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up for consideration. Mr. Douglas is here, and I am sure the com

I mittee will find him completely conversant with this whole subject, with the background, the history of the investigation and the need for it and for the legislation. Mr. Page and Mr. Hanes are here from the American Bankers' Association, and other gentlemen are here who will be heard if they desire or if the committee finds it necessary.

I think the bill has been worked out through cooperation with the Commission and the bankers' association, and I do not think that there will be any serious opposition to this bill. There may be some provision that might be changed here and there, but substantially the bill meets the approval of the whole financial world, as I understand it, and those who will be expected to come under it and be governed by it.

The CHAIRMAN. The subcommittee will be very glad to hear from you, Mr. Commissioner.

STATEMENT OF WILLIAM 0. DOUGLAS, MEMBER OF THE SECURI

TIES AND EXCHANGE COMMISSION, WASHINGTON, D. C., ACCOMPANIED BY EDMUND BURKE, JR., MEMBER OF THE STAFF OF THE SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, D. C.

Commissioner DOUGLAS. Mr. Chairman, if you desire it I might take a few minutes to sketch, in brief terms, the general background of the corporate trustee problem, to acquaint the committee with the point of view and the general philosophy expressed in the Barkley bill.

The CHAIRMAN. Yes; I think you should.

Commissioner Douglas. If at any time I get too far away from specific detail I wish you would remind me; and thereafter I can go through, in such detail as the committee desires, the committee print of the Barkley bill, indicating what the major provisions are.

As a general background, in our judgment the problem presented by the Barkley bill is that of providing greater protection and safeguards for investors under trust indentures. It has been conservatively estimated that 40 billions of dollars of securities nationally distributed have been issued and are outstanding under trust indentures.

The inadequacies of law and of corporate practice which exist in connection with these instruments have created national problems which require present solution. To these the Barkley bill is addressed. To these problems the Securities and Exchange Commission in the past 2 years has given intensive examination and thought, and, last summer, submitted to Congress a report on the subject.

The current interest in the matter is evidenced also by the studies undertaken during the same period by special committees of the American Bankers Association and of the Investment Bankers Association, and by the earnest endeavor of the leaders among the corporate trustees to raise the standards for their profession.

The Commission, I would like to say, has received from these groups many constructive suggestions and ideas in the course of its study of these problems.

EVOLUTION OF TRUST INDENTURE

The trust indenture is the product of a hundred years' evolution in the methods of financing commercial and industrial development by the widespread sale and public distribution of corporate securities. It is undeniably a convenient adjunct in the sale of issues of bonds, debentures, and notes wherever assets are to be pledged or mortgaged to secure such issues. The practice of giving security for a loan is, of course, as old as the history of private enterprise itself; as investment needs and markets grew, the sale of secured bond issues merely gave a broader scope to a very old institution.

Senator BARKLEY. Mr. Chairman, if I may interrupt just a moment: There is no objection to giving members of the press copies of this confidential print, is there?

The CHAIRMAN. I think not.

Senator BARKLEY. It has not been agreed to, but it is a matter of public information.

The CHAIRMAN. It is really your final submission?

Senator BARKLEY. Yes; but of course it is subject to any change that the committee may want to make. If the public is interested, I think you might as well let them have it.

Commissioner Douglas. At a relatively early date in the development of the trust indenture device, the idea became fixed that it was preferable, for both legal and practical reasons, to make the pledge or mortgage of assets run to a single title holder, a trustee, instead of directly to the constantly shifting and changing body of persons who were the owners of the securities. Instead of having many mortgagees, there was therefore only one—the trustee- so that in the event of a default the borrower would not be subjected to the harassment and expense of many foreclosure actions arising out of the one default. Then, too, by placing in the trustee the principal right, and duty, to bring foreclosure actions when these became necessary, the convenience of the bondholders was also served, and a great deal of duplication of effort and expense avoided in regard to the enforcement of their security.

As an incident to this, if claims had to be filed by the bondholders to protect their interests in a judicial proceeding, the trustee was a convenient agent to perform this necessary function. In this way there were gradual accretions upon the powers of the trustees.

The trust indenture is the instrument embodying the obligations of the issuer; the powers, duties, and responsibilities of the trustee; and the powers and rights, as well as the disabilities, of the owners of the securities.

The vesting of important powers in the trustees was inevitable in the nature of the trust indenture device. The security holders themselves are generally widely scattered and their individual interest in any one issue is likely to be small. For example, I might say parenthetically that in our study of real-estate issues, all of which were uniformly secured by these indentures, the average holding by investors was about $2,000. They do not have the initiative, the knowledge, the time, or the funds necessary for the constant and continued safeguarding of their investments.

The trustee, on the other hand, soon came to be, and is generally today, a single large bank well equipped by training and competence for its responsibilities under these indentures. And it is to a great

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extent empowered by the provisions of the typical trust indenture to take quick and vigorous action in a variety of ways to protect or enforce the security underlying the bonds, debentures, and notes.

Under the very terms of the trust indenture the trustee alone is capable of effective action in this connection. And it is the only agency avowedly designed for the protection of security holders during the entire life of the security from the date of its issue down to the final reorganization or final payment of the security.

RELIANCE ON TRUSTEE

It is to be expected, then, that upon the public distribution of bonds' debentures, or notes secured by an indenture the institution which will act as trustee is frequently a prominent one. Persons are undoubtedly influenced, to some extent at least, in their purchase of securities by the size, prestige, and financial strength of the trustee. The individual security holder often assumes that the trustee is his alter ego in safeguarding his rights; the prominence of the trustee, therefore, ostensibly lends some assurance that the investors' interests will be adequately protected.

The necessity for reliance of the security holder upon the indenture trustee for protection of his investment is rather complete. It is common knowledge that purchasers of securities, though they are legally bound by the terms of the trust indenture, seldom examine its terms unless they happen to be large and substantial investors. In any event their effort to do so would be futile.

The significance of the elaborate provisions of a trust indenture can be understood only by specialists. The investor relies for the adequacy of the security underlying bonds, notes, and debentures, upon the reputation of the issuer, the underwriting bankers, and the trustee.

But for honest, faithful, and efficient operation of the provisions of the indenture, reliance must be primarily placed upon the trustee as representative of the securityholders.

The issuer—that is, the debtor-can hardly be expected to make adequate safeguards against weak or meaningless protective clauses. To a large degree the creditor and debtor interests are incompatible in this regard. And the underwriter, though admittedly performing at times a protective function, has too often been motivated by factors not compatible with the objectives of the prospective investors.

If a larger degree of protection is to be afforded in these situations, it must come from the trustee under the indenture.

Furthermore, investors buy securities and retain no effective control over the issuer's performance of its obligations in respect of them. Such control is in practice surrendered to or assumed by the trustee, which is invested with power to certify securities; to supervise the deposit and withdrawal of collateral and the application of the proceeds of the bond sale; to take action on the investor's behalf when default occurs; and, in short, to do everything upon which the protection and the enforcement of a bondholder's security depends.

In theory the result should be decidedly beneficial to the securityholder. He should benefit because of increased expedition, economy, and efficiency; and the trustee should be able to act vigorously and effectively under broad powers granted in indentures, without the delay and difficulty of consulting and reconciling the individual opinions of securityholders.

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NEED FOR GREATER RESPONSIBILITY

But in the past practice too frequently has fallen short of those objectives. Examination of the provisions of modern indentures and their administration by trustees has disclosed that the reliance of investors is to a large extent unfounded. Too commonly, though by no means always, trustees have not exercised the powers which are the bondholder's only protection. Though they have taken many powers designed to protect the bondholders, they have too frequently rejected the duty to exercise them. By means of involved provisions which by and large are unintelligible to the investor, the express duties of the trustees have been cut down, until too frequently they are practically nonexistent. And, furthermore, exculpatory clauses have been used in such a way as to leave trustees harmless despite their inactivity and, at times, despite even negligent conduct.

In other words, the responsibilities which trusteeship normally imports have too commonly been absent. The so-called trustee that was left has been a mere stakeholder and clerical agency. This perhaps was the intention. But the current of modern thought, including that of enlightened and progressive trust institutions, is that it should no longer be the case.

The Commission's study and investigation, and its report to the Congress, have made plain the critical conditions which have prevailed in segments of this field and the basic and the fundamental changes which should be made. A brief discussion of some of the major points emphasized by our report will, I believe, illuminate the nature of the present legislative problem and the Barkley bill which is designed to solve that problem.

They are, first, the degree of care and activity which the trustee should exercise, and, second, the problem of conflicting interests.

DEGREE OF CARE NECESSARY

(1) First, as to the degree of care, it seems obvious, for example, that where assets are pledged or mortgaged to secure a bond issue, the first essential is to see that the mortgage is properly recorded. Individual investors cannot do so. In any case it is natural for them to rely upon the issuer and the trustee for such matters.

Yet issuers may, deliberately or out of carelessness, fail to discharge this obligation.

A study was made by the Commission of some 424 typical indenture provisions in this connection, and there was found in 86 percent of the indentures an express provision to the effect that the trustee was under no obligation to see to any recording, registry, or filing of the indenture.

It would require no radical step to place this responsibility upon the trustee. It is the fact that in practice, though not in law, the conscientious trustee assumes that he has that duty in spite of the exculpatory clause in the indenture. To place that obligation on all trustees would, then, be doing no more than what is already done by the more meticulous and conscientious corporate trust institutions.

(2) Furthermore, it is a common duty of corporate trustees to certify bonds issued under indentures, at the time of their issuance. In legal effect this means no more than a guarantee that the particular security is issued under a described indenture, and is not a counterfeit or an overissue.

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But frequently conditions precedent to certification are set forth in the indenture, relating to the deposit with the trustee of a certain quantity or quality of security; the existence of certain stated earnings of the issuer; and the like.

Though the consequences to investors are definitely harmful if these conditions precedent are not fulfilled, the trustee is normally given protection against liability for certifying in such cases if it obtains an adequate certificate from an officer of the issuer attesting to the happening of the conditions.

This means, in effect, that the trustee need act merely mechanically, need take no steps to investigate the adequacy of the certificates, and may proceed to certify bonds, notes, and debentures without careful inquiry and analysis.

So long as such conditions precedent can be safely circumvented and violated by issuers on account of acquiescence or passivity by the trustee, such provisions are inadequate. They promise investors a measure of protection which in practice may turn out to be unreal, unless actually exercised in the manner followed by a conscientious, high-standing corporate trustee.

What is required is an obligation upon the trustee to use reasonable care and diligence in ascertaining the truth of representations of the issuer in this connection.

(3) When a bond issue is sold to raise money for a particular and stated purpose, some supervision must be exercised by the trustee over the application of such proceeds. Yet in our examination of typical trust indentures, the Commission found that in more than half of 413 indentures examined there was an express statement that the trustee was under no obligation to see to the application of proceeds. And in only about 24 percent of the cases were the proceeds of the issue received by the turstee and disbursed.

The history of real-estate financing, for example, points to the tragic results which this absence of supervision may cause to investors. It seems clear that they should be given all practicable assurance that the funds which they pay are invested in the manner represented to them when they bought their securities, so that they will end up by owning an apartment house rather than a hole in the ground.

While it is conceded that it is impracticable for trustees to follow the proceeds of an issue so closely that it becomes involved in routine business of the issuer, there are proper cases, some of which we outline in our report, in which the trustee without undue hardship to itself or to the issuer can supervise the application of borrowed funds. This would demand merely the exercise of reasonable care on the part of the trustee, a standard of conduct to which the more reputable trustees have already come to adhere. This seemingly minor reform would provide investors with protection against practices which in the past have occasionally taken heavy toll and caused undue damage.

(4) Furthermore, some trustees have relied upon purely technical performance of their responsibilities, so as to slight such negligible duties, for example, as publication or announcement of notice of default, upon the nonpayment of interest, failure to meet sinking fund payments, delinquencies in the payment of taxes, and the like.

At times trustees have not bothered to see that they received from issuers schedules showing the issuer's assets and liabilities in a manner

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