Brief for the SEC, Amicus Curiae , in Support of the Petitioner — Manufacturers Trust Co. v. Becker

Supreme Court brief1950

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INDEX

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Introductory statement —=—s—iséi(CSSSttitsti<(CSststSs er. 1

Opinions below © ii ai ne ci 2

Jurisdiction... 2

Questions presented _ of Siena eee in tae 7 igh aa Soa 2

ONS 5. iS cs cS Sale china Pe eehe as ae eg es esta

Argument ...... Mae es BEAT wig ee bu awe core ae Chee be 4

I. A director who has eho claims against his cor-

poration for a fraction of their face amount dur-

_ ing. the insolvency of the corporation cannot profit

‘thereon in proceedings under the Bankruptey Act

subsequently initiated by the debtor :......... 4

II. Where claims are purchased during insolvency by a_ -

director acting within his sole discretion. as agent

for kis wife and mother, and by an office associate

with the assistance of the director, such claims

must be treated as if the director had purchased

i SY TOME ee ae cis cep 14

COMBINIIOR 6554 os es es Raed Se RCUS See ees Niessen 21

CITATIONS

Cases:

Bramblet v. Commmonwealth Land & Lumber Co., 26 Ky.

St iy TI BRT Oe We. Wie MO ag eta eee. int ae

Bulkley v. Whitcomb, 121 N. Y. 107, 24. N. E.13...... = 13

Chicago Rapid Transit Ce., In re, No. 65,037 (N.D.

«TE GRASSI, Bn nee inen cing ie geen Sp npoaa a

Drake Stadium and Field House Corp., In re, No. 9758

CUR e WD seks 5 55s oo eae Re RAE See 2

Franklin Building Company, In ve, 83 F. Supp. 263.... 2,15

Fulton’s Will, In re, 253 App. Div. 494, 2 N.Y.S. 2d

SERENA POCA ee CELE ea a be acs aa 18 .

Gochenour v. Cleveland Terminals Building Co., 142 F.

2d 991, certiorari denied, 323 U.S. 767. 9

Gunther v. Gove, 275 Mass. 235, 175 N. E. 464... 18

‘Holman v. Ryon, 56 F. 2d 307... 2.20. eee, ~ 48

‘Hotchkiss v. Fischer, 136 Kan. 530, 16 P. 2d 531. PRPS 8

Inland Gas Corp., In re, 73 F. Supp. 785. . ae 18

Jersey Materials Co., In rv, 50 F. Supp. 428 ‘s 4, 9,13

Los Angeles Lumber Products Co., In-re, 37 F. ‘Supp. 2

Fe nc ene AAG Oh ORE RA CVE ews UE Eas 18

Los Angeles Lumber Products Co., In re, 46 F. Richi 7:..° 48

Magruder v. Drury, 235 U. S. 106... .. is eae

McCrory Stores Corp., In re, 12 F. Supp. 267. Peake fe 4

- Meinhard'v. Salmon, 249 N. Y. 458, 164 N.E.545.- sO

Midland United Co:, In ve, 64 F. Supp. 399. Rae

Midland United Co., In re, 159 F. 2d 340 + 12,18 —

(1)

“ je

Cosne—Chatinned : : eo, ‘ho

Monroe v. Scofield, 135 F. 24725... 4,13

Mountain States Power Co., In re, 118 F. 2d 405. 42.

Norcor Mfg. Co., In re, 109 F. 2d 407, certiorari denied,

310 U. S. 625 . 4

Pepper v. Litton, 308 U. S. 295 a 5,

Philadelphia & Western Ry. Co., In re, 64 F. Supp. 738. 4,

: Securities: and Exchange Commission v. Chenery Corp.,

ai A PO OD RL SY AAT BOOT TAS TET Tee DEN

Strong v. Repide, 213 U. 8. 419. ....... es ees 5,

Taylor Vv. Standard Gas ¢ Electric Co., 306 U.8,307.... 5,

Van Sweringen Co., In re The, 119 F. 2d 231, eertiorari

enied sub nom..Terminal & Shaker Heights ey

Co. v. The Van Sweringen Co., 314 U. 8. 671. . 4,9

* Wade Park Manor Co., In re, No: 64, 870 (N.D. Ohio) 2

Wendt v. Fischer; 243 N. Y. 439, 154 N. E. 303... " ll.

Woods v. ¥itie National Bank and Trust Co., 312 U.

MN AS Se 4,5

Statutes:

Bankraptey ia as ‘sieved, 52 Stat. 840 fa U.S.C.

§ 1 et seg.):

I a i ok kk ibe Okeke 12

PN Te ae ry es oes ice ak tad dec veks 12

UI A ii ek ig Fah ce essa 13

NE I ge ie Be ee 13

i TI a a ei a cas he has 13

Securities Reohange Act of 1934, 48 Stat. $81, Section 7

16(b), 1 U.S.C. § Map th) -. a : 8

Miscellaneous : :

iH. Rep. No. 1409, oe Pett Ist Bees., al 7 (1937) .. 16.

Ine Segre Gero Bate ies

OcTOBER Term, 1949

" No. 55

| MANUFACTURERS TRUST Company, ‘AS TRUSTEE

- UNDER ANT INDENTURE MapE BY THE DEBTOR

UNDER Date or SEPTEMBER 27, 1933, anv INDI-

VIDUALLY, PETITIONER’ : 3

, 3 v.

REGINE Becker, EmiLy K. BECKER, AND WALTER A.

_ Fripoure .

ON WRIT. OF CERTIORARI TO THE UNITED STATES

“COURT OF APPEALS FOR THE SECOND CIRCUIT

BRIEF FOR THE SECURITIES AND EXCHANGE COM- >

MISSION, AMICUS CURIAE, IN SUPPORT OF PETI- :

TIONER

INTRODUCTORY STATEMENT

Although this appeal arises under Chapter XI

_ of the Bankruptcy Act, the Commission is submit-—

ting this brief as amicus curiae since it is of the

opinion that the determination of the,questions in-

yolved herein will have an — t bearing on

(1)

similar questions arising under Chapter X ofthe 4

Bankruptey Act i in proceedings to which it may be I

a party.’ | | i

OPINIONS BELOW . z t

_ The opinion of the court of appeals (R. 175- 188) !

is reported at 173 F. 2d 944. The opinion of the

district court (R. 91-95) ase at 80 F.Supp. |

822, : Se eae on"

a: JURISDICTION :

‘he judgment of the court of apical | was en-

tered on March 3, 1949 (R. 189). The petition for

a writ of certiorari was filed on April 20, 1949, and = -

granted on June 6, 1949 (R. 189). The jurisdiction

of this Court i is invoked seer 28 U. 8. C. 1254.

-QUESTIONS PRESENTED

oe ek a a et tk em

1. May a director who has purchased claims

against his corporation for a fraction of their face

amount during the insolvency of the corporation be

permitted to profit thereon in a proceeding under

. the Bankruptcy Act oo initiated by the

~debtor ?

2. Assuming that distribution t. toa divectur | in the

above situation would be limited, to cost, does a

1 At the wechenk time, eeunions siaikias to those presented

here aré involved in several Chapter. X reorganizations to

which this Commission is a party; purchases by a fiduciary

‘during insolvency of the company are involved in In re Drake

Stadium and Field House Corp., No. 9758 (S.D. Ia.) ; family

relationships are involved in In re Chicago Rapid Transit Co. =

* No. 65,037 (N.D. Hl); both of these issues are involved in

ee a ee. en ae .. ae ee ee |

In re. Wade Park Manor Corp., No. 64,870 (N.D. Ohio); and

in In re Franklin Building Company, 83 F. ee 263 (E. D.

Wis.), —_— pending in C.A.7,

; /

. - °

° S

ce ee > ae ‘ .

\ ; Pipe

= j

} .

different rule apply where the purchases were

made (a) in the sole discretion of the director /act-

ing as agent for his wife and mother, or (b) with

the assistance of the director by his office associate ?

Sede

: _ STATEMENT 3

The facts are set forth in the briefs filed by the

rties, For purposes of this brief, we note merely

“that the court below found that the debtor, Calton

Crescent, Inc., was insolvent during the entire

_ period when the purchases of the claims involved pare

here were made—a four-year period preceding the

~ filing of the voluntary petition under Chapter XI

of the Bankruptey Act; that the purchases of the

‘respondents Regine and Emily K. Becker (the

mother and wife, respectively, of a director) were

made with their own funds by the director without

these ladies’ exercising any independent judgment

in the investment; that the purchases made by re-

_,spondent Fribourg, office associate of the directors

_ of the debtor, were made with his own funds upon

information furnished by the directors; that in

all of these purchases there was no,evidence of any

wrongful overreaching or concealment; and that

all of the securities acquired as a result of these

purchases were allowed to participate without

- limitation, on a parity with the holdings of public —

security holders.

See ‘ ¢ Nae cea. 4

. o/.

| '

puaeiicier. he

Sle

— or a Fraction of Their Face t During

of the Cannot Profit

Then be the Bankruptcy Act

fests Initiated by the Debtor *

The prevailing rule in the federal courts,

which the decision below in our view conflicts

that during the insolvency of a corporation its

directors and officers may not profit by trading in

-elaims against the company.’ The court below did

not directly repudiate this rule but, by reasori of

. {a what.we believe to be a misapprehension of its pur-

pose, has grafted onto the rule an unwarranted

exception. The exception would limit the appli-

cation of the rule, in cases where the purchases

prior to the commencement or imminence

honoaiar pang igre in this case by directors

rchaved during the insolvency of the corpora-

- tion tion and whic would therefore be dubject ad the rule limiting

ation on such claims to cost in subsequent bankruptcy

it is necessary to establish this proposition in

brace to determine the ultimate question involved herein

_ whether the rule should be held appiicable to the claims of the

"wife, mother and office associate of the director.

iad danon io Co., 109 F. 2d 407, 411 ACA. 7), cer-

j S. 625; In re The Van Sweringen Co.,

‘119 F. 2d 231, 234 (C.A. 6), ri denied sub nom.

~ Terminal & Shake? Heights Realty Co. v. The Van. oe

Co., 314 US. 671; In re Los Angeles Lumber Products

46 F. Supp. 77 (S.D. Cal.); In re Jersey Materials Co., 50 F.

Supp. 428 (D. N.J.); Pepper v. Litton, 308 US. 295, 311;

Woods y. City National Bank and Trust Co., 312 US. 262,

268-269; Monroe v. Scofield, 135 F. 2d 725 (C.A. 10); In re

Philadelphia & Western Ry. Co., 64 F. Supp. 738 (E.D. ayy

ER ECCTNE States COP, 12 F. Supp. 267; 269 (S.D. N.Y §

jew eG

ON IAD Sore ye

lee 2

- eck wap riN he Apa

of bankruptcy proceedings, -to situations where |

there is proof of overreaching or concealment by

the director, or where there is a showing of injury +

either to the corporation or the selling creditors.

This exception appears to derive, in part, from a

conception that the rule is solely related to the pro-

tection of selling security holders — their

management. _ Sores F

In our view, however, the ultimate purpose of the

rule is to prevent fiduciaries from placing them-

selves in a position where they may be tempted to

vio ate their obligation of undivided loyalty.’ Its

| diate objective is to prevent the diéctors

from trading in its corporate obligations when, be-

eause of insolvency, they are fiduciaries to all se-

" eurity holders of the corporation.’ It is an appli-

_eation of the principle of the law of trusts which

was set forth by this Court as follows in Magruder

v. Drury, 235 VU. S. 106, 119:

| ‘It-is a well settled rule that a trustee can

make‘no profit out of his trust. The rule in such -

eases springs f his duty to protect the in--

terests of the te, and not to permit his

personal interest to in any wise conflict with |

“Cf. Woods v. City National Bank and Trust Co., 312 US. |

262, 268. There are other doctrines, remedial in nature, as >

illustrated by Strong v. Rede, 213 U.S. 419, and Taylor v.

_ ~ Standard Gas & Electric Co., 306 US. 307, which are designed

to give relief to parties injured by overreaching, concealment

or mismanagement by fiduciaries and it is significant that

these doctrines are applicable whether or not the corporation

was solvent or insolvent when the breach of fiduciary duty

‘’

2 Pepper v. Litton, 308 U.S. 295.

his duty in that respéet. The intention is to

provide against any. possible selfish interest ex-

ereising an influence which can interfere with

the faithful discharge of the duty which is

owing cath fiduciary capacity. 3

The court below recognized but failed, we believe,

to make a realistic application of that principle. A

director clearly owes to an insolvent corporation a

duty to take whatever steps may be necessary best.

- to protect its security “holders. These steps may

~. well: be inconsistent with what would be-most ad--

_ Yantageous’for a director acquiring the debt securi-_

ties of the corporation. As an insider, he is in an

unique position to asse&s the yalue of the claims

against the corporation and if the market should

assess this claim at a lower value, he may find it

_ advantageous, for example, to adopt measures to

_ stave off bankruptcy proceedings so that he cain~

continue his purchase program, The immediate

_ institution of proceedings, however, might be in the

~ best interests of the debtor’s security holders, since

"it might release the corporation from onerous con-

tracts or otherwise prevent its assets from being —

~wasted.. The broad area of ‘‘business judgment’

' in which a director may act and the impossibility

of proving what might have resulted had different

steps been taken * normally make it impossible to”

show that a diréctor intentionally sabotaged his” :

Ne meee ene eouneer

8Cy. Taytor v. Standard Gas & Electric Co., 306 US. 307,

323.

ne tet 5

PR ESSAI SCE eee 5 OR PETC

_ corporation to achieve a personal gain—and indeed,

. in-a particular case it might appear,in the light of

hindsight that the action of the director has turned

out in the best interests of the security holders of

the corporation. This possible coincidence, how-

ever, is insufficient protection for the insolvent

corporation’s security holders who.are entitled to

have their fiduciaries act without being influenced

in any respect by considerations as to their own.

personal advantage or disadvantage. —

_ Contrary to the holding below, we believe that

there is rio sound distinction between purchases

during the period when bankruptcy proceedings

are ‘‘contemplated’’ and during the period of in-

solvency preceding such contemplation. The court

below apparently used’ the term ‘‘contemplated’?

_ to apply to situations where a decision has already

been reached to institute the proceedings or at

‘least the individual fiduciary expects that action to.

be taken after a contemplated meeting of the board

of directors. It should be noted, however, that in “

a very real sense reorganization proceedings neces- _

sarily are contemplated from the moment that in-.

solveney occurs because that is ‘clearly one of the

. few, possibilities open to the corporation. It is at

this time that the directors must become concerned

not only with the normal] running of the corpora-

, tion but also with the steps necessary for rehabili-

tation or for equitable distribution of the corporate

assets. Whether the interests of the corporation

8 .

nd its security holders will best be served by a

“bt adjustment through negotiation or by pro-

edings under the Bankruptcy Act or other

atutes should be determined without reference to

1¢ self-interest which the securities purchase pro-

ram of a director would motivate.’ Indeed, such

|fferences -as do exist between the period of. in--

Nlyeney preceding bankru ptey and the period when

inkruptey proceedings are pending. actually thake

more essential that the rule be applied during the

mer period. After proceedings are instituted

e court becomes the guardian of the debtor’s af-

‘irs and-the corporation and the entire commun-

y of interests it represents have the protection of

idicial surveillance and supervision, which is ab- «

. e

7 We. recognize that it is possible-for a director to be

bject to conflicting interests even when the corporation

mains solvent, and similarly, a conflict of interests may

ise after insolvency as # result of purchases of ‘securities

ade prior thereto. These dangere have never been regarded

’ courts of equity as sufficient to justify a change in the

mmonrlaw rule which permits directors to trade freely in

e securities of solvent corporations so long as they indulge

no overreaching or other fraudulent acts. See Securities and

rchange Commission v, Chenery Corp., 318 US. 80, Strong v.

ppide, 213 U.S. 419, and Hotchkiss v. Fischer, 136 Kan. 530,

y P. 2d 531 (1932).. However, conipare Section 16(b) of

Le «

e Securities Exchange Act of 1934, 15 USC. § 78pib),

Siok in recognition of the difficult problems relating to the

fair use of inside information, categorically prohibits direc-

rs, officers and other “insiders” of corporations with listed

urities from taking any profit on “quick-turn” transaction

the equity securities of their corporation. In any

ent, the fact that the rule has not been applied to

minate all of the potential temptations to divide his loyalty

1ich may arise for a director is no sound reason for limitin

still further in 4 situation where it is clearly applicable, |”

sent during the period of insolvency preceding the

institution of proceedings. :

-The only circumstance -that tthe court below

pointed to as indicating that the rule of limitation

to.cost should not be applied prior, to the institution

of bankruptey proceedings or the ‘‘contempla-

tion’’ thereof is the fact that most of the cases

applying the rule involved claims purchased ‘‘after —

some type of bankruptcy proceeding was pending

or was imminent and known to be so by the direc-

tor.”” (173 F. 2d at 950.) None of these cases, how- -

ever, made this an indispensable basis for invoking

the rule, and the opinions uniformly state the rule

in terms of insolvency.” Moreover, there are cases

in which the rule has been applied where the

claims had been purchased before bankruptcy pro-

ceedings were commenced, or contemplated in the

sense that it had been determined to institute pro-

ceedings.” Indeed the rule has been applied where |

no bankruptcy Or reorganization proceedings were

evet involved. See Bramblet vy. Commonwealth

' * See cases in note, 3, supra. ‘ ‘

*In re The Van Sweringen Co., 119 F. 2d 231 { ~ ce

Dp a cag mat von Termin | aker Heights Redit7j |

‘e-+¥-Fié Van Sweringen Co., 314 WS. 671 (purchases madg .

a full year prior to the filing of a voluntary petition, as‘

indicated in related case of Gochenour v. Cleveland Terminals:

Building Co., 142 F. 2d 991, 992 (C.A. 6), certiorari denied,

323 U.S. 767); In re Jersey Materials Co., 50 F. Supp. 428.

(D. N.J.), (purchases made five months before the filing of

an involuntary petition). Cf. In re Norcor Mfg. Co., 109 F. .

2d 407 (C.A. 7), certiorari denied, 310 US. 625; where the

purchases were made during a period commencing two and

one-half years prier to the filing of an involuntary petitien,

but during a‘state court receivership.

Land & tuber Co., 26 Ky. L. Rep. 1176, 83 s. Ww.

599, 602 (1904), where the court said: :

We have no hesitancy in declaring the law

to be that a president of an insolvent and fail-

_ . ing corporation cannot traffic in its property

to his advantage and to its disadvantage, or

buy in debts against it at heavy discount and .

then assert them for full value, To the argu-

ment that it does not matter to the corporation

who owns its debts, so it honestly owes them,

and that it is immaterial to it whether its

president gets them for nothing, as it does not

have to pay any more than it actually owes in

any event, the answer is, it. does matter, for

human nature is not so constituted that the

_“"same person can fairly represent opposing —

sides of the same question—cannot be both

creditor and debtor. ‘The corporation was en-

titled to the untrammeled judgment and ef-

forts of its president in administering its af-

fairs in its behalf exclusively. When he

assumed an attitude wherein his personal in-

‘terest came into conflict with his duty to his

corporation—where he would be tempted to

serve it less diligently in order that he per- .

sonally might profit by his relaxation of off-

cial vigilance—his disloyal act.to his company. _

will be turned aside from his pocket, and the

profits of his speculation will be turned into

sos ¢ ration. The policy of the law is to

(fidelity. of trustees to their trusts ‘by

sakes it impossible for them to profitably

neglect or abuse them. Whether the derelict

officer acts: from a mistaken notion of his

Oe es 6 Min &

Nee eee VS & te

marie’

: rights, or from an actually fraudulent purpose,

..-ls- immaterial, as affecting the invalidity of

the transaction. The principle is too well set-

tled to require elaboration.

Judges have frequently warned oe the es :

ation to relax the rigidity of the rule that fidu-

iaries may not be permitted to profit where their |

ersonal interests may conflict with those of their

sstuis in cases where the trustee has

ct in good faith and no damage to the

e shown. As Ji udge Cardozo_pointed out,

onsiderations constitute

no sufficient answer by a trustee catted of

his duty.. The law ‘‘does not stop to inquire

whether the contract or transaction was fair _

or unfair. It stops the inquiry when the rela- |

tion is disclosed, and sets aside the transaction

_ or refuses to enforce it, at the instance of the

party whom the fiduciary undertook to repre- _

sent, without« undertaking to deal-with the —

question of abstract justice in the particular

ease’”’ [citing cases]. Only by this uncom-

promising rigidity has the rule of undivided

loyalty been maintained against disintegrating

erosion.” ; fa

Until the sentind case, the decisions limiting di-

ectors to cost for claims: purchased during insol-

ency considered irrelevant the questions whether —

he insider acted in good faith { and whether the

1926). See also Meinhard v. Salmon, 249 N.Y. 458, ‘464,

B4 N.E. 545, 546 (1928).

—

debtor. suffered any injury—and, indeed, most of

these cases gave no consideration. to whether the

insider committed any overreaching or concealment

in acquiring the claims upon which he is permitted —

no profit. The decision below has subjected a salu-

tary principle to the very kind of ‘disintegrating

erosion’’ against which Judge Cardozo warned.

a . * ae *

Although the Commission’s primary co cern.

with the decision below is the effect which it may

have upon current and subsequent proceedings un-

der Chapter X-of the Bankruptcy Act, to which |

it is a statutory party, we feel strongly that this

equitable principle must be recognized us equally

applicable in any kind of insolvency proceeding in

the federal courts. Respondent urged below, un-

successfully, and we presume will argue in this ~_

Court, that ina Chapter XI proceeding the federal '

_ court has no jurisdiction to invoke the limitation

to cost rule. This Court has said that the power

to subordinate or limit claims is inherent in the

powers of a court of bankruptcy as a court of-

equity. Pepper v. Litton, 308 U.S. an, 306, 307."

ten ee

1! Provisions of the “Act which do deal with iveach of .

fiduciary relationship in other contexts’ specifically recognize

' the appropriateness of. the sanction of limitation to cost.

Ch Sections 212 and 249 of Chapter X. It is clear that these

provisions are not intended in any way to limit either the

gedpe or the applicability of the broad Fw EFS principles

froyn which they are derived. See In re Midland United Com- .

pany, 159 F. 2d 340 (C.A. 3); In re Mountain States Power

3 Coy 8 F. 2d 405 (C.A. 3)% and is re Los Angeles Lumber

< 3

=n ai \-

coin Bein

In addition, Chapter XI provides that when a

voluntary petition is filed thereunder by the debtor,

the court's jurisdiction, powers and duties shall be °

the same as if the proceeding were one in straight

bankruptcy,” and this doctrine has been consist-

ently applied by federal courts in straight bank-

ruptcy proceedings. See Monroe v. Scofield, 135

_ F. 2d 725 (C.A. 10); In re Jersey Materials Co.,

50 F. Supp. 428 (D. N.J.). Moreover, under See-

tion 366 the court is charged with the duty of deter-

mining that the arrangement is “fair and equi-

table”’ and accordingly, an arrangement which did

not follow equitable principles of distribution

should not be confirmed.

Products Co., 46 F. Supp. 77, 92 (S. D. Cal. ) As was pointed

out in the last cited case:

Whether or not the specific language sed in these sec-

tions [Section 77%, sub. b. and in Section 212 of Chap-

ter X] is sufficicatly broad to include the acts of Mr. |

Faries in the instant case, is beside the point. The very ©

remedy provided in those sections has long been recog-

nized and applied in the exercise of the general equitable

power of the bankruptcy court. See Bonney y. Tilley,

supra [109 Cal. 346, 42 Pac. 439 (1895)]; In re Norcor

Mfg. Co., supra. Cf. In re McEwen’'s Laundry, Inc.,

6cr, 1937, 90 F. 2d 872.

And compare: the state cases in which this rule has been

recognized and applied as an incident of the courts’ inherent

equity power. Bramblet v. Commonwealth Land & Lumber

-Co., 26 Ky. L. Rep. 1176, 83 S.W. 599 (1904); Bulkley v.

| Whitcomb, 121 N.Y. 107, 24 N-E. 13 (1890).

12 See Sections 312 (2) and 322, Bankruptcy Act, 11 USC.

§§ 712, 722. |

II.

Where Claims Are Purchased During Insolvency by a

Director Acting Within His Sole Discretion as Agent ' |

for Hie, Wife and Mother, and by an Office Associate

With the Assistance of the Director, Such Ciaims Must

ee re ee Serene Ebene fee

Himself —

We believe that the decision of the court below

opens new avenues of evasion of equitable limita--

tions applicable to a fiduciary by holding that these _

limitations do not apply to close relatives or busi-

ness associates of a fiduciary who. act with his

knowledge and assistance. The majority below

held that even on the assumption that the insider

himself would be limited to cost, an extension of the

limitation-to-cost rule would be required in order

similariy to limit the claims of the respondents,

_ because they ‘were not directors or officers of the —

debtor ; their own funds were invested, and no offi-

cer or director of the debtor has any interest in the

debentures they purchased’’ (R. 185)." The court

4 In allowing the claims the court below relied strongly

the decision in In re Philadelphia & Western Ry. Co., 64

F. Supp. 738 (E.D. Pa.) in which the claims of McKernan, - '

an officer of a corporation whieh had a management contract

- with the debtor, and Stoughton, the father of an officer of the -

debtor, were allowed_without limitation’ We disagree with

the Philadelphia and Western case msofar as that case held

that McKernan was not a fiduciary of the debtor despite her

management contract and insofar as Stoughton was not held -

to have the burden of establishing that his son had not

furnished him with any inside information or assistance.

We do not, however, regard the Philadelphia and Western

holding to be directly i in point where there is an unquestioned -

fiduciary relationship ok lear proof of advice and assistance

by the fiduciary in the.purchases by respondents. Cf. In re

Midland United Co., 64 F. Supp. 399, 416 Jas Del.).

a ae Pe gee ee ee ee ee a

— on Se oe

then enunciated the general rule that claims of rela-

tives and business associates should be limited only

where it is coesaiiat n that they have “know ingly con-

federated’’ in a breach of trust by the fiduciary.

a this doctrine to the instant case, the —

court held with respect to Fribourg, the business

associate, that ‘‘investing one’s own funds on a

‘tip’ received from an officer or director of a

debtor’’ was not ‘‘knowingly confederating”’ with a _

fiduciary in a breach of trust (R. 185). As to the

Becker ladies—the wife and mother of the director

who acquired the debentures for them—the court

found that although they are chargeable with the

_knowledge and equities of the director since they

exercised no independent judgment -in the invest- —

ment of their funds, nevertheless the disciplinary

‘sanction for ‘‘knowingly confederating’’ with a

disloyal fiduciary should not be imposed since there

was no overreaching of the sellers when the fidu-

ciary made the purchase for his principals.

- In our view this decision is inconsistent with the

ultimate purpose of the limitation-to-cost rule and

invites its circumvention by permitting the insider —

to utilize his special information, advice and.assist-

ance on behalf of relatives and close business asso-

ciates."* To restrict the scope of the rule to cases

4 An indication of how wide this avenue of evasion can be-

come is illustrated by the facts in In re Franklin Building Co.,

83 F. Supp. 263 (E.D. Wis.), appeals pending in C.A. 7. In

that case the claimants are the wife, daughter, and son of a

fiduciary of the debtor and its bondholders. Purchases for

the wife and daughter were made by the fiduciary while the

wherg associates and relatives have been guilty of

‘‘knowingly confederating”’ with a fiduciary in the :

sense used by the court below is to dilute greatly |

the detérrent effect of the rule. The holding serves

as a precedent for permitting fiduciaries to do indi-

rectly what they may not do directly, and, if applied

in other cognate situations, could do much to

thwart one of the major objectives of ‘the reforms

in reorganization practice embodied in the Chand-

ler Act.” ; ce ee -

As we have argued in Part I above, we conceive

that the rule is designed to deter director-fiduciar- |

ies from. placing themselves in a position where

they may be tempted to violate their obligation of

undivided loyalty when, because of insolvency,

therefore, it would seem that the basic determinant

as to the application of this rule to purchases by

_ debtor waa insolvent and — and subsequent to prior

reurganization proceedings completely within his owa dis-

cretion with funds belonging to the ladies. During the same

_period some of the son's purchases were made by the father

and the remainder were purchased by the son entirely upon

the father’s judgment. “Moreover, many of the bonds were

purchased by the fathcr and son-with moneys which came

from a single safe in the law and real estate offices shared by

them. The district court limited the claims of the husband

and father because he was a fiduciary but, adopting an

attitude even narrower than the one reflected in the opinion -

below, allowed the claims of the son, wife and daughter in

full.

18 See H. Rep. No. 1409, 75th Cong., Ist Sess. p. 37 (1937),

where it is stated that a major objective of the reforms was

to prevent abuses whereby “the financial wellbeing of in-

vestors and the public” was “sacrificed to the insiders’ desires

for protection and for future profit.”

Vim SDR TRS Bah Ore ey

HERI OSPR I ARE A SIRI AEP MLD NI he hire SAM

Ty RAR Ete be

RARE

relatives and business associates of fhe fiduciary

- after insolvency should be whether or not the ‘*tend-

cy to evil’’ at which the rule strikes exists in a

_ given situation. ‘The rationale underlying the ap-

plication of the rule in such cases is not the impo-

sition of sanctions or penalties for the personal

misconduct of the persons presenting the claims.

Rather, it is the recognition of the effect: upon the

fiduciary’s motivation where he is left free to.

facilitate the realization of trading prey by close

- relatives. and associates.

It is unrealistic and destructive to the operation

of the limitation-to-cost rule to argue that the ’

when he has the kind of a financial interest which —

property or tax laws might recognize. There are

many other equally compelling personal interests

which, as a practical matter, produce fully as much

pressure on trustees. This is especially true where

the fiduciary’s opportunity to make a direct profit

from a diversion of loyalty is proscribed by well-

. settled principles of law.

Where a wife is involved, the ae and extent

of the director’s personal interests which are in

conflict with the interests of his beneficiaries stand

out most clearly. In view of the economic realities |

of American family life (which Congress has

taken into recognition in the present income, gift, —

and estate tax laws) it is apparent that a husband

has_a financial interest, even though it may be in-

340, 347 (C.A. 3), where an attorney was denied a

fee from the estate because, among other things

his wife traded in the securities of a subsidiary of

the debtor in reorganization during: the course of

the reorganization : |

It will be noted that we have regarded Mrs.

Evans’ transactions as being in the same cate-

gory as those of Mr. Evans. While she financed

her. securities dealings entirely with her own

funds, Mr. Evans candidly stated that she en-

gaged in ‘the various transactions with his.

—— “entire approval and knowledge.’’ Under such

circumstances it is clear that the bankruptcy

court was justified, in the exercise of its proper

powers, in extending the principles applicable

to the conduct of the fiduciary to the ciara

wife. The settled rule in equity is that

a fiduciary is barred from compensation the

prohibition extends to his wife oe

“In the instant case the Sirounantinnen are even

? strongér’ than in the Midland case where the puré

chases were made with the fiduciary’s ‘‘entire ap-

proval and knowledge’’ (159 F. 2d at 347). Here

e - the wife “exercised no independent judgment” in

18 See also Holman v. R on, 56 F. 2d 307, 311 (C.A D.C.);

In re Inland Gas-Corp., 73 F. Supp. 785 (E.D. Ky.); In re

Fulton’s Will, 253 App. Div. 494, PO N.YS. 2d 917: (1938);

Gunther v. Gove, 275 Mass. 235, 175 N.E. 464 (1931); ef.

In re Les Angeles Lumber Products Co., 37 F. Supp. 708 -

(S.D. Calif.).

direct, in seeing his wife’s separate estate increased. . _

_As stated in In re Midland United Co., 159 F. 2d

Lg APR NS ed Wd I AACR SE ET eB oA AL RA SOIT a diet Sa RATE Ue a Nig! SEY Ris RIEL Mle pinyin oN

Re ed pie aise te ee ele ee ee

LEME LAL LIAR PS EEE ATE

> osAl WA See Re

the purchase of the bonds; they were purchased for

her by the director (R. 185).

The purchases made for Becker’s mother stand

upon substantially the same basis, in relation to

- the policy of the rule, whether we look to expecta-

tion of inheritance, recognition of a moral obliga- |

tion of support or merely a filial affection as moti-

vating the fiduciary’s assistance in inaking the

purchase. Nor should the line be drawn with close

relatives so as to exclude purchases by a close busi-

ness asociate, such as Fribourg.” Such relation-

ships commonly involve not only close ties of affec-

tion but also the expectation, if not specific under-

standing, of receiving reciprocal advantages for

making available to the business associate invest-

ment opportunities which the fiduciary may regard

himself, for one reason or another, as precluded

from realizing.

We believe that the court below failed to recog-

nize the importance of these factors in the context

of this prophylactic rule. Certainly where, as

here, claims are acquired on the basis of a fidu-

ciary’s information, and with his advice and as-

sistance, and the relationship between the claimant |

1' This case does not present the ‘asta of under what

circumstances equitable sanctions should be imposed to dis-

courage purchases by relatives or associates of the trustee in _

the absence of any—evidence that the fiduciary advised or

assisted in connection with such purchases. We believe that,

as a minimum, the person whose close relationship to the

fiduciary warrants an inference that he may have received

inside information or assistance would have the burden of

establishing the contrary.

sad

and the fiduciary is ak that an interest of the

type discussed ahove must be presumed to exist,"

all of the forces underlying the limitation-to-cost

rule come into play. We submit that the rule

ean be effective only if the claimant in such :

‘fiduciary, without regard to any active aiding,

abetting or “‘confederating”’ on his part.” We be-

‘lieve that there is no hardship in makirfg the ac- _

ceptance by the third person of the gratuitous.

assistance from the fiduciary subject to the very

same limitations with respect to realization of

profit as if the fiduciary had traded for his owr

account,

upon some active participation by the relative or associate

oe tee of trust, we believe that in this context

is ab 0 ) ’s part to arrange or

fecieiee oy Sueaiee ae, hnaete Seneaie Os perchants be

ia precluded from ation” i ew own account, and that

sos ncvbluney

also otha that the tion is insolvent, since in

the insider's tip or guidance he should be chargeable

with ail the information known to ; the insider—particularly

where as in thi: case the price paid for the security 1s indicative

of Snantial distress if not ipe actual insolv cain

{

' CONCLUSION ve ¥ ee

For the above reasons the Comntiasion submits ee

that the decision of the court of Leng should be.

| reversed. ce a

Ue “Respectfully submitted, -

St | Par B B, PERLMAN,

| = es Solicitor General.

Roar Ss. here,” a aE

Davin Ferser, | ee e

Le ee Special Covinscl,: | ae

Wz. Victor Novy, ,

GERALD W. SIEGEL, —

‘Attorneys, oe toNna

oe Securities and Exchange Commission.

= Ocronen 1949 :

é ie

- 4 . ss o : 5

Dic < :

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