Opinion ID: 1615949
Heading Depth: 1
Heading Rank: 2

Heading: Evidence as to Imprudence of Purchases in the Bond Fund.

Text: Substantial questions arose in regard to the bond fund concerning the purchase of securities of six real estate investment trusts (REIT's). REIT's are entities primarily engaged in mortgage lending on security of real estate, or in a combination of lending with the ownership and commercial development of real estate. One witness called REIT's the mutual funds of real estate. In September 1971, First Alabama purchased the unsecured debentures of six REIT's for $2,608,443.00, which comprised 23.2 percent of the principal of the bond fund. First Alabama suffered a 47.03 + % loss on these bonds when they were sold for $1,381,645.00, for a total loss of $1,226,798.00. Questions were raised as to whether REIT's are safe trust investments. Kenneth Campbell, an expert witness for First Alabama, testified that the purchases of the REIT's were prudent investments. Yet he had called REIT's shaky legal undertakings in his book, New Opportunities in Real Estate Trusts 29 (1978). Testifying for the plaintiffs, Dr. Johnston stated that REIT's were risky investments. He applied a test set out by Benjamin Graham in his book Security Analysis (4th ed. 1962), which included size of the company, ratio of income to fixed charges, ratio of income to fixed charges in the company's worst year, ratio of income to funded debt, value of property ratio, ratio of net assets to funded debt, and a debt to capital funds ratio. Johnston testified that Graham's standards required one to look at the record of an REIT for a period of seven to ten years before making the investment, in order to determine the ratio of income to fixed charges. This was impossible here, however, because all of the REIT's were too new to apply this test. Johnston concluded that all six of the REIT's failed to meet the test suggested by Graham. Johnston concluded it was a poor decision to purchase REIT's because there were other options available which were less risky. The plaintiffs also offered the prospectuses of the REIT's, which contained several pages of risk factors. These risk factors pointed out: (1) That the issuers were mortgage trusts engaged in making highrisk development and construction loans; (2) the competition in that field; (3) the conflict of interest with the sponsor-adviser; and (4) the fact that they operated principally on a leverage basis (that is, borrowing capital to increase earnings). Plaintiffs' evidence showed that the REIT's were making high-risk loans dependent upon the borrower's ability to pay. The plaintiffs contended that if the borrower had good credit, it could borrow directly from the bank and not have to pay the REIT fee. Campbell, testifying for the bank, stated that the REIT's concept has limited if not dangerous application for mortgage lending trusts. John Davis, hired by First Alabama to replace Eldon Davis as trust investment officer, testified that in his opinion the purchase of the six REIT's was imprudent because they were all leverage. Davis testified that the REIT's would not meet the standards of the Bank today. Mr. Byrne testified that in 1972 First Alabama's standards for bond purchases were to buy bonds from companies that were well managed, that were generally AA or better, that had the ability to withstand industry trauma, and that were the larger companies available in the bond market. None of the six REIT's met those standards.