REGULATION OF SALE OF SECURITIES

TUESDAY, JUNE 22, 1937

UNITED STATES SENATE,

SUBCOMMITTEE OF THE BANKING

AND CURRENCY COMMITTEE,
Washington, D. C.

The subcommittee met, pursuant to adjournment on Tuesday, June 15, 1937, in the Banking and Currency Committee room, Senate Office Building, at 10:30 a. m., Senator Robert F. Wagner (chairman of the committee) presiding.

Present: Senators Wagner (chairman), Bulkley, Hughes, Herring, and Townsend.

Also present: Senators Alben W. Barkley and William H. Smathers; Mr. Ronald Ransom, vice president, Board of Governors of the Federal Reserve System; Mr. William O. Douglas, a Commissioner of the Securities and Exchange Commission, Washington, D. C.

The CHAIRMAN. The committee will come to order. Mr. Ransom, I believe, wished to read into the record a certain letter.

STATEMENT OF RONALD RANSOM, VICE CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, WASHINGTON, D. C.

Mr. RANSOM. Mr. Chairman, this letter is addressed to you as chairman of the committee, signed by me as vice chairman of the Board of Governors of the Federal Reserve System. It is dated yesterday. [Reading:]

References appearing in the press this morning give the impression that a report prepared by the Federal advisory council relative to the trust indenture bill had been submitted to the Banking and Currency Committee of the Senate at my suggestion or with my advice.

The facts are that the report emanates entirely from the council, which is a statutory group composed of as many members as there are Federal Reserve districts. The directors of each Federal Reserve bank annually select one member. The council is empowered to confer with and to make oral or written representations to the Board of Governors of the Federal Reserve System concerning matters within the Board's jurisdiction.

As a matter of courtesy, the council asked the Board whether there was any objection to the submission of this report to your committee and the Board replied that it had no objection. The views expressed in this report, however, are those of the council.

I desired to make this clear in order that there might be no impression that the report is an expression of my own views or those of the Board of Governors.

Senator BARKLEY. What is the date of that so-called report? I have never seen it.

The CHAIRMAN. It just came in today; that is the reason you have not seen it.

Mr. RANSOM. It is dated June 17.

Senator BARKLEY. Is this a report to the committee or to the Wall Street Journal? It seems they got it first.

Mr. RANSOM. They frequently do.

Senator TOWNSEND. Is it a critical report?

The CHAIRMAN. We shall have it read to the committee later on. Mr. RANSOM. I simply wanted the position of the board to be clearly before the committee.

The CHAIRMAN. Thank you very much.

STATEMENT OF LOUIS S. POSNER, MEMBER OF THE MORTGAGE COMMISSION OF THE STATE OF NEW YORK, NEW YORK CITY

The CHAIRMAN. We shall hear from Mr. Posner. Mr. Posner is a commissioner of the Mortgage Commission of the State of New York. Perhaps, Mr. Posner, you will state your position and connections yourself. And will you give a brief statement of your background for the purposes of the committee?

Mr. POSNER. You referred to the Mortgage Commission of the State of New York. I am a member of that commission. Some 2 years ago, when it commenced operations in New York, we took into our jurisdiction nearly 700 millions of defaulted guaranteed mortgages probably the largest private trust ever administered by a public office, if not indeed by a private group.

Senator TowWNSEND. How is the commission constituted?

Mr. POSNER. It is constituted of three members appointed by the Governor.

Senator TOWNSEND. They are appointed by the Governor, you say? Mr. POSNER. Yes.

Senator TOWNSEND. For what purpose?

Mr. POSNER. For the purpose of administering and conserving these properties covered by mortgages. These are mortgages whose payment is guaranteed by mortgage guaranty companies, all of which defaulted in their guaranties. The mortgagors themselves defaulted. Some 250,000 holders, distributed throughout the country-and mainly in New York-hold these shares or participations in mortgages. Nobody seemed to have the authority adequately to handle the situation; and after perhaps a year of agitation this body, for the first time, I think, created under the laws of any State, was created in New York. We administered the property. We foreclosed and took care of management and saw that the property was put in proper shape, reorganized the mortgages and terms, and studied what the properties could produce, and the like. Of course, in many of those situations we found the equivalent of what you had here, in the way of trustees under mortgage indentures.

My own appearance here, I should say, has nothing to do with that; because I speak wholly in a personal way, and with no relation to the mortgage commissioners. The subject of trust indentures for more than 30 years in New York has interested me very greatly; and some 10 years ago, my practice having been largely in the financial field until then, I decided to write upon the subject of indenture trustees having found that there had not been any legal writing on that subject in this country.

Senator TOWNSEND. What you may say has the approval of the other commissioners?

Mr. POSNER. Oh, no.

The CHAIRMAN. No; he is appearing as a private individual and as a man who has studied the situation himself. I am very familiar

with his work in that connection.

Mr. POSNER. Yes; purely as a personal opinion.

About 10 years ago I wrote an article on the subject of liability of the trustee under the corporate indenture, published in the Harvard Law Journal of December 1928, and this winter, in response to a request from the editors of the Yale Law Journal, I wrote a summary of the law of the country, entitled, "The Trustee and the Trust Indenture", which appeared in the March issue of the Yale Law Journal, which included a discussion of the recommendations of the Securities Commission in its report of June of last year.

I am very glad to be invited to express my views on the present Trust Indenture Act. I have taken the occasion to prepare a brief summary, which I hope will not be found unduly long; because I have, myself, a very sharp appreciation of what time means. But the subject is one which, from my studies-and even without any study-it is plain is of prime importance in this country. As late as the end of 1934 there were some $37,000,000,000 of these issues represented by trust indentures. To those who may not realize the situation, that gives an idea of its importance-an amount substantially in excess of the then public debt of the United States.

The proposed Trust Indenture Act appears to be well designed to accomplish the important objectives foreshadowed in the report of the Securities and Exchange Commission in June of last year. In the main its provisions appear to be adequate, and to safeguard the investing public in the many directions in which it has long needed protection. The origin of the difficulties so adequately portrayed in the Securities and Exchange Commission report of June last is not difficult to trace. The trust indenture as we now know it is the product of hardly more than 50 years of American experience. As the devices of finance varied and multiplied, the trust indenture kept pace in size and complexity until it has become in fact the largest of all legal documents. With the growth in volume of finance the powers of the trustee to take action were correspondingly enlarged, but the duty of the trustee to take action was not commensurably increased. That, I think, is the origin of the difficulty in which the whole situation is now involved.

The trustee invariably protected itself against liability for inaction by the use of clauses which created such liability only in the event of gross negligence, willful default, or bad faith. The modern trust indenture fairly bristles with such exculpatory clauses. In this way the investing public not infrequently was deprived of the protection which it needed. The day of reckoning was bound to come and I think it has come. I am in hearty accord with many of the provisions of the act, well designed to remedy these conditions and to enforce appropriate standards. At the same time I must confess my belief that certain of the provisions of the act appear to go beyond the necessities of the case, are unnecessarily rigid, and may at certain points result in hurt to the investors whom it is designed to help.

Senator TOWNSEND. Have you any modifications?

Mr. POSNER. Yes; I shall suggest two or three of the essential ones here.

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The provisions concerning maintenance of lists of bondholders I regard as of an importance exceeded only by the higher degree of care which the trustee will be required to exercise. If these two improvements alone are accomplished, without more, the great labors of the Securities and Exchange Commission will have been justified. Lists of security holders have long constituted a sort of battleground between the "ins" and the "outs", with the lists as the fortress of the "ins." These lists were so valuable for unified and effective action that, as the Commission's report shows, occasionally those who possessed such a list would succeed in extracting for its surrender the impudent price of a general release to themselves against any claims of wrongdoing. This was notably so in the real-estate mortgage situation. With such lists readily available, no longer will the bondholder, first concerned, be the last consulted. Upon bondholders the burden of ultimate loss must fall, and to them should be given the earliest opportunity, in cooperation with the trustee, to preserve the status, conserve the assets, and reduce the loss.

Since I intend to speak only in general terms of the proposed act, though I am prepared to discuss it with such particularity as this committee may wish, perhaps I should say at this point that I do not agree with Mr. Untermyer's view, expressed at your hearings last week, that the provisions with respect to these lists are inadequate. If they can be strengthened, well and good, but I believe that section 7 (f) covers the situation fully, and the reservation to the Commission's judgment of the terms and conditions upon which the lists may be made available to security holders is a precautionary clause that emphasizes the care with which this entire paragraph was drawn. Nor do I agree with Mr. Untermyer that the trustee be required to give notice to security holders of all defaults whatsoever that may

occur.

I noticed, Senator Barkley, that you were particularly interested at last week's hearing on that point; and it seemed to me, if I may say so, that your views were completely justified, if I correctly interpreted them.

There are many situations of delicacy where a default is technical, or goes even beyond that, or occurs under circumstances which promise early remedy, or at least does not threaten immediate serious consequences. Premature notification in such cases might well precipitate a disaster that could otherwise be weathered, and inflict serious and avoidable damage upon the investors. In the past, shielded by the general immunity clause, trustees have ventured to withhold notifications of default in certain situations and have granted the obligor a reasonable period within which to repair the default. have been many such instances in the past whereby financial collapse has been avoided and the security of the investor safeguarded, due to the sound judgment of the trustee in withholding notification. Personally, I would have been interested to see some such instances disclosed in the Commission's report. It is my opinion that section. 7 (k) is altogether adequate.

There

I am in full accord, however, with Mr. Untermyer in opposing the provision of the next succeeding subsection (1) which grants discretion to a court, in a security-holder's suit, to assess reasonable costs, including reasonable attorney's fees, against any party litigant, having due regard to the merits and good faith of the suit or defense.

Senator HUGHES. I am greatly concerned about that matter, as to whether the provision is sufficient.

Mr. POSNER. The provisions of the statute seem to safeguard that, rather thoroughly. In the main, the decision as to whether there shall be notification or shall not be notification, depends-if I am correct upon the requirements and regulations of the Securities and Exchange Commission. There is only a narrow margin, I feel, for the trustee's independent action in that regard. As to notices of all defaults, subdivision (k) of section 7 covers that.

Senator HUGHES. Yes.

Mr. POSNER. It seems to me that the margin is really very narrow. I think there is really very little danger there. You must remember that heretofore trustees may not have been as quick to notify security holders of defaults as they should have been; but now they are under a high fiduciary duty, and when default occurs you may take it for granted that they are not going to run any risk of possible claims against them by violating their duties in a fiduciary capacity in not telling the security holder what he ought to know. Indeed, I think you should protect them in their liability, because it is only upon the bondholder that the loss would fall, if there is a premature notice. That is the "rich-picking" time in the market, for those who know that the default is technical, when the great bulk of security holders could not be notified of that. And if the trustee considers whether not to notify, so as to protect the security holders, or to notify so as to protect itself, in case of such a required choice the trustee will notify, whatever the result may be and protect itself. I think the burden is wholly upon the shoulders of the trustees.

Senator HUGHES. I think probably you are right about that. Mr. POSNER. I have said that I am in accord with Mr. Untermeyer's suggestion regarding the provision which grants discretion to a court, in a security-holder's suit to assess reasonable costs, including reasonable attorney's fees, against any party litigant, having due regard to the merits and good faith of the suit or defense.

This is presumably aimed at the so-called strike suits. As a matter of fact, such suits brought by aggressive bondholders have often served valuable ends and resulted in the recoupment of considerable sums. This fact is recognized in the S. E. C. report. It is not sufficient to say that the assessment of costs and fees is not mandatory but rests in the discretion of the court. Such litigation is usually difficult, often intricate, and always expensive. One who seeks to assert in a law court what he deems to be his rights and those of his fellow investors should be unhampered in the opportunity to do so and should not be faced with the threat of such costs and fees. The provision is directly contrary to the policy of our American law and I think the clause should be eliminated.

With certain specified exceptions, the act takes control of all issues of securities. It requires that all be governed by trust indentures "as to which an application for qualification is effective." The indenture can thus become qualified only if the application therefor filed with the commission shall show conformity to the provisions of the act and the regulations adopted by the commission pursuant thereto. The commission may issue refusal orders until it does thus conform. In this manner the commission can regulate and govern all indentures so as to eliminate the clauses and provisions which its