adequacy of indenture provisions, it generally adds nothing to the sales value of the security to insert in it adequate protective clauses. Indeed, bankers may regard any mention to prospective purchasers of the all-important provisions respecting default as undesirable. 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 little improvement has been made heretofore in the provisions relating to remedies in the event of default, and rights of the trustees and bondholder majorities with respect to amendments, curing of defaults, interpretation or modification of the instrument and readjustments and reorganizations. This may be explained by the fact that when it has been suggested to underwriters that there be insertel in these indentures comprehensive provisions giving bondholder majorities rather broad powers, subject to the approval of the trustee, to deal "Proceedings before the Securities and Exchange Commission In the Matter of Kreuger & Toll Co. (1935), at 115. 15 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), the court held that defendant trustee did not owe the bondholders any duty of care in drafting the indenture, because it did so not as trustee, but "on the employment of the Standard Oil 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 advised that some reference to these provisions must be made in the circular, have said, 'Well, then don't put them in. When we sell securities we don't talk about defaults'." 16 The good-will of customers, furthermore, towards the underwriting bankers is not dependent on the insertion of adequate protective provisions. The problems and considerations involved are so technical that it is unlikely that security holders will be sufficiently astute to trace a loss on their security to the absence of protective provisions in the indenture; and if they do observe a failure to protect their rights, it is only natural that they should charge it to the corporate trustee, not to the banker. Such responsibility as they are apt to charge to the banker is for the value of the security and the financial condition of the issuer. For the technical protection of their rights they will look to the trustee, who in fact is represented as serving in this capacity. Nor can adequate protection to security holders against emasculating and oppressive provisions in indentures be expected from issuers. Their dominant interest will always be in retaining as great freedom and flexibility of action as possible. They are interested in effectively tying up, by mortgage or pledge, as little property as possible; they are concerned to have the greatest possible freedom to withdraw collateral and sell pledged property; and they are anxious to have the most liberal opportunity to avoid and postpone the consequences of default. Each of these is a desire antithetical in principle to the interests of investors. In this situation the inherent incompatibility of interest arises, common to all creditors and debtors. 1. NEGATIVE PLEDGE CLAUSES One example of a situation where increased watchfulness on the part of the trustee over indenture provisions and their performance is essential if the interests of the investors are to be safeguarded will suffice. We refer to negative pledge clauses and the notorious history of their circumvention. These clauses commonly appear in debentures-unsecured obligations of the corporation. They are in general designed to insure investors that claims upon corporate assets will not be incurred which will rank prior to theirs. Consequently, they specify that none of the borrower's assets will be mortgaged or pledged; or, in some instances, that the debenture will be ratably secured in the event that corporate assets are mortgaged or pledged.1 16 Dallstream, 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 |