specified in their indentures, even though this was an essential element in checking on the issuer's obligation to security holders to maintain a stated ratio of assets and liabilities.

These are acts which constitute defaults by the issuers. Yet 93 percent (some 391 out of 420 of the indentures examined by us were found to contain a standard provision that the trustee could shut its eyes to the existence of any default until formally notified of it by a specified percentage of the bondholders-a prime example of putting the cart before the horse.

Such type of provisions should, by and large, in our judgment, hereafter be avoided. Reasonable care and conduct on the part of trustees in matters such as these are required, so that security holders may be the better apprised of the true condition and expectations of the enterprise in which their money is invested.

The trustee must assume the affirmative obligation of taking all such steps as are reasonably necessary to advise security holders of impending or existing defaults.

I will revert to that complicated and difficult matter again when we get down to the specific provisions of this bill.

INADEQUATE DUTIES ON DEFAULT

Throughout the life of its trust many occasions arise for the exercise of a trustee's powers and responsibilities. These occasions will increase in frequency and importance as the period of reorganization or liquidation draws near or arrives; and as we will show, when we get down to the provisions of the pending bill, there is quite a distinction between the functions of the trustee prior to default and the functions of the trustee subsequent to default. But even in these reorganization situations, trustees too frequently have been inactive.

The CHAIRMAN. Do you mind a question now and then?
Commissioner DOUGLAS. Not at all.

The CHAIRMAN. I am not going to ask very many. Some little while ago you spoke of trustees in some cases failing to register or record a mortgage.

Commissioner DOUGLAS. I was speaking not so much of any prevalent failure of trustees to do that, as of provisions in the indenture which did not require the trustee to do that.

The CHAIRMAN. Did you find cases actually where there was a neglect to record?

Commissioner DOUGLAS. Yes; there are such cases. I do not want to leave the impression that those cases are widespread and numerous. I say that there are occasional cases, but I think they are of importance in this connection for the reason that when they do arise they are cases where great hardship is occasioned.

The CHAIRMAN. I agree with you that there ought to be some definite obligation, and I wondered whether that was really neglected in many cases.

Commissioner DOUGLAS. In many, many cases it is not. Where it has been neglected, great hardship or great loss has occurred. But I do not point that out as one of the prime abuses or the sole occasion for this legislation. Other abuses transcend that in importance.

Senator BARKLEY. But it is sufficiently prevalent to justify the inclusion in the law of a requirement that the trustee look after that? Commissioner DOUGLAS. I think so, sir; and I think the trustees

themselves, as they can tell you better than I can, agree on the principle of that.

The CHAIRMAN. The obligation ought to be somewhere; that is

sure.

Commissioner DOUGLAS. Yes. As respects these reorganizations, the lack is not so much one of power as of affirmative duties. Trustees are generally given ample powers by their indentures to bring suit to collect principal, to foreclose, and to enforce all other rights under the indentures. But instances of trustees not taking such action unless and until they are forced to do so by bondholders have been too common in the past. Ninety-three percent of the typical indentures which the Securities and Exchange Commission examined (391 out of 420) provided expressly that, although defaults of one sort or another had occurred, the trustee had no duty to foreclose or to initiate other judicial proceedings or any other action specified in the indenture, unless enough bondholders to make up a stated percentage of the principal amount of securities then outstanding made demand upon it.

That percentage I think runs pretty close, in most cases, to 25 percent. To obtain that percentage you normally are faced with the necessity of forming a protective committee.

In more than half of the cases (226 out of 391) the trustee, by express provision, still retained the power to choose the remedy to be pursued. Only if a specified, and higher, percentage of the bondholders demanded it, could it be compelled to take the particular type of action which those bondholders desired.

A further barrier to action is also not uncommon. Even after all that I have related has been complied with the trustee may still refuse, and the indentures expressly permit this, to take any action which is likely to involve it in expense or liability unless the security holders furnish it with indemnity. About 96 percent of the indentures examined by us contained such provisions.

Insistence upon the formalities of written demand and indemnity, despite the lien for all their expenses which trust indentures ordinarily give to trustees, merely delays necessary activity on the part of the trustee, as do the other unwieldy, cumbersome, and inadequate provisions which I have just outlined.

In our judgment and, I think, in the judgment of the leaders of the corporate-trust business, only by requiring a more active trustee who will move whenever the occasion demands without waiting for direction from the security holders will the latter be adequately protected.

All trustees should be required to do what in practice the vigilant trustee has done, that is, to act with that vigilance and thoroughness which it could be expected to exercise if it were protecting its own investment.

That is a general standard that is made more specific in the Barkley bill; and I will revert to that later on.

I have mentioned the exculpatory clauses in indentures which commonly afford trustees protection from all liability for negligence and all acts or failure to act, except for outright fraud or gross negligence. Such exculpatory clauses, all agree, have been too common.

It follows, in light of the trustee's mechanical duties and its absolution from real risk or responsibility, that the use of the word "trustee”

is indeed a misnomer. It is a misrepresentation to investors of the nature of the protection for which they are paying. The only remedy is to require a return to the theory that a corporate trustee is a trustee and that it should assume the duties and discharge the responsibilities of a trustee. That leads us again back to the specific requirements, the specific standards of conduct in the Barkley bill, to which I will refer later.

CONTRACTUAL NATURE OF INDENTURE

At present the kind of provisions I have described are regarded, as a matter of law, as parts of a "contract" between the trustee and the security holders. The trustee, however, is usually a passive participant in the drafting of this contract. The trustee is usually selected by the issuer or the underwriter, or by agreement of both. Commonly, the indenture is drafted by counsel for the underwriting bankers or the issuer, or both, and is then presented to the trustee for its acceptance. Out of 244 cases which we sampled, we found that counsel for the trustee drafted the indentures in only 16, and had some kind of participation in the drafting of 98. Even in these cases, the evidence would indicate that the trustee's concern was principally with the provisions relating to its own protection. A great deal of the fault for inadequate care of investor's interests must therefore be placed upon the trustee.

Bankers, lawyers, and courts have contributed to the evolution of these indentures. Almost exclusive consideration and weight have been given to the intent of the parties to the indenture. Accordingly, it has been assumed that the trustee could take or refuse to take practically any right or duty, power or privilege, which was agreeable to him and the issuer. It has also been assumed that this contract between trustee and issuer is binding on security holders on the theory that they acquire only such rights as the contract which these parties have made gives them. That is to say, the supposition is that the indenture evidences the intent of the security holders whose loans it secures. But that mutuality of intent which is assumed is in fact nonexistent. To the extent that the indenture is the product of the borrower, the underwriter or the trustee, only their respective intents are reflected therein. The individual purchaser of such security cannot normally bargain for special provisions. Nor can prospective buyers normally unite in anticipation of an issue, to exact desired terms. Inequality of bargaining power between investor and issuer is inherent in the very technique of security_distribution. Yet the courts in their treatment of the trust indenture have proceeded on the same basis as the draftsmen and have concluded that the indenture is a contract which binds the security holders even though they had no part in its making.

As in the case of other contracts involving persons not capable or not 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. The underwriting bankers have not afforded adequate protection to security holders against emasculating and oppressive provisions in indentures. Too frequently they are interested in acceding to the wishes of the issuer.

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.

The basic problem is to refashion the trust indenture for the purpose of according greater protection for the holders of bonds, notes, and debentures. 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.

These contracts which the trustee and the issuer make are in a real sense affected with the public interest. There should be added to the drafting table, so to speak, a fourth person representing the public interest and the interest of investors.

And that concept of another person added to the drafting table is the basic concept running throughout the whole Barkley bill, as I will develop subsequently.

CONFLICTS OF INTEREST

The second point that I mentioned was that of conflict of interests. The remedy for the problems in the corporate trustee field is not to be found merely in the substitution of active for passive trustees. A prerequisite to any contractual or legislative mandate for active trustees is that trustees not have material conflicts of interests, so that they are free to discharge their responsibilities actively and vigorously.

One conflict, not uncommon, is the identity of interest between the trustee and owners of junior securities or equity interests. This has been conspicuous particularly in the real estate bond field. There the trustees were usually officers, directors, or affiliated corporations of the houses of issue. The house of issue, as a result of advances made by them to meet payment of taxes, principal and interest, had acquired junior securities or equities in the properties. It was to the obvious advantage and self-interest of these houses to preserve these junior securities and equities against being diluted or wiped out by the bondholders whom the trustee represented. It could hardly be expected that the trustee, so closely identified with the house of issue, would take adequate steps to preserve the bondholders' position against these adverse claims of the house of issue. And it is a matter of record that the trustees did not. The many ways in which the inaction of these trustees served to protect the investments of the houses of issue are matters of record. Even though, at times, the effect on the security holders of a trustee's identification or affiliation with owners of junior securities or equity interests may be difficult to measure or ascertain, and may mean merely that the advocacy of the cause of the securityholders is less aggressive and more timid than it otherwise would be, yet it is clear that it is incompatible with the

fiduciary obligations of a trustee that it own or represent or be affiliated with those who own or represent securities which conflict with or are adverse to those of the beneficiaries of the trust. Divorce of the trustee from such adverse interest is essential.

Senator BULKLEY. In a general way, who are these trustees that you are talking about? Are they big bankers?

Commissioner DOUGLAS. They are, by and large, at the present time commercial banks which have trust departments. They are not exclusively commercial banks. The vast percentage of them are commercial banks. There are occasionally separate institutions that do nothing but a trust business and that do not do a commercial banking business. In the latter category is a very large institution in Chicago by the name of the Chicago Title & Trust.

Senator BULKLEY. But this complaint that you are making in general terms lies principally against banks, does it not?

Commissioner DOUGLAS. Take the real-estate field, for example. In the later stages of the Straus financing the trustee under the Straus issues was a bank. However, in many of the real-estate issues the trustee was not a bank, but an individual, and he was, in the Straus and some other cases, an employee of Straus or the house of issue. That was conspicuous in the case of real estate issues. The employee relationship made the trustee subservient to the house of issue; it made him a "vest pocket' trustee of Straus.

The CHAIRMAN. Did the bank select the trustee or have the influence to select its own employee?

Commissioner DOUGLAS. Oh, yes; the house of issue would name the trustee in that case.

The CHAIRMAN. There was a relation between them?
Commissioner DOUGLAS. Yes.

Senator HUGHES. Is not that true almost invariably?

Commissioner DOUGLAS. The issuer together with the underwriter selects the trustee. But in the real-estate situation the issuer was relatively unimportant. He was a little fellow that had a piece of property-very often an impecunious person though not always— and he would incorporate himself and his wife and his eldest son, and Straus would sell the bond issue. Straus was the real dynamo. When you go to the industrial field you do not find that situation precisely.

The CHAIRMAN. Do you find a lack of independence, nevertheless? Commissioner DOUGLAS. At times you do, and I will get to that. On the ownership of junior or senior securities by the trustee, where the ownership is of a substantial amount, I think all agree that the trustee should not at the same time be in a fiduciary relationship under the indenture; that is to say, if he is trustee under a first-mortgage bond issue and, say, owns the entire second-mortgage bond issue and has it in his own portfolio, he is not in position to protect adequately the first-mortgage bondholder against himself, the second-mortgage bondholder.

Senator BULKLEY. Is it always undesirable to have the same trustee for a first- and second-bond issue?

Commissioner DOUGLAS. I think as a general proposition it is. I do not think there is any disagreement on that. The provisions of the Barkley bill generally disallow that; although when we get to that we will see that there is an exception for a very small isolated group of