cases. But I can explain that better, perhaps, when we get to the committee print.

Conflicts of interest may be present if the trustee is a banking institution which has made loans to the issuer of the bonds which are out

standing when default impends or occurs. As bank creditor it owes an obligation to its depositors and stockholders to take all steps necessary to protect and preserve its loan irrespective of the injury which such measures might cause to others who were investors in the same enterprise. But as trustee for bondholders its duty may lie in the direction of taking prompt and vigorous action to protect the interests of the bondholders.

The impact on the securityholders of the conflict of interest arising as a result of the trustee being a short-term creditor usually will be greatest immediately preceding or immediately following default. But such conflict of interest may be detrimental to the securityholders on other occasions as well. One such instance is the case where the trustee is a bank creditor as well as trustee of a debenture issue which contains a negative pledge clause. The issuer of the debentures may be faced with the necessity of incurring new long-term indebtedness in order to repay its bank loans. To float a new security issue the issuer may feel that, if it complies with the negative pledge clauses in debentures which are presently outstanding, it may have difficulty in selling the new securities. If the trustee of the debenture issue is likewise one of the short-term creditors to be paid with the proceeds of the new security issue, it can readily be seen how the self-interest of the trustee may result in its closing its eyes to the avoidance or circumvention of the negative pledge clause. In such situations the debenture holders are apt to find that their trustee is not a vigorous champion of their rights.

Senator BARKLEY. For the benefit of the record would you explain what you mean by the negative pledge clause? If you have done it elsewhere in your statement you need not do it now.

Commissioner DOUGLAS. I will make some comments on those clauses later.

Senator BARKLEY. Very well.

Commissioner DOUGLAS. A further danger lurks in affiliations which a corporate trustee may have with the underwriters of the bonds under its indenture. If it can exert influence upon the trustee, the house of issue may be able to conceal default and postpone action. Affiliated trustees might not accommodate a group hostile to the bond house, and could not be compelled to act unless bondholders massed that percentage of the total amount of outstanding bonds, as required by the indenture, and made demand on and furnished indemnity to the trustee. And a rival group could hardly do this because the house of issue possessed the only list of securityholders. Without such list, there would be small hope of organizing a substantial block of holders necessary to make the demand.

Such affiliations of the trustee with the underwriter, whose objectives in reorganizations are frequently incompatible with those of investors, tend to submerge the interests of the security holders and to make them subordinate to the wishes, desires, and possible selfish interests of the underwriter. The trustee will be either unable or unwilling to look at the situation coldly and objectively with a single eye to the protection of his beneficiaries.

To the extent, also, that the underwriter has an interest in securities which conflict with those which an affiliated trustee represents, the trustee is not an independent representative of his beneficiaries. Furthermore the underwriter may have reasons for concealing defaults when it would be to the best interests of the security holders to proceed forthwith to foreclosure, receivership, or bankruptcy. The underwriter may have junior securities to protect. It may have a market to maintain. It may have ties to the management which are so strong as to induce it to lull the security holders into a false sense of security. It may have a desire to obtain control over the whole reorganization when it does come and to conceal defaults until the reorganization stage is set, in order to obtain for itself the many emoluments that run to those who are able to control reorganizations. To the extent that the trustee is closely affiliated with the underwriter, the trustee shares the conflicts which arise out of these adverse interests of the underwriter. In sum, if trustees are to be expected to live up to the standards of conduct before and during reorganization which I have outlined, they cannot be allowed to possess antagonistic duties and loyalties to themselves as creditors or holders or representatives of conflicting securities, or to the management or its bankers.

TRUSTEE AS PERMANENT PROTECTOR

What I have said briefly concerning the activities and possible objectives of underwriters in connection with reorganizations has implications in addition to demonstrating the undesirability of affiliations on the part of trustees with such underwriters. These facts lead irresistibly, I believe, to the conclusion that only the corporate trustee, once it is freed of its conflicting interests and charged with active duties and responsibilities, can be relied upon as the agency which will supply continuing, uninterrupted, and effective protection to bondholders during the entire life of their security. Underwriters and distributors of bonds undeniably have a moral obligation to do all within their power to foster and protect the interests of the investors for whom they have sold securities. But if the experience of the last decade has taught anything in this connection, it has been to demonstrate that too often conflicts of interest arise to inhibit proper performance of this obligation by underwriters. Furthermore, no permanence or guaranty of continuity attaches to the life of the ordinary underwriter. The Banking Act of 1933 ended the securities affiliates of commercial banks. The fortunes of underwriters are subject, also, to the ordinary hazards of competitive business. What investors in securities issued under indentures require is a permanent, stable, financially responsible fiduciary institution as their agent and representative.

The protection of investors will require not only permanent trustees but also, as I have said, some safeguards against impecunious and irresponsible trustees. This is essential lest the safety of funds be jeopardized and the administration of these vast trusteeships fall into irresponsible hands.

In summary, it seems to us necessary in the public interest and for the protection of investors that trustees under indentures should be disqualified from acting or serving if they have or acquire conflicts of interest incompatible or inconsistent with their fiduciary obligations; and that they should be transformed into active trustees with

the obligation to exercise that degree of care and diligence which the law attaches to such high fiduciary position, along lines which I indicated earlier.

INADEQUACY OF PRESENT LAWS

The Securities and Exchange Commission is at present vested only with limited powers which can be exercised to the end of reaching these desired objectives. While by virtue of the powers vested in it under section 19 of the Securities Exchange Act of 1934 it can by appropriate rules and regulations change the listing requirements for securities on national securities exchanges or by order alter or supplement the listing rules of such exchanges, there are practical limitations on such program. In the first place, such listing requirements would reach only the rather limited classes of securities dealt in on such exchanges. In the second place, the Commission cannot in justice to exchange trading, set up such strict standards for the indentures and the trustees acting thereunder as to make it more attractive for issuers to stay off the exchanges and thus to be able to use any form of trust indenture and any trustee desired. Hence, its powers under section 19 of the Securities Exchange Act of 1934 are inadequate for effectuation of the proposed reforms. Uniform legislation by Congress is accordingly necessary.

As in the case of the Securities Act of 1933, the point of administrative control should be the time of the public offering of securities. The legislation which is needed would be an extension of and supplement to that act. Such legislation should provide for the setting of minimum standards for indentures under which securities are issued and publicly offered and qualifications for those undertaking to act as trustees for such security issues. It should forbid the use of the mails or any means or instruments of transportation or communication in interstate commerce for the sale of securities issued under indentures, unless these indentures and the trustees thereunder meet the prescribed standards.

These remedial and administrative measures are in substance embodied in the Barkley bill. If the Congress enacts that bill, the result would be that investors will have in the trustee an active guardian of their interests throughout the entire life of the security. There would be carried over into the corporate field the standards of fiduciary relationships comparable-at least after default-to those which have long obtained in personal trusts and with which these professional trustees have had a long and rich experience.

I have indicated the problem of reform in this field, not for the purpose of condemnation of corporate trustees but in an attempt at an objective appraisal and critique of the institution of the trust indenture in its modern setting. The program of reform envisaged in the Barkley bill, as I read it, is not new and revolutionary. Nor should it have any disruptive effect on legitimate business. It brings to fruition the constructive thinking that has taken place in the corporate trustee field during the last decade. These ideas are by no means exclusively those of the Securities and Exchange Commission though we heartily endorse the Barkley bill as a constructive and progressive measure. But as important is the fact that the philosoply of the bill meets the highest standards of the corporate trust business. Enlightened and constructively minded corporate trust institutions

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have, especially in recent years, moved toward the same general objective in their thinking and planning. This is evidenced not only by the various groups from the profession who have been working on the problem but also by the various codes of ethics which they have from time to time been promoting for general adoption and approval. The thought here has been toward uniformity of practice and policy. But progress in that direction has at times been difficult and slow in view of competitive conditions which prevail.

The corporate trust business like most other business has in it various levels of competency and efficiency. Here, as elsewhere, there has not been complete uniformity in practice. The problem of the responsible and enlightened corporate trust institutions has been to raise the standards of the entire business to the higher level. Great strides toward that objective should be made by reason of the Barkley bill since it affords uniformity of standards throughout the entire business and makes possible the injection into substantially all of this type of trust business the highest standards which prevail today. Experience may reveal the need for additional strength in parts of this bill but as it stands it is, in my judgment, an adequate, practical, and workable measure. With this, I am confident, responsible trust

officials will agree.

You can obtain from them first-hand information on that. Senator BARKLEY. Before you go into the details of the bill, I would like you in a word or two, for the record and for the benefit of the committee as well, to state two or three typical conditions leading up to the issue of these indentures and the appointment of trustees.

The CHAIRMAN. Where abuses exist.

Senator BARKLEY. Yes; for instance, the things that lead up to the issue of these debentures and the appointment of a trustee; just two or three instances that lead up to it.

Commissioner DOUGLAS. I believe I understand correctly what you desire. Take the case of a person who has a piece of ground and wants to build an apartment house on it. He has no funds. There is in business an underwriter a person who devotes himself to the problem of getting those funds. He and that underwriter get together and decide on the amount of the issue and the types of provisions to be contained in the indenture. They hire their lawyers and sit down and draft what normally would be called a mortgage or a trust indenture a mortgage on that piece of property and on the building that is to be erected thereon, and perhaps, also, on the personal property to be placed in the building.

It is conceivable that a thousand persons will buy those bonds; maybe more. Perhaps they are in thousand-dollar denominations; perhaps one-hundred-dollar denominations. That mortgage cannot run to a thousand different people; or even if it could, some of those people will die or sell and what not, with the result that there would be a constantly shifting group of mortgages. That would be unworkable. So the practice developed of executing the mortgage, so to speak, to the trustee. In the real-estate field it was too commonly the practice to have that person an individual working for the house of issue, and he would take the conveyance and hold the property under mortgage in trust in trust for all these security holders.

The person who owned the property, the mortgagor, and the trustee would be the two parties to that contract-that is, the mortgage.

The

house of issue and the obligor or mortgagor would select the person who was to be trustee. That person, together with the obligor, the issuer, would execute the mortgage and would, from time to time, release to the house of issue or the obligor the securities that had been sold. That is the general mechanism.

Senator BARKLEY. That would apply in the case of a real-estatepromotion scheme.

But let us have an instance of a corporation that is already in business; it has already outstanding securities in the way of stock and maybe bonds. I would like to have you put into the record just a brief explanation of the condition existing in connection with such a company where debentures are issued.

Commissioner DOUGLAS. The company has, say, outstanding stock and also a first-mortgage-bond issue. It needs some temporary financing, say, 3-year or 5-year financing, perhaps for certain capital requirements or what not. They discuss the problem with their customer, who is the underwriter, and they go over the situation thoroughly to determine what the interest rate should be, what the pricing should be, taking into consideration market conditions, money rates, and so on, and they decide on the protective clauses that the debenture holders should have. Here is one type of problem that will arise where the debenture issue is not to be secured: The issuer may execute another mortgage, thus taking away from the debenture issue some present unmortgaged assets. That raises a question of broad policy. Do the debenture holders need, for their protection, a provision in the indenture which forbids the issuer from mortgaging away those assets or which provides that if such a mortgage is issued the debenture holders will receive pro-rata protection thereunder?

That is a matter of business judgment. The issuer and the obligor decide that in view of a variety of circumstances they may or may not put in such a protective clause. So they work out the various protective clauses that they think the debenture holders need, and they draft an indenture. There is no property pledged under it, but the rights of the debenture holders are spelled out in it, and the trustee is set up to be the focal point for enforcement of the obligations of the debentures and also the protector of the investor against the violation of any of the covenants in the indenture.

In other words, the situation in the real-estate field that I have indicated is in miniature what the usual commercial transaction of an industrial enterprise is on a much larger scale.

Senator BARKLEY. Of course, the relative rights of the holders of these debentures are involved either subsequently in the liquidation or in reorganization, to a very large extent?

Commissioner DOUGLAS. Yes; that is true.

Senator HUGHES. "Debenture" is a very much misleading term, is it not? And it is also meaningless.

Commissioner DOUGLAS. There have been undoubtedly many debenture issues that have contained misleading and meaningless protective clauses.

The CHAIRMAN. You speak of real-estate transactions being miniatures of larger ones. Have there not been in late years most flagrant abuses in that field, where stockholders of these debentures have practically lost everything they invested?

Commissioner DOUGLAS. Oh, there is no doubt about that. There have been.