How many persons in the ’twenties bought real estate bonds (under many glittering appellations) and industrial debentures because they saw a reputable financial institution named as trustee? A good many, I dare say. A reputable trustee was deemed essential to the successful selling of securities. The following colloquy, at a hearing of the SEC on January 28 on investment trusts, yields the evidence: —
‘What is to prevent salesmen from carrying around a copy of the Chase National Bank’s latest statement and saying to prospective customers, “This is the institution that’s back of us"?‘
Hayward A. Hibberd (Vice President, Chase National Bank of New York): ‘I am rather inclined to think our name as trustee does contribute to the selling value of a trust share in the mind and in the eyes of the small investor, leading him to believe he has something a little better perhaps than if the name were a small town bank.‘
But, as investors have found to their cost, the word ‘trustee’ as applied to a mortgage, or bond, or debenture, or trust share, is a misnomer. The corporate trustee has very little in common with the ordinary or active trustee. The ordinary trustee is supposed to represent the interests of the beneficiary, and to represent those interests alone. According to law, his loyalty to the beneficiary must be undivided. So strict is the rule of undivided loyally that a trustee who has any interest inconsistent with his trusteeship may find himself called upon to explain and justify it. The trustee under a corporate indenture, on the contrary, has his rights and duties defined, not by any fiduciary relationship with the beneficiary, or bondholder, but exclusively by the terms of his indenture with the obligor, or the seller of the securities. This relation allows of great play in loyalty. Far from having an undivided allegiance to the beneficiary, corporate trustees may at the same time be acting as promoters, underwriters, bankers, financial advisers, bondholders, and creditors of corporations whose debenture holders they have ostensibly been selected to protect!
The trouble is not the deviousness of corporate trustees; it is in calling them trustees. This ancient and honorable word has what Cromwell would have called ‘a worm in it’ as applied lo corporate trustees. A highcourt judge once described them more aptly as stakeholders. They are bursars as well; but certainly not trustees.
When a corporation seeks to borrow money from the general investor public, it makes many promises, including the major promise to repay the loan, which are incorporated in a document called the trust, indenture. Somebody has to keep this indenture and the security behind it. And the logical depositary or stakeholder is a bank. Usually the underwriters parcel out trusteeships among friendly banks. The fee is not to be spurned, running up to $5000 a year; and, as only a few banks do a large business in corporate trusteeships, the number per bank runs high. For this fee the bank’s corporate trust department receives the bond coupons from the public as they fall due, and mails out in small lots the interest payments received from the corporate debtor.
Doubtless other mechanical duties are performed. If the corporation is unable to meet payments, for instance, the corporate trustee may issue certificates against bonds sent in to protective committees of the unfortunate creditors. But any helpfulness to the bondholder is rigidly ruled out. During the early ’thirties, correspondents used to write me and ask how X corporation could default when Z bank was ‘back of it.’ Rack of it — but only as a dummy! I was once told of a rebuke administered to a clerk in the investment department of a bank for not keeping up this dummy appearance in responding to information sought about an issue for which the bank was corporate trustee. The correspondent merely wanted to know when a forthcoming interest payment would be made. The clerk gave all the aid he could, and for his pains was reprimanded by his superiors, the order then being issued to the office staff that in future any such queries should be referred to the corporate trust department, which made the noncommittal answer its stock-in-trade, except when news was public.
One could go so far as to say with Bernard J. Reis, in his book. False Security, that the signature of a corporate trustee is the most insignificant part of the indenture. A trust officer brought this out under questioning at the SEC. He was asked these questions: —
You would say that the trustee has no duty to make any independent investigation of the company which is contemplating the issuance of new securities?
Or to see that the provisions of the indenture are carried out?
Or to supervise the management?
Or to check the issuing bankers?
The answer in every case was no.
This testimony merely underlined the revelations which had already been made in the courts. The leading ease had to do with one of Mr. Insull’s companies, the National Electric Power Company. This company issued $10,000,000 of debentures, and the Chase National Bank of New York was appointed trustee. As security for the debentures, the company deposited with the trustee the stock of certain operating companies. So far, so good. But in the indenture of trust executed by the company and the trustee it was provided that at any time the National Electric Power Company could withdraw lhe collateral and substitute something else. This, in due course, was done. And it was the substitution that caused the trouble. In place of the operating company’s stock, which included that of the New England Public Service Company, the obligor of the debentures handed the trustee the bonds of a certain holding company. In time the National Electric Power Company went bankrupt. So, unfortunately for the debenture holders, did the holding company, the worthless bonds of which went to the debenture holders in satisfaction of their claims, though the stock which was originally deposited with the trustee remained of substantial value. The debenture holders sued the trustee for recovery on the grounds that the substitution was evidence of bad faith and gross negligence.
However, the case, which came before the New York Supreme Court last year, was decided in the trustee’s favor. It was held that the bank had acted strictly in accordance with the trust indenture, wherein a substitution of the collateral was provided for. Not only so; the prospectus under which the debentures were sold stated that the debentures were secured by the deposit of the enumerated stocks ‘under and subject to the provisions of the indenture.’
Yet nobody seemed to regret the decision in favor of the trustee defendant more than the judge himself, Justice Samuel I. Rosenman! He simply had to obey the letter of the law. After giving judgment, however, he allowed himself the indulgence of some caustic references to such ‘particularly vicious’ trusteeships. To quote the judge; —
The clauses permitting substitution are so astutely tucked away that the average layman would have the greatest difficulty in discovering them. Not only the average layman, but seasoned financial experts like those who publish Moody’s Manual, apparently overlooked the power of substitution, for until after the collapse of the system Moody’s Manual, in describing these bonds and the security behind them, never mentioned the power or possibility of substitution of collateral.
Bondholders may not have got much profit from this and similar revelations of a system which, in Justice Rosenman’s words, ‘had all the potentialities of fraud upon innocent investors.’ They may, however, feel some satisfaction that an effort is now being made to protect a new generation of investors. At long last the SEC has prepared the way for legislation putting corporate trustees back on the trustee standard. A bill has been submitted by Senator Alben W. Barkley of Kentucky. It would prevent, trustees under indentures from having interests in conflict with their fiduciary obligations, and in general would transform corporate trustees into active, trustees. I am glad to see that the bankers are not opposed to it.