The work of corporate trust departments

Preface

The tendency of modern financial institutions is toward specialization. ‘To-day, the typical trust company or bank in a financial center is a complex organization composed of a number of departmental groups, each busy in its own sphere of activities. The intensive study by each department of its special problems has featured the development of banking institutions in recent years. ‘This concentration on technical requirements, while in no wise lessening the desirability of a broad knowledge of banking, does emphasize the need and the value of trained specialists.

The reading matter on the subject of the fiduciary services of trust companies and banks on behalf of corporations, and in relation to corporate securities, is somewhat limited. Several excellent studies of corporate trusts and certain special phases of corporate agency functions have been made by lawyers of high standing. In the standard books on banking practice some space has been allotted to the trust department. Valuable collateral reading is to be found, also, in the various textbooks on investments and corporation finance. But there is little material in printed form from which those engaged in this line of work can learn the viewpoint and observe the operating methods of others in the same field.

The purpose of this book is to discuss the various services rendered by corporate trust and corporate agency departments, and to describe the methods of a large financial institution in this connection. In treating these subjects, emphasis has been laid on how things move, but the reasons why have not been overlooked. A study of this nature might be carried to much greater length. For instance, the legal questions which arise could be discussed authoritatively only by counsel, and such discussion would result in substantial expansion of the book. In respect of legal matters the authors have been content, in most instances, to give quotations from the writings of lawyers of recognized standing and to make references and citations which will assist the reader to an understanding of

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IV 7 PREFACE the,point involved. The aim has been to include such material as will be useful to trust officers and others charged with carrying on the corporate fiduciary activities of their institutions. In reaching a decision as to the relative value of the various subjects, the authors have been guided by their own practical experience and by the valued suggestions of their banking associates and their friends in the legal profession. While written chiefly for those engaged in this special field, it is felt that enough of a background has been given to make the book helpful to students specializing in banking and kindred subjects.

With the kind permission of ‘The Bell Telephone Company of Pennsylvania, one of its mortgages has been used as a basis for discussion in the chapters on the form of corporate mortgages. This mortgage, with names and dates changed, but substantially as executed, has been reprinted in the appendix. Likewise, other documents which appear throughout the book conform, except for minor alterations, to those used in actual practice. ‘The records illustrated are those of the Bankers Trust Company, New York.

The authors are appreciative of the assistance derived from the various sources referred to in the text. Grateful acknowledgment is due to the author’s associates at the Bankers Trust Company who cooperated in reading and revising the text of many chapters, and to Mr. Roberts Walker and Mr. Jesse E. Waid, of Messrs. White & Case, for much valuable assistance in both the practical and the legal aspects of the subject.

Contents

CHAPTER PAGE

I—CorRPORATE FIDUCIARIES; ORIGIN, GROWTH,

AND ORGANIZATION... l

Chapter II Corporate Trust Services; Trusts Based On The Corporate Mortgage

Definition of mortgage.-—When a borrowing corporation conveys real property to a trustee, in trust for holders of the obligations to be issued, the instrument usually is called a “mortgage” or ‘“‘deed of trust.” ‘The word ‘mortgage,’ ” writes Mr. Roberts Walker,’ “is from the French: ‘mor?’ and ‘gage, ‘dead’ and ‘pledge.’ A pledge .. . is the transfer of property by Hodge to Sadler, to secure to Sadler the payment of money loaned by him to Hodge or to secure the performance of some other promise made by Hodge. In its origin, a pledge involved transfer of possession. A pledge may, however, be made without surrendering possession,’ and, generally speaking, this is true of the modern corporate mortgage, regarding which Mr. Walker continues: ‘“The name ‘mortgage’... is a rank understatement. The modern form of document not only has the effect of a mortgage, but is also a collection of agreements, covenants, and ‘don'ts,’ whereof many have no logical relation to the familiar process of mort- A 99

Paging). 6. |

In many instances, however, the company does not mort gage its property to secure the payment of its bonds. It may pledge securities, claims, receivables, chattels, or other personal property as collateral, or it may simply agree to observe certain conditions. “he instrument under which the bonds are issued is then given the title, ‘trust indenture,” “trust agreement,” or some similar designation. Its purpose is the same in all cases, that is, to evidence the contract between borrower and lender and to afford the security or assurances required by the lenders in addition to the company’s promise to pay.

Types of mortgages.—As any corporate mortgage or similar instrument exists solely to protect the obligations issuable

1“The Modern Corporate Mortgage” (a lecture delivered at Princeton University, March 2, 1917).

thereunder, it seems appropriate to draw attention first to some of the more important types of corporate obligations. The title of a bond usually gives some indication of the security for the issue, although unqualified reliance on the title would be unwarranted. Investors are learning to judge bonds on their merits; they are more interested in equities than in bond titles, and are coming to realize the necessity for an examination of the exact position of each issue.

While no reputable corporation would countenance a misleading description of its bonds or mortgages, it is customary to select the most attractive designation consistent with the status of the issue. Suppose a corporation wishes to issue bonds under a new mortgage which will be a third lien on its property. It might term the new mortgage a ‘“‘general mortgage,’ or a “refunding mortgage,” or label its bonds with some title descriptive of one or more of the outstanding features of the issue; but it would not be likely to apply the title “third mortgage.”

Detailed consideration of the various types of bonds and their purposes belongs in the study of investments? and corporate finance, but a brief outline is given below of the types of mortgages and bonds which are met with more frequently in trust department work. ‘The descriptions which follow relate to the characteristics of the various mortgages at the ttme of execution. It should be borne in mind that a mortgage with a title implying a junior lien position ofttimes, through the retirement of prior lien obligations, becomes a senior lien. For example:

Assume that in 1925 a corporation executed a general mortgage and issued bonds thereunder maturing in 1950; prior mortgages at that time consisting of a first mortgage securing bonds maturing in 1935; and a first and refunding mortgage securing bonds maturing in 1940, so that the general mortgage really constituted a third mortgage of the corporation. When the first mortgage bonds are paid in 1935 the general mortgage bonds will move up to second rank,

2 A comprehensive classification of bonds appears in Lawrence Chamberlain’s “Principles of Bond Investment”; also in W. E. Lagerquist’s “Investment Analysis,” Catalogue Description of the More Important Bonds, pp. 675-697.

and in 1940, upon payment of the first and refunding bonds, the general mortgage bonds will move into first place.’

Some of the characteristics which, at the time of execution, may apply to mortgages of the types indicated, are briefly mentioned below.

First mortgage.—This is the most common and simple form of corporate mortgage, constituting a first lien on the property pledged. In some cases, a first mortgage covers all property of the debtor corporation, and, in other cases, only specified property. Sometimes, when the mortgage covers all property of the corporation, it also provides that its lien shall attach to any property of the corporation thereafter acquired. Such a provision, usually referred to as an “‘after-acquired property clause,” is found in various types of mortgages, and is not necessarily restricted to first mortgages.*

Second mortgage.—In past years it was usual to have second, third, and even fourth mortgages on property of the same corporation, particularly railroads, the title of the mortgage indicating the relative rank of the lien which it created. To-day trust companies are sometimes requested to act under indentures, the titles of which embrace the words ‘second mortgage,’ but seldom under those with titles containing words indicating a lien junior to a second mortgage. This is to a considerable extent due to the current practice of giving to bonds complicated titles which, while technically correct, sometimes fail to emphasize the distance of the lien which they create from the property covered by the mortgage.

First and refunding mortgage.-—Such a mortgage is a first lien on a part of the property pledged (sometimes a very small part), and a lien on other parts of the property subject to prior liens. Its lien position on the remainder of the property

8 This illustration relies wholly on precedence in time. The mortgage might permit a prior lien to be created.

4For a further discussion of the “after-acquired property clause,” see C. W. Gerstenberg, “Financial Organization and Management of Business,’ Chapters XII and XIII. |

5 According to the White & Kemble Atlas and Digest of Railroad Mortgages (supplement issued in 1924), the Great Northern Railway Company mortgage, dated May 1, 1911, securing an issue of first and refunding mortgage bonds is a first direct mortgage on 2108.92 miles; a first collateral lien on 543.33 miles; a second direct mortgage on 4112.82 miles; a third direct mortgage on 663.09 miles.

is improved as the prior liens are paid off, through the refunding operations provided for in the mortgage, that is, the retirement, at maturity, or otherwise, of prior obligations, through the issuance of first and refunding mortgage bonds.

Refunding mortgage.—This title is inadequate, as it does not indicate in any way the rank of the lien, except by the inference that in due time prior liens will be removed through refunding operations under the refunding mortgage.

General mortgage.-—This term, while indefinite, indicates, in most cases, a general lien on all or most of the property subject to several existing liens.

First and collateral mortgage.—This title indicates a first mortgage on a part of the property of the company and an interest in other property through pledge with the trustee of stocks or bonds, frequently those of subsidiary or controlled companies.

Prior lien mortgage.—This title indicates a lien prior to other obligations of the debtor, and, usually, although not necessarily, a prior lien mortgage secures the prime issue of the company.

Purchase-money mortgage.’—As the term implies, such a mortgage is given in part payment of the purchase price of property. It usually constitutes a first lien on the property purchased, but not necessarily on all, or any other, property of the mortgagor. |

Leasehold mortgage.—Such an instrument constitutes a lien on a leasehold interest in real estate, but not on the real property itself. Because title to most permanent improvements on real estate passes with title to the real estate on which such improvements are located, and because default | of the lessee under the terms of the lease creating the leasehold may destroy the debtor’s title to the actual value behind such a mortgage, many trustees have had unsatisfactory expe-

6 White & Kemble report that the Great Northern Railway Company general mortgage, dated January 1, 1921, is a first direct mortgage on 238.11 miles; a second direct mortgage on 2,108.92 miles; a second collateral lien subject to the first and refunding mortgage on 543.33 miles; a third direct mortgage on 4,112.82 miles; and a fourth direct mortgage on 663.09 miles.

7C. W. Gerstenberg, in “Financial Organization and Management of Business,” p. 207, gives an interesting chart to illustrate the process of acquiring property by use of a purchase-money mortgage.

riences with this type of mortgage, although there are outstanding exceptions.

Income mortgage.—A mortgage of this kind provides for an issue of bonds on which the interest is payable only if earned by the debtor. Such a mortgage usually contains a formula for the determination of net earnings. ‘The title of the mortgage seldom indicates the lien position, which is usually well down the scale of the mortgagor company’s indebtedness. Interest may be “cumulative” and, if unpaid, continues as a charge against the company secured by the lien of the mortgage.

There are many other titles such as “improvement, Xtension,” “unified,” or “‘adjustment”’ mortgage, each title giving an indication of the purpose of the bond issue thereunder; but unless such titles are further amplified they give no indication of lien position. ‘There are also numerous variations and combinations of these titles, such as “first lien and general mortgage,’ “refunding and improvement mortgage,” “consolidated and refunding mortgage,’ and so forth. These titles convey, to some extent at least, the purpose and nature of the issue.

Indentures, other than mortgages.—Many issues of corporate securities are secured by lien on, or by the pledge of, personalty; that is, property other than real estate. Two typical examples of issues of this character follow.

Collateral trust bonds’ which are secured by the pledge with the trustee, pursuant to the terms of the indenture providing for the issue, of specified collateral, usually securities.

Equipment obligations,’ usually issued by railroads, but sometimes by steamship or industrial companies, and secured by the equipment, such as locomotives and cars, specified in the indenture under which they are issued.

Unsecured obligations. — Some corporations are strong enough financially to borrow without giving a lien or pledging securities. Such issues are, however, made under trust agreements and are classed as “unsecured.” They are gen-

8 See Chapter XII. 9See Chapter XII.

erally given the title of ‘“‘note,” “debenture,” or “‘certificate of indebtedness.”’

Income and adjustment bonds are sometimes unsecured, and, conversely, notes and debentures occasionally are given mortgage or collateral security, or they may contain a covenant that no subsequent mortgage will be made unless the notes or debentures are secured equally with the subsequent issue.

Further variation in titles.—Each of the titles just discussed, when applied to the bonds issued under the mortgage or indenture, usually is combined with other terms indicating special features of the issue. Some examples of these terms acer

Sinking fund—indicating that the indenture provides for a fund to be’paid periodically to amortize the debt in whole or In part.

Serial—indicating maturity in periodical ‘ installments. This should not be confused with the word “‘series.”” Many of the modern mortgages authorize the issue of bonds in series, the terms of each series, such as interest rate, sinking fund, maturity, and so forth, to be determined by the corporation at the time each series is authorized. ‘The different series of bonds under a given mortgage are usually distinguished by a designating letter, such as A, B, C, and so forth. ‘“Serial’’ issues, however, while they may have a distinguishing letter, are usually issued to the entire authorized amount at the time of, or shortly following, the execution of the trust indenture. The payment of each installment as it matures, say, annually or semi-annually, serves as a ‘‘sinking fund.’’ Equipment obligations are the best example of serial issues.

Convertible—indicating that the issue gives to the holders thereof, on terms stated in the indenture, the option of converting the bond into another security, usually the common stock of the debtor company.

10 Francis Lynde Stetson, in “Some Legal Phases*of Corporate Financing, Reorganization, and Regulation,” p. 6, makes this statement: “In England, according to Palmer [Sir Francis Palmer], the term ‘debenture’ seems to comprehend all serial obligations of the corporation, whether or not secured by a charge, and whether or not issued under a trust deed, those issued under a trust deed being generally styled debenture stock. In this country, the term ‘debentures’ has come to mean any class of serial obligations of a corporation mot secured by a specific lien upon property.” Py

Participating—indicating that the issue is entitled, on stated terms, to receive, in addition to the specified interest, some share in the profits of the debtor company.

Guaranteed—indicating that the issue bears the guaranty of some party other than the borrowing company.

Joini—meaning a security issued by two or more companies.

Gold—meaning that the bonds are payable in gold coin of a specified standard of weight and fineness.

Sterling, franc, etc.—indicating the currency in which the issue is payable.

For example, an issue entitled, “First and Retunding Mortgage Convertible Sinking Fund 5% Gold Bonds, Series C,” would, by its title, imply: (1) that the bonds are secured by a mortgage which is a first lien on some property and which provides for the refunding of certain prior liens, and through the refunding operations an improvement of the original lien position; (2) that the bonds are convertible at the holder’s option, but on terms set forth fully in the mortgage and briefly in the bonds themselves, into some other issue, usually stock of the debtor company; (3) that the bonds are subject to a sinking fund, the terms of which are fully set forth in the mortgage, and briefly summarized in the bonds, providing for the amortization or partial amortization prior to maturity of the debt represented by the bonds; (4) that the bonds of this series bear interest at the rate of 5 per cent annually; (5) that the principal and interest of the debt represented by the bonds is payable in gold; and (6) that the bonds under this mortgage are issued in series of different terms, Series C being presumably the third series.

Mortgage, etc., as used herein.—The use of the word ‘mortgage’ technically should imply that the instrument is a lien on property. However, as most of what follows in respect of corporate mortgages applies with equal force to agreements providing for the issue of other kinds of corporate obligations, it will serve our purpose to understand that, except where the context clearly indicates a limited use, subsequent references to mortgages include other similar types of agreements, and likewise references to bonds and bondholders are to be understood as embracing, respectively, bonds, notes, debentures, or other principal obligations and the holders of such obligations.

In principle a corporate mortgage is essentially the same as the simple mortgage of an individual on his home. In fact, corporations may, and frequently do, borrow money on the security of the familiar real estate bond and mortgage, provided the amount required is not too large to be advanced from one source. But the present-day corporate mortgage provides a means by which a loan may be divided among a great many lenders through the issuance to participants in the loan of numerous separate bonds, all secured by a single mortgage to a trustee.

Individual trustees for corporate mortgages.— [he earlier mortgages were made to an individual trustee (or perhaps to two individual trustees); but it soon became evident that this practice was unsatisfactory, as many times the individuals so named were not available when their services were needed, and they might die during the term of their trusteeship. Consequently, in recent years, it has been the almost invariable custom to appoint a bank or trust company as trustee. An individual co-trustee sometimes is joined with the corporate trustee, because of statutory requirements ;” but, except upon default, his duties are merely nominal, the corporate trustee being charged with the active duties. It is customary, where no reason exists for making a distinction, to refer to the corporate trustee as ‘‘the trustee.”’

Qualifications of trustees.— Corporate fiduciaries are nowadays appointed as mortgage trustees to the practical exclusion of individual trustees, due not alone to the permanence of their corporate form, nor even to the qualities of strength and stability which we are accustomed to associate with financial institutions, for of equal or greater importance are the advantages which result from the appointment of an adequately, equipped trustee whose experience enables it fully to understand the responsibilities, and properly to perform the duties involved in the trust relationship. To these desirable qualities, namely, permanence, strength, stability, experience, and facilities, let us add one more—impartiality.

11 See page 23..

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Trustee’s duties.—The paramount duty of the trustee is to protect the rights of the bondholders, and its actions under a mortgage should always be considered from the viewpoint of the bondholders’ interests. It is only natural that. the trustee should also wish to administer a trust to the satisfaction of the mortgagor. Until default the trustee has a contract with the mortgagor and should live at peace with it. However, in the event of a conflict between the mortgagor’s and the bondholders’ interests, the trustee must respect its duty to the bondholders. Every carefully drafted mortgage will clearly define the duties and responsibilities of the trustee which, in later chapters, will be considered in detail. But it seems appropriate to point out at this time that, under a typical corporate mortgage, the responsibilities which the trustee accepts are definitely limited. Its position is well stated by Mr. William Lilly:” “Assume that the mortgage is made to a trust company. Though in form the trust company is the mortgagee, it appears that it is mortgagee, not to secure a loan it has made but to secure the loans made by a multiplicity of people who receive the bonds of the corporation as evidences of their rights as creditors of the corporation. The trust company is mortgagee for the benefit of the bondholders. ‘The position it occupies in the transaction is called that of ‘trustee.’ It is not to be assumed, however, that its position exactly corresponds with that of the trustee of an estate left by a will who is charged with the duties of managing the estate. The trustee under a corporation mortgage, as will be seen, does not accept a responsibility of this kind. In essence, unless and until the corporation defaults in its obligations to the bondholders, the trustee has no active part to perform excepting purely formal administrative duties.”’

The scope of the trustee’s duties varies with the mortgage, consequently, the trustee must examine closely into the mortgage provisions in each case. In our discussion herein we shall consider a typical mortgage; other instruments might impose greater or less responsibility on the trustee. The trustee does not seek to avoid responsibility which it might properly accept, but to have the mortgage clearly set forth its duties and responsibilities so far as it is possible to do so. Of course, the provisions in the mortgage relative to the

12 William Lilly, “Individual and Corporation Mortgages,” p. 78.

trustee should be considered in the light of the many legal decisions on the subject. It might well be said that trustees generally would be willing to accept a much greater degree of responsibility than at present, if adequately compensated for the risks involved. It is probable that the trustees’ services will be gradually broadened as the value of more extensive service is recognized.

Chapter III Acceptance Of Corporate Trusts

Securing business; preliminary negotiations.—How and where is corporate trust business secured? What are the necessary steps in establishing such a relationship? These questions naturally arise at the very outset of our study of this subject.

Corporate trusts, from the standpoint of solicitation, are a most difficult subject. Appointments as trustee are receiyed from two main sources: (1) the borrowing corporation, and (2) the bankers who underwrite or sell the issue; and, strange as it may seem to those who are not familiar with this field, it is the bankers who, in the majority of cases, control the appointment. Few corporations desiring to borrow on a large scale through the medium of a bond issue will undertake, themselves, to sell the bonds to the public. The business of selling securities is highly specialized, and one or more of the bond-selling houses is usually requested to consult with the officials of the corporation, in determining the details and terms of the proposed issue. ‘The entire issue is then sold by the corporation to a bond house or underwriting group at a price fixed by mutual agreement, or at times the sale is made after competitive bidding by as many of such houses as may submit an offer... The successful bidder and associates, if any, then offer the bonds to the public at a price intended to net a profit to the underwriters commensurate with the risk and service involved. The practice has grown among the banking houses of inserting in the underwriting contract a provision that the trustee shall be nominated by the bankers. ‘There are two reasons for this practice: (1) the bankers are interested in selecting as trustee an experienced and efficient guardian of the rights of the bondholders; and (2) the appointment, in the eyes of banking institutions with fiduciary powers, is desirable business which the bankers like to place with their own friends among the banks and trust companies.

1p, F. Jordan, in “Investments,” Chapter XVII, discusses the work of syndicates and bond-selling houses.

Investigation of proposed trusteeships——Unless the proposed mortgagor is already a client in good standing, any offer of corporate trust business should be carefully investigated. The trust company should satisfy itself as to the character and ability of the corporation’s management and the reasonable expectancy of success in its operations. In some cases it may be desirable to obtain credit reports and to request the corporation to submit financial statements. The trust company also should be assured as to the standing of the bankers who are to underwrite the issue.

Qualification in states.—One of the first questions in considering the offer of a trusteeship under a mortgage on real property is whether the trustee is qualified to act under the laws of the state or states in which the property is located. This problem, while purely legal, requires constant vigilance, because of the wide variation and constant change in state laws. It would be most embarrassing to the trustee, as well as expensive, and perhaps seriously detrimental to the bondholders if, when occasion arose to proceed under the provisions of a mortgage, it developed that the trustee could not act, because it was not qualified under the laws of the state in which the mortgage must be enforced.

Individual and corporate co-trusteeships.— ‘Those states which have legislated against ‘‘foreign’’ corporate trustees (corporations organized under the laws of other states), by prohibiting them from enforcing trusts in the state courts or otherwise restricting their activities, cannot similarly restrict the individual citizens of other states.* Consequently, one

2The United States Constitution, in Section 2 of Article IV, provides, “The citizens of each state shall be entitled to all privileges and immunities of citizens in the several states.” ‘This is the basis for the constitutional point that no state can prohibit a natural person, citizen of the United States, from acting as trustee within its borders. Some state statutes relating to trusteeship make the distinction between natural persons and corporations of the several states.

When the United States Constitution was adopted, business was scarcely done at all in the corporate form, and the question of corporations holding trusteeships in foreign states certainly was not in mind. Corporations have grown up under special statutes of the several states and, in this connection, are not at all to be compared with natural persons. It has never been held to be unconstitutional for a state to restrict the business that a foreign corporation may do therein, or to prescribe the conditions upon which it may exercise its powers. In other words, the states may admit “foreign” corporations on the states’ own terms.

or more individuals often are joined as co-trustees with the corporate trustee. ‘he situation is sometimes met by appointing, a9 co-trustee, a trust company or bank situated in the state in which the mortgaged property is located. Generally speaking, an individual or corporate co-trustee has no active duties to perform unless and until proceedings are undertaken to enforce the mortgage. Even in this event, while the proceedings may necessarily be had in the name of the co-trustee, this situation is almost without exception directed by the corporate trustee and its counsel. Frequently a mortgage delegates to the corporate trustee the power to name a successor to the individual trustee in case of the death or resignation of the individual originally designated, or permits the appointment of a co-trustee in case of need.

Restrictive state statutes—Iwo or three illustrations of the attitude of several states toward the exercise of fiduciary powers by foreign trustees may not be out of place:

Some years ago Indiana passed a statute requiring that intra-state trusteeships must be exercised by citizens of Indiana. [he statute has been held unconstitutional, so far as natural persons residents of other states are concerned; but prior to the decision on the constitutional point it was the basis for joining a resident of Indiana as co-trustee under mortgages on property in that state.

In Missouri the restrictive statute has taken a somewhat different tack, and prohibits foreign corporations from enforcing trusts of real estate in the courts of Missouri, unless joined by a resident trustee. The prohibition is not recognized by the Federal courts, but it has not been held unconstitutional.

California statutes along this line started in 1913 with an attempt to deny to foreign corporate trustees the right to certify bonds secured by property in California. ‘The validity of this statute was immediately questioned, so far as it concerned acts to be performed outside of California. However, during the time when the law remained in effect it resulted merely in the appointment as trustee of individuals, officers of trust companies which, but for the law, would have been selected in their corporate capacity. Subsequent modifications of the California statutes have resulted in a situation wherein individuals or California trust companies are joined as co-trustee.