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that he does not have any investment in the securities whatever. Is that right?

Commissioner Douglas. He usually does not. He may, but that would be wholly incidental. He usually makes a commitment with the issuer to sell or to dispose of the particular security in question.

Mr. BOREN. Then he is in a sense a commission merchant?
Commissioner Douglas. He is a merchant; yes.

Mr. BOREN. Well, do you not think that the term "commission merchant” fits him in that he draws a commission on the sale of securities which he takes?

Commissioner Douglas. He gets his commission or his "spread." He commonly purchases the issue from the issuer or agrees to find purchasers for that issue; or he may merely agree to take all of the issue that remains unsold after the issuer has completed its offer.

Mr. BOREN. I think that answers my question, Mr. Chairman.

(The following summary of the deficiencies found by the Securities and Exchange Commission to exist in the present-day trust indenture was submitted by Commissioner Douglas, at the request of the subcommittee, for inclusion at this point in the record.)

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SUMMARY OF DEFECTS IN TRUST INDENTURES In the course of its studies made pursuant to section 211 of the Securities Exchange Act of 1934, the Commission examined more than 400 indentures of issuers of all types. There follows a brief summary of the deficiencies found by the Commission to exist in the forms of trust indenture now in common use. Page references are to the various parts of the Commission's report of this study.

1. Trust indentures frequently fail to provide the trustee with the necessary tools for making an effective check on the performance of even the more important obligations assumed by the obligor in the indenture.

Where property is mortgaged or pledged under the indenture, the first essential is to see that the indenture is properly recorded. Failure to do so may mean disaster for the bondholders. Nevertheless, in 86 percent of the indentures examined, there was an express provision to the effect that the trustee was to be under no obligation to see that such recording was effected. (See pt. VI, Trustees Under Indentures, p. 24.)

In many cases it is not only proper, but essential, that the trustee make some check upon the disposition of the proceeds of the bonds issued under the indenture. The trustee received and disbursed the proceeds in the case of one-fourth of the indentures examined by the Commission. In practically none of the remaining indentures was any machinery established for a check by the trustee upon the disposition of the proceeds. (Šee pt. VI, p. 127.)

It is also essential, in many cases, that proper machinery be established whereby the trustee may make an effective check upon the performance of the conditions precedent to the issuance of additional securities. The failure to make such a check may be definitely prejudicial to the bondholders. (See pt. VI, pp. 26–29.)

If the indenture fails to establish adequate restrictions and conditions upon the release and substitution of property mortgaged or pledged under the indenture, the bondholders may find, when trouble arises, that the assets upon which they have relied for security have been whisked away out of their reach. (See pt. VI, pp. 16–23.)

2. Indentures commonly failed to require the obligor to make reasonably informative periodic reports to the trustee. More than one-third of the indentures examined made no provision whatsoever even for annual reports by the obligor. (See pt. VI, p. 125.)

3. None of the indentures examined contained provisions requiring the obligor to file with the trustee information as to the names and addresses of the bondholders, or provisions requiring the trustee to make such information or the use thereof available to the bondholders themselves. Such provisions are an essential part of the necessary machinery for the transmission of information to the bondholders, and for the organization of the bondholders for the protection of their own interests.

I have already mentioned the impracticability of any attempt by the average bondholder to enforce his rights by individual action. Some form of concerted action, ordinarily through the formation of a protective committee, is not only advisable—it is essential, under the terms of the typical indenture provisions referred to in paragraph 5 below. And access to a list of bondholders is a practical prerequisite to concerted action. (See pt. I, Strategies and Techniques of Protective and Reorganization Committees, pp. 408–457.)

The obligor itself and its investment bankers now have practically complete control over bondholders' lists. (See pt. I, pp. 436–446.) The indenture trustee frequently has no list at all, or only an incomplete one, and even if it has a list, it is very likely to refuse to make it available to the bondholders except upon court order. (See pt. VI, pp. 130, 131.) Out of a total of 943 protective committees which reported to the Commission, nearly 88 percent obtained their lists of security holders from the underwriters or from the company itself. (See pt. I, p. 439.) Under the circumstances it is not at all surprising to find that protective committees are so largely composed of persons connected with either the issuer or its underwriters. (See pt. II, Committees and Conflicts of Interest, pp. 536, 537.)

Control of bondholders' lists has been a major basis for banker-management domination of the reorganization process. Section 7 (f) of the bill, even standing alone, would do much to restore to the bondholders control of their own destinies.

4. Not a single one of the indentures examined imposed upon the trustee any obligation to notify the bondholders of the occurrence of even the most serious defaults. (See pt. VI, p. 125.) In fact, although the trustee usually learns of a default before the bondholders do, nearly two-thirds of the indentures examined contained the so-called ostrich clause, which permits the trustee to shut its eyes to the existence of a default unless formally notified of it by the holders of a specified percentage of the bonds. (See pt. VI, p. 38.) The practical consequences are illustrated by the case histories which appear at pages 31 to 42 of part VI.

5. Indentures commonly make inaction the path of least resistance for the trustee, even where action is imperative, first, by absolving the trustee from any duty to act unless it receives notice of default, demand for action, and indemnity, from substantial percentages of the bondholders, and second, by protecting the trustee from liability even for its own negligence.

The trustee was generally given ample power to bring suit to collect the principal of the bonds, and almost invariably it was vested with the exclusive power to enforce the rights under the indenture against the property mortgaged or pledged thereunder. (See pt. VI, pp. 42, 43.) But practically all of the indentures examined absolved the trustee from any duty to act unless the trustee received a demand for action from upwards of 25 percent of the bonds, and indemnity against possible expense or liability, notwithstanding the fact that indentures commonly give the trustee a prior lien for such expenses and liability, upon the property mortgaged or pledged under the indenture or upon the proceeds of suit. (See pt. VI, p. 43.) I understand that the committees of trust institutions regard this sien as affording adequate protection. Further, under most of the indentures examined, even after the necessary demand and indemnity had been received, the trustee retained the power to elect the remedy to be pursued, unless the holders of a majority of the bonds directed it to take a particular type of action. (See pt. VI, pp. 43, 44.) In addition, practically all of the indentures expressly exempted the trustee from liability except for gross negligence or willful misconduct. (See pt. VI, p. 125.)

6. Finally, trust indentures rarely contained provisions prohibiting the possession by the trustee of interests which materially conflicted with those of the bondholders and not infrequently specifically authorized the trustee to possess such materially conflicting interests.

The foregoing summary is based upon our examination of more than 400 trust indentures in the course of our studies pursuant to section 211 of the Securities Exchange Act. In addition, the Commission has had occasion to examine a large number of indentures filed with it under the Securities Act, many of them filed after the publication of the part of its report in which those deficiencies were pointed out (June 18, 1936). The results of that examination clearly show that no substantial progress has been made in the correction of those deficiencies in the 2 years since that part of our report was published.

The more conscientious trust institutions will use their best efforts to protect and enforce the rights of the bondholders, within the limitations imposed by the deficiencies in the indenture itself, notwithstanding the fact that they could safely refrain from acting. But the traditional view is that the indenture trustee is merely a mechanical, clerical agency. (See pt. VI, pp. 4, 23.) The practical consequences, to the bondholders, of the adoption of such a view are illustrated by the case histories cited in part VI, pages 20-23, 48-61, 68, 69, and 129, and in part I, pages 329-341.

The obligor and its underwriters ordinarily control the lists of bondholders. They therefore are in the best position to galvanize a reluctant trustee into action, and to direct the action to be taken by the trustee. The net effect of the deficiencies referred to is to deprive the bondholders of control of their own destinies, and to vest such control in the underwriters and in the obligor itself. The correction of those deficiencies in the manner provided in the bill would make it possible for the indenture trustee and the bondholders themselves to take whatever action their interests might require, independently of the obligor and the underwriters.

The committees of the trust institutions themselves do not oppose the correction of those deficiencies. Any unselfish opposition, on the part of the underwriting houses, must in large part be based upon the theory that the bondholder should continue to rely, and to have to rely, almost exclusively on the underwriting house for protection. But if, when trouble arises, the underwriting house has ceased to exist, or if it fails to discharge its moral obligation, or if its judgment is in error, these deficiencies in the indenture itself constitute a serious handicap to any effort by the bondholders to work out their own salvation.

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Commissioner DOUGLAS. Now, this bill does not give the Commission any jurisdiction whatsoever over such matters as the wisdom of the issue or the amount of security to be mortgaged or pledged under the bonds, or the offering price, or the maturity date, or the interest rate, or the sinking-fund provisions. In other words, the Commission is not, under this bill, given power to pass upon the investment merits of particular securities. That is not the theory of it.

Nor does this bill give the Commission any power with respect to the enforcement of the provisions in these indentures. Under this bill, if it were the law, the Commission would be concerned only with those provisions which relate to the protection and enforcement of the rights of bondholders. Once an indenture has been determined by the Commission to conform to the standards of the statute, the work of the Commission will have been completed. After that date the Commission has no continuing jurisdiction over the corporate trustee; no continuing jurisdiction to take steps in connection with the enforcement of the various covenants in the indenture. The indenture, after it has been "qualified" under this statute, will be enforceable in the same manner as any other contract is enforceable, in the same manner that indentures presently executed are enforceable.

(Discussion of necessity for regulation resumed at p. -, infra.)

TIE-IN WITH THE SECURITIES ACT

Mr. EICHER. Mr. Douglas, will you point out right there a little more precisely just how this proposed measure will dovetail in with the jurisdiction that the Securities and Exchange Commission possesses now under the Securities Act and to what extent it adds to its jurisdiction.

Commissioner Douglas. By and large, Mr. Chairman, with very few exceptions, this bill is applicable only to those bonds and similar securities which now have to be registered under the Securities Act of 1933. There are a few exceptions that are not particularly important at this point.

Under the Securities Act, the indenture has to be filed and we have to examine it to determine whether or not there are provisions in it which ought to be disclosed in the prospectus or in the registration statement. We commonly require certain key provisions in the indenture to be so disclosed.

Under this bill there has to be more than the mere disclosure now required in the registration statement under the Securities Act. An application would be filed under this bill for the qualification of the indenture under which it is proposed to issue the bonds.

Mechanically, we have under this statute the same 20-day period that we have under the Securities Act. This is designed to provide the staff of the Commission with ample time to make

an examination of the indenture, and to check its proposed provisions against the standards of this statute.

The indenture to be qualified under this statute, comes into a position for clearance by the Commission at the end of the 20-day period.

There is this important distinction: Under the Securities Act our Commission can, and frequently does, issue stop orders against the further sale of secutities after the registration statement has become effective and after some of the securities may have been sold. That is done pursuant to the powers which we have, under section 8 (d) of the Securities Act, to stop the sale of securities where there have been material misrepresentations of fact.

Under the proposed bill the Commission will have no power, after the indenture has been qualified, to issue a stop order against the further sale of bonds to be issued thereunder. The reason for that is this. Under the Securities Act, disclosure, and disclosure alone, is the standard for clearance. Under this bill the standard is not merely disclosure. The test is whether or not certain of the provisions in the indenture meet the requirements of the statute.

Now, that indenture is a contract. After the contract has been made and some of the bonds are outstanding thereunder, it would be difficult, as a matter of law, to recall that contract and to remake it. So, after the indenture has once been qualified, the Commission, under this bill, cannot step in and issue a stop order against the further sale of securities issued thereunder. After it has been qualified, the indenture becomes a contract. Thereafter it is enforceable only by the bondholders, the trustee, and the obligor. The Commission cannot intrude, at any point of time thereafter, upon the enforcement of its covenants or the assertions of rights thereunder in any respect what

Now, since the Commission will not have the second line of defense, so to speak, provided by the stop-order machinery, it is considered unwise to impose a mandatory requirement that refusal order proceedings (the method by which the Commission may prevent an indenture from being qualified) be instituted within a shorter period of time than the 20 days provided in section 6 (c) of the bill, although in many cases-probably in most cases—the Commission will be able to complete its examination and give the issuer an opportunity to correct any defects in the indenture within a considerably shorter time. In any event, the obligor, under this bill, can insure that the indenture will become qualified at or before the time that registration of the bonds themselves become effective, by the simple expedient of filing the indenture, together with the information and documents required in the application, before it files its registration statement under the Securities Act. Most, if not all of such information and documents are of such a nature that they could easily be supplied in

soever.

advance of the filing of the registration statement. To the extent that they are not available at the time, the Commission will have the power to consent to the filing thereof by amendment as under the Securities Act and thus prevent delaying the qualification of the indenture. The registration statement now required to be filed under the Securities Act includes not only the form of indenture, but also most of the information and documents which would be necessary under the bill in connection with the examination of the indenture. Unnecessary duplication of such information and documents can be avoided by incorporating them in the application by reference to the registration statement, or vice versa, pursuant to rules which the Commission is authorized to make under section 8 (c) of the bill.

With the few exceptions that I have mentioned, the statute is set up mechanically in much the same way as the Securities Act, so that the proceedings under both statutes will in effect be a consolidated proceeding not involving additional time or confusion, or red tape. I think, from the point of view of the administrative agency, that this bill and the Securities Act are geared very closely together mechanically, so as to produce full efficiency in the operation of both.

LIMITED SCOPE OF INTERFERENCE WITH CONTRACT BETWEEN LENDER

AND BORROWER

Mr. EICHER. Mr. Douglas, this bill then does enter to a degree, at least, into the field of regulation of private contracts?

Commissioner Douglas. That is correct, Mr. Chairman.

Mr. EICHER. Is the constitutional authority for that power found in the precedents permitting regulations defining fair business practices, or is there a possibility that some of the power that you might exercise under the sanction of this bill would impinge the constitutional inhibition against the impairment of the obligation of contracts?

Commissioner Douglas. Well, it comes rather basically down to the question as to the power of the Congress to deal adequately with securities flowing in interstate commerce.

Under the Public Utility Holding Company Act of 1935, the Congress gave the Commission the power to pass upon securities being issued by registered holding companies and their subsidiaries. It gave the Commission standards such as whether the security was reasonably adapted to the earning power of the issuer, and it required the Commission to make findings as to the type of capital structure, the interest rate, underwriters' commissions, and so on. The theory of such provisions of that act was and is that some supervision or control is necessary to see to it that conservative investments are put out by these holding-company systems rather than securities that have little or nothing back of them. That is to say, the theory was and is that our economic welfare is dependent upon the pumping of private capital into enterprises. We cannot allow the reservoirs of private capital to be tapped recklessly. The Congress has the power to require that certain minimum safeguards be set up so that the interstate streams from those reservoirs of capital will not become polluted, or contaminated.

Certainly, if the Congress had the power to take that major step under, say, section 7 of the Public Utility Holding Company Act, it would, in our judgment, have the power to take the much lesser step,

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