Opinion ID: 232455
Heading Depth: 1
Heading Rank: 2

Heading: The Trustee-Bank's Appeal

Text: 34 1. From the Partial Sustaining of the Second Objection. This is the Bank's attack on the surcharges for the releases of cash which we have discussed above under the objectors' appeal from the dismissal in substantial part of their second objection. The Bank challenges any surcharge, denying that any security was in default and relying upon certificates of nondefault given by the debtor to it. 35 Of the two mortgages found to be in default, the Hillman Hotel and the Elmhurst-Hampton mortgages, the first in the face amount of $675,000 became in default upon the nonpayment of $11,000 of principal due August 1, 1930, and, as found by the Master, remained so to the Bank's knowledge until May 27, 1931. Upon this finding the first six releases of cash from October 31, 1930, through April 27, 1931, were improper. To this the Bank makes several answers. Relying upon its conclusion — rejected by us above — that a default of 60 days or less was immaterial, it asserts that the default did not actually occur until January 2, 1931; and the 60-day period of grace would thus afford protection for the first five releases. The basis for its contention is that the mortgage actually did provide for the payment of installments of principal on January 1 and July 1. But the property was a summer hotel deriving most of its income in the summer, and by a rider to the mortgage it was provided that the January installment would be deposited with the guarantor (the Prudence Company) on the preceding August 1. Failure to comply with this promise was surely a default in the mortgagor's obligations, as appears to have been settled in other Prudence cases, e. g., Prudence-Bonds Corp. v. State Street Trust Co., 2 Cir., 202 F.2d 555, 560. The Bank makes other claims: that the guarantor did collect the interest due August 1 and inadvertently failed to claim the principal due, and that the amount actually collected must be held by the guarantor in trust to satisfy the requirement of payment on the principal. None of these, it seems to us, can affect the basic and controlling fact that the mortgagor was not meeting its obligations as required. 36 To avoid the sixth or very substantial release of cash on April 27, 1931, the Bank contends that the default was cured by its sale on that date of the default to the guarantor for $11,000, together with a junior participation in the mortgage. The latter was an agreement by the Bank to accord the guarantor a participation in the mortgage to the extent of $11,000 in all respects junior to its own interests as trustee. But it could make no sale even before default, In re Prudence-Bonds Corp., 2 Cir., 102 F.2d 531, 534; and this seems only a plan whereby some one other than the obligor makes good the mere amount of the default in order to obtain a release and a weakening of the protection of the trust fund to the extent of the amount withdrawn, $525,450,000. Again the basic fact of the mortgagor's default remains. 37 The Bank also relies on a written expression of opinion by Prudence counsel that the transaction would be effective to erase the default and permit withdrawal of excess collateral; it cites Article V, § 1, of the trust agreement, protecting it from liability for action taken by it in good faith in accordance with the opinion of counsel. It did not, however, actually rely on this opinion, since it sought the advice of its own counsel, who replied hesitantly that, although this method of curing the default in the Hillman Company mortgage is not expressly provided for in the Trust Agreement and is perhaps not the most satisfactory method from the Trustee's point of view, yet he thought that the risk which you run in complying with the Prudence Company's request is slight. So dubious a backing for so dubious a method favoring the guarantor, whose interest adverse to the bondholders was perfectly clear, can hardly be considered a good-faith reliance upon the opinion of the guarantor's counsel. In fact the debtor itself had suggested to the original trustee some two years earlier with regard to this provision of Article V, § 1, that if an opinion of counsel is necessary, it should be the opinion of your counsel. 38 Surcharge for the first six releases being thus established, we turn to the situation as to the Elmhurst-Hampton mortgage, default in which has been held established below to support the surcharges for the remaining six cash releases from June 8 through August 17, 1931. This mortgage in the amount of $190,000 was divided by an ownership agreement into a senior participation of $160,000, denominated a first mortgage and held by the Trustee in the trust fund, and a junior participation of $30,000, held by others. In March, 1931, the attorney for the junior owners, wishing to foreclose because real estate taxes due November 1, 1930, and interest on the mortgage due March 1, 1931, remained unpaid, sought through an officer of the debtor and the guarantor consent of the senior owner as required by New York law. So this officer, on behalf of the Trustee as senior owner, gave this consent in writing, together with authorization and instructions to foreclose the junior participation. On March 26, 1931, a summons and complaint and lis pendens of an action of foreclosure in the name of the Bank as trustee and the junior owners against the mortgagor (who was not served) and others, including an intermediate transferee, who was notified, were filed in the office of the appropriate county clerk. Thereafter a title search showed that this transferee had itself transferred the record title to one Bortz by deed recorded on March 12, 1931. Consequently supplemental service was made on Bortz on May 12, 1931. The Elmhurst-Hampton mortgage provided that the whole of the principal sum should become due at the option of the mortgagee on default for 20 days in the payment of interest, but that written notice must be given of such acceleration of the principal. The Master has held that such notice was therefore not given until May 12, 1931. 39 At the hearings below the officers of the Bank denied all knowledge of these steps and no actual knowledge was brought home to them. It is true that on August 8 the attorney for the junior owners procured release of the mortgage papers by the Bank to him for the purpose of the action; but this was after all but the last cash release. The foreclosure went through, the premises were sold at foreclosure sale on October 9, 1931, and the junior owners received a small balance on their mortgage. The Bank did have knowledge of the defaults in payment of interest during the period covered by the cash releases from March 1 to October 20, 1931, because of the monthly collection statements it received early each month from the debtor. And the certificates of non-default which we discuss below were carefully limited to exclude reference to the interest defaults. On these facts both the Master and the district judge, albeit by somewhat different routes, held the Bank for the six releases made during the period of the default of this mortgage. The Bank challenges all the routes to this conclusion. 40 There are several theories urged in support of the result reached below. The one most extensively reasoned by the Master is that from the standpoint of the Trustee's obligation, the time when the power to call the principal became operable determined the time of default. Although the judge rejected this ground, holding that default in obligation as to the principal did not occur until an actual call was made, the rationale of the Master appears to be sound. He argues that the power to call the principal and the power to draw down excess of collateral are both powers in trust, to be more strictly construed as between trustee and beneficiary than between the property owner and his mortgagee. We have recently had occasion to hold that indenture trustees, assuming the high obligations of a trustee to the investing public, should be held to a standard of conduct required of such fiduciary. Dabney v. Chase Nat. Bank of City of New York, 2 Cir., 196 F.2d 668, 671. So here, when the Trustee learned that collateral for the protection of its beneficiaries was in a weakened condition because of a default in the assumed obligation of the mortgagor, and it could proceed at once to protect its fund by taking legal steps to enforce the obligation, should it be able not merely to stand by, but also to weaken its fund by releasing cash? A negative answer seems more consistent with the obligations of a trustee. Moreover, it makes for the more coherent scheme of operation of the trust, for it avoids all question, such as occurred here, as to just when a call occurred and when its duty to protect its fund became critical. In fact, the Court of Appeals has so ruled against a company issuing guaranteed first mortgage certificates. Fisher v. Title Guarantee & Trust Co., 287 N.Y. 275, 280, 281, 39 N.E.2d 237. Judge Inch's distinguishing of this case on the ground that Principal became due ipso facto upon a failure to pay interest is not sound, for N.Y. Real Property Law § 254(2), McK.Consol.Laws, c. 50, treats mortgage clauses such as the one in question as granting only an option of call and the case shows neither call nor action to foreclose the mortgage. 41 Judge Inch concluded that the institution of the foreclosure on March 27 was a sufficient act of acceleration of the principal, so far as concerns the Trustee, and that notice to the titleholder was not required to fix rights against the latter. Here again, having regard to the fiduciary obligations assumed by the Trustee, the conclusion seems sound. The debtor and the guarantor were its agents for collection of the amounts due on the collateral in the trust fund, and they had the power and the duty to institute or authorize foreclosure in the name of the Trustee, as they did here. Had the Bank by its own officers started foreclosure, that would have been a call of the principal surely sufficient to put it on notice that its collateral was in default. When the same action is taken for it by its authorized agents, the result should be the same. 42 Finally our conclusion above, that there was no clear day and that mortgages in default as to interest or for less than 60 days still cannot be used in computing excess collateral, leads to the same result. We have already ruled that there was no excess collateral justifying the large withdrawals of June 8, 1931; and the grounds taken by us in supporting the Master and reversing the trial court on this issue require the result reached below unless, indeed, the certificates of non-default, so strongly relied on by the Bank, grant absolution. 43 Authority for these certificates is found in the last sentence of the second full paragraph of Article I, § 6, supra: The Trustee may accept as conclusive the written statement of any officer of the Corporation as to whether or not any securities deposited in the Trust Fund are in default in the payment of principal or interest. Certificates were furnished when the releases were requested, and an issue has been made of their adequacy. The debtor's letter asking for the first release, that on October 31, 1930, contained no statement; those for the releases between November 29, 1930, and April 27, 1931, contained statements advising the Trustee that none of the securities deposited in the Trust Fund are in default in the payment of principal or interest for sixty days or more; while those for the releases between June 8 and August 17, 1931, omitted any reference to interest. Both the Master and the district judge found that the Bank did not accept these statements as conclusive. It had full knowledge of the default in the Hillman mortgage which we have set forth above; and it had full knowledge of the default in interest on the Elmhurst-Hampton mortgage from March 1 on and that the entire principal was and had been callable since March 20, 1931. Such exculpatory provisions should be strictly construed, Prudence-Bonds Corp. v. State Street Trust Co., supra, 2 Cir., 202 F.2d 555, 563, citing 1 Restatement, Trusts § 222 (1935); and such knowledge might in any event be sufficient, whatever the notices. But it is apparent that on the construction we have given the trust agreement, the notices were quite inadequate; they left unmentioned the essential feature of the status of the interest payments. We need not consider their adequacy, therefore, had the issue actually been one turning only on securities in default for 60 days. 44 2. From the Sustaining of the Third Objection. The third objection involves the Bank's acts on six different occasions from February 23 to December 9, 1932, in accepting bonds of this series for cancellation in lieu of cash collected by the debtor on account of principal on mortgages in the trust fund. The Master recommended a surcharge on the last three items only because they alone occurred after May 1, 1932, the date on which the debtor defaulted in the payment of principal of this series of bonds. And as to one of these items he allowed $500 only because the foreclosed premises were ultimately restored to the trust fund at that cost. The total surcharge he recommended on this objection was $3,966.68. 45 Judge Inch upheld the Master on this allowance, but ruled further that the objection should be sustained also as to the first three items, since the Bank had notice on or about January 2, 1932, to the effect that the maturing bonds would not be paid when due. It is true that an event of default, upon which certain rights such as acceleration of the maturity date of all issued bonds might turn, would not occur until eighteen months after such principal default; but the trust agreement makes a clear distinction between a default and an event of default. Article IV, § 1, and Article V, § 1. In President and Directors of Manhattan Co. v. Kelby, supra, 147 F.2d at pages 478, 479, we held that the trustee there should not have accepted bonds for cancellation after this notice of default; and the Bank's attempts to distinguish that case are not persuasive. In addition, as Judge Inch points out, the cancelled bonds were those only authenticated after receipt of the notice and never issued or sold to the public. Hence this was merely a device to permit the debtor to retain cash which it should have deposited in the trust fund. We agree with the judge when he says: The Bank, as Trustee, should not have countenanced these transactions. 46 The court therefore correctly increased the surcharge under the third objection by $12,749.98 to a total surcharge of $16,716.66. 47 3. From Denial of the Defense of Partial Restoration. Between July 20, 1931, and November 10, 1931, the debtor restored to the trust fund $19,375 without withdrawals therefor. For this amount the Bank claims credit. But the Master declined to allow it for lack of a showing that the amounts restored had any connection with the cash released. Various other trust transactions occurred thereafter and were in part supported by the deposited bonds; thus new bonds to the amount of $46,900 were authenticated between December 3, 1931, and October 31, 1932. There would be no reason for allowing restoration to the losses here only thus to promote a deficit elsewhere in the fund and the Bank does not show that this would not result. 48 Summary and Direction. The result of our holdings explained above is that the Bank's appeal is rejected, while on the objectors' appeal the judgment stands except in two particulars. We have ruled that the second objection must be sustained in full and the Bank surcharged for all the twelve cash releases from October 31, 1930, through August 17, 1931, together with interest on each at 3 per cent from the date when it was made; and we have further ruled that the Bank must pay all the costs of this proceeding, including the compensation to the Master. 49 Accordingly on the Bank's appeal the judgment is affirmed; on the objectors' appeal it is reversed for the additional awards here directed.