IN RE BANKERS TRUST CO. OF DETROIT, (E.D.Mich. 1936)

In Bankruptcy. In the matter of Bankers Trust Company of Detroit, debtor. In proceedings for reorganization of a corporation, wherein certain creditors objected to claims filed by certain others.

Order in accordance with opinion.

Report of Special Master Sayres follows:

To the Honorable Ernest A. O'Brien, District Judge:

Pursuant to the general order of reference in this cause, and as special master thereunder, I have received and carefully considered the proofs, oral arguments, and briefs submitted to me by various parties herein, relative to the matters hereinafter mentioned, and I herewith submit to the court my findings of fact, conclusions of law, and recommendations thereon, as follows:

The sole question now before the court is whether the debtor herein, Bankers Trust Company of Detroit, is liable herein for the payment, to holders of certain mortgage participation certificates executed and sold by it to them, of the principal and interest which, by certain language of such certificates, it promised to pay to the holders thereof; or whether, on the other hand, the execution of such certificates was to that extent ultra vires and contrary to public policy and therefore such holders are not entitled to such payment. Included in this question is the incidental query as to whether the aforesaid question may be raised in this proceeding.

Although the proofs and arguments have covered a somewhat broad range, the material facts, as I find them from the record, may be stated, sufficiently for the purposes of this opinion, as follows:

The debtor is a Michigan corporation, organized in 1917 as a trust company, under Act No. 108 of the Michigan Public Acts of 1889, entitled "An Act to provide for the incorporation of trust, deposit and security companies" (sections 8044-8077 of the Michigan Compiled Laws of 1915, superseded by Act No. 67 of the Public Acts of 1929, sections 11997-12042, Michigan Compiled Laws of 1929, which re-enacted the provisions of said Act No. 108 material here). Continuously thereafter until, and including, the present time the debtor has carried on the business of such a trust company. From the time of its incorporation up to January, 1931, the debtor also engaged actively and extensively in a mortgage business, loaning its funds in large amounts to various borrowers on their notes to it, secured by real estate mortgages, and selling to the public, by means of the aforesaid certificates, participating interests in such notes and mortgages.

Each of the said mortgages contained the following provision: "It is distinctly understood by me that you are placing this mortgage to sell for my account, and that you are acting as my agent, and that any money which you may or might advance to me before the sale of such mortgage shall be considered only as an advance against the proceeds of sale, and in taking said mortgage you are underwriting a construction loan on this property. I agree that your proposed method of placing this loan is to take from me a promissory note for the amount of the loan, payable to you, secured by a mortgage direct to you, and that you will then sell said note and said mortgage, either as a whole or in part, or by participating certificates, in which you may guarantee to the purchaser both principal and interest and thus add to the soundness and saleability of my mortgage."

On the outside cover of each of the said certificates, when so sold, appeared the designation: "Guaranteed Real Estate Mortgage Bond Certificate." Below those words appeared the following language: "Principal and Interest Guaranteed by Bankers Trust Company." Each certificate recited that the said Bankers Trust Company did thereby "sell, assign, transfer, and set over to the holder" of such certificate, subject to certain specified conditions which need not be stated here, "a proportional undivided interest in a certain note given by a named person to said Bankers Trust Company and secured by a real estate mortgage also given by such person, the payor in such note, to said Bankers Trust Company "and a like proportional interest in such mortgage," subject to the same conditions. A few of these certificates expressly recited that the said Bankers Trust Company "guaranteed" the payment of the note and mortgage in question. None of the other of such certificates used the word "guaranty" or "guaranteed" except on the outside cover, but instead there appeared in the body of the instrument the following provisions: "The Company shall pay the holder the principal as and when collected from said note and mortgage, but in any event within eighteen months after demand of the holder made to the Company subsequent to the due date of the principal fixed in the preceding paragraph on surrender of this certificate. The Company will pay the holder interest upon the principal according to the coupons hereto attached on presentation of such coupons at its offices at maturity."

Each of the said coupons recited that said Bankers Trust Company would pay to the bearer thereof on a certain date a specified sum, "being on account of interest then payable on the note and mortgage described in the mortgage certificate" to which such coupon was attached.

The debtor engaged in this business of thus loaning on notes and mortgages and then selling to the public participating interests in these securities, not for the purpose of raising necessary funds to conduct a trust business, but solely as a part of a profit-making venture by trading in these securities, and its promises contained in said certificates, just quoted, were made as inducements to effect such sales. The debtor thus engaged in the sale, on an extensive scale and for many years, of a continuous series of these mortgage participation certificates as a regular business.

At the time of the commencement of this proceeding for reorganization of the debtor under section 77B of the Bankruptcy Act (11 U.S.C.A. § 207), the total amount which the debtor had thus agreed to pay to holders of the said certificates and which then remained unpaid aggregated approximately $24,000,000. The total authorized outstanding capital stock of the debtor at that time was $1,000,000. Thereafter, certain creditors of the debtor to whom the latter owed indebtedness not arising from any of these certificates intervened herein and filed petitions praying for the disallowance of all claims based on the clauses of these certificates just quoted, on the ground that the contract evidenced by such clauses constitutes the guaranty of the debt of another person, which is ultra vires, contrary to public policy, and void. Thereupon the court issued an order directing all such holders of certificates to show cause why the prayer of said petition should not be granted, which petitions are now here for decision.

I am of the opinion that the facts and legal rules here involved are in all substantial respects the same as those involved in the case of Reichert v. Metropolitan Trust Company, 262 Mich. 123, 247 N.W. 128, 130, and that the decision of the Michigan Supreme Court in that case, holding that a trust company incorporated under the Michigan statutes, has no power to guarantee payment of the debt of another person as part of a profit-making venture in which it engages as a regular business, and that its agreement to do so is ultra vires, contrary to public policy, and absolutely void, is applicable here and, being an adjudication by the Michigan court of last resort as to the powers of a trust company incorporated under the laws of Michigan and as to the effect of such laws on its contracts, will, under familiar law, be recognized and followed by this court in cases to which it is applicable.

An examination of the record in the case just cited shows that it involved facts which included the following: The Metropolitan Trust Company, a Michigan corporation, loaned its general funds to the public. Among the securities accepted under these loans were many mortgages upon real estate. Metropolitan Trust Company, as an individual, sold certain of these mortgages to the Metropolitan Trust Company, as trustee, accepting in payment therefor, from the said trustee, certain certificates of participation, in trust form, issued by such trustee, and bearing the title, "Metropolitan Trust Company guaranteed first mortgage six per cent. collateral bonds." The trust company then guaranteed the payment of, and proceeded to sell, these certificates of participation to the public. Each of said certificates, so designated as "bonds," included the following language: "The principal amount represented by this bond is payable out of the principal payments received by the Metropolitan Trust Company on said notes and mortgages * * * and in the meantime semi-annual distributions of interest received by the Trust Company upon said notes and mortgages will be made by the Trust Company * * * and said Trust Company hereby guarantees the payment of the principal of this bond as and when collected from the respective mortgagors, but in any event within eighteen months after demand by the holder made to the Trust Company on or subsequent to the due date of the principal of such bond, and the interest accruing thereon semiannually from the date hereof." In a comparatively few of these "bonds" the word "unconditionally" appeared before the word "guarantees." Other provisions of the certificates do not appear to be material here. The Metropolitan Trust Company having suspended business and statutory receivers having been appointed for it, holders of said certificates filed proofs of claim against it for the full par value of such certificates. The receivers objected to these claims on the ground that the agreement of the trust company on which such claims were based constituted a contract of guaranty which was not only ultra vires but also void because it contravened public policy. The case reached the Michigan Supreme Court on certified questions under applicable Michigan appellate practice, which questions included the following:

"Was the guaranty of Metropolitan Trust Company on such bonds ultra vires?

"If the foregoing question is answered in the affirmative, is the defense of ultra vires now available to the receivers as against the holders of the bonds upon which claims have been filed?"

The court answered both of these questions in the affirmative. In its opinion the court said: "The record shows that the trust company engaged actively in a mortgage business, loaning on mortgages, and then selling a participating interest in these securities to the public. It did not sell these mortgages or beneficial interests therein for the purpose of raising necessary funds to conduct a trust business, but sold them outright as a part of a profit making venture by trading in these securities. Its guaranty, made as an inducement to effect such sales, was an exercise of a power extended neither by statute, charter, nor necessary implication. Were this an isolated case where, in order to raise funds with which to carry on a trust business, a mortgage or participations in it had been sold accompanied by a guaranty, and the latter had been set up as a contingent liability in the company statement, there might be some merit in the assertion that this was merely a method by which the trust company exercised its express power to borrow money and issue notes accompanied by adequate security. The record, however, plainly shows that the trust company went much further, and engaged in the sale of a continuous series of guaranteed mortgage participations as a regular business. It was beyond the power of the trust company and against public policy for an organization of this nature to engage in such a venture."

Notwithstanding the able arguments to the contrary presented by counsel for holders of the certificates here in question, in an effort to distinguish this case from that just cited, it seems to me clear that, if mere form be ignored and regard be had to substance, the two cases are, in principle and effect, substantially identical in respect to the questions here involved. Thus, for example, it is true, as already noted, that in the Metropolitan Trust Company Case the clause in the certificates under consideration provided that said trust company "guarantees the payment of the principal of this bond as and when collected from the respective mortgagors, but in any event within eighteen months after demand by the holder made to the Trust Company"; while here the corresponding clause provides as follows: "The Company shall pay the holder the principal as and when collected from said note and mortgage, but in any event within eighteen months after demand of the holder made to the company subsequent to the due date of the principal fixed in the preceding paragraph." As, however, this clause, by which the Bankers Trust Company agrees to pay the certificate holders certain amounts "as and when collected" from a certain note and mortgage but "in any event within eighteen months after demand" by such holder, just as the Metropolitan Trust Company did, follows a clause by which the Bankers Trust Company has assigned to the said holders an undivided interest in the ownership of such note and mortgage, at least in equity, and has thereby itself parted with such interest, this agreement is in reality a promise to pay to such holder, within the time so specified, a sum owed to the holder, at least in equity, by the maker of said note and mortgage, if the latter does not do so. This, manifestly, constitutes a guaranty. 28 Corpus Juris, 886. Assuming, however, that this is not technically a "guaranty," yet I can discover no real difference between the substance of this provision and that of the analogous provision in the certificates of the Metropolitan Trust Company. Bearing in mind the references, in the language of the mortgages and of the title to these certificates, as already quoted, to the "guaranty" by the Bankers Trust Company of the obligations in question, having in mind also the fact that both in the Metropolitan Trust Company Case and in this Bankers Trust Company case the clause now under consideration is an undertaking on the part of the trust company to pay the certificate holder the amounts due thereunder "as and when collected" from the note and mortgage in question, but "in any event within eighteen months after demand by such holder," and in view of the general similarity between the situations presented in the two cases, there can, in my opinion, be no doubt that the contract between the Bankers Trust Company and its certificate holders, as evidenced by the certificates involved in this case, whatever its technically precise name may be, is exactly the same kind of contract which was made between the Metropolitan Trust Company and its certificate holders.

The contention that because the certificates in the Metropolitan Trust Company Case expressly recited that said company holds "in trust for the benefit of the holder" the "undivided beneficial interest" in question, that case is distinguishable from the present case, seems to me to be clearly without merit, not only for the reason that the certificates here involved provide that the trust company will hold the note and mortgage to which it relates "separate and apart upon its books for the benefit of the holders of assignments of this series until all assignments mature or are paid as herein provided," but for the further reason that this court has already held, in this proceeding, that these certificates created a trust under which the Bankers Trust Company holds such notes and mortgages as trustee, for the benefit of the holders of such certificates as beneficiaries. There is, therefore, no difference in this respect between the certificates of the Metropolitan Trust Company and those of the Bankers Trust Company.

Nor am I able to agree with the contention to the effect that because, as counsel claim that the proofs here show, the Bankers Trust Company has on hand, and will be able to repay to its cestuis que trustent, all trust funds which it holds as a trust company in its fiduciary capacity, regardless of any liability on its part under these certificates, it cannot be properly argued here, as it was in the Metropolitan Trust Company Case, that the execution of such certificates imperiled trust funds committed to its care. Although one of the justices of the Michigan Supreme Court referred, in his own opinion in that case, to the prejudicial effect upon the beneficiaries of that trust company which its claimed liability in question would produce, it is by no means clear that such reference was intended by him as a ruling that a showing that such effect would actually follow was necessary in order to negative such liability. In any event, however, as will be noted from the opinion of the court itself in that case, hereinbefore quoted, there is nothing in such opinion to indicate that the court intended to so limit its broad holding that it was "beyond the power of the trust company and against public policy for an organization of this nature to engage in such a venture," that is, the execution and sale of such certificates "as a part of a profit-making venture." It seems plain that the court intended to, and did, decide and announce, in positive language, whose meaning is unmistakably clear, that the execution of these mortgage participation certificates for the purposes shown by the record herein is, per se and necessarily, beyond the power of a trust company incorporated, as is the Bankers Trust Company, under the laws of Michigan. It is difficult to conceive language more unequivocally explicit to that effect than that thus used by the Michigan Supreme Court. The question so decided was one of power and public policy and their legal effect upon the validity of these contracts at the time of the execution thereof, at which time, obviously, it could not be foreseen whether liability thereunder would actually imperil any trust funds held by the trust company.

It is also argued on behalf of the certificate holders that, assuming that the contractual provisions in question are contracts of guaranty, the proviso of section 12019 of the Michigan Compiled Laws of 1929, limiting in certain respects the power of a Michigan incorporated trust company having "outstanding liabilities in the form of guaranteed obligations" to "engage in the general banking business, as provided for in this section," which section was enacted in 1929 as an amendment to the statutes governing such trust companies, constitutes a legislative recognition of the validity of such contracts. It would seem that if the Legislature had intended by this statute to confer on trust companies this power which they did not then possess it would, as it easily could, have amended the section (section 12018 of said Compiled Laws) which specifies the various things which such companies "shall have power" to do, or at least would have expressly and affirmatively provided that said companies would have such new power. This new section, however, merely authorizes the state banking commissioner to permit such a trust company to engage in the general banking business and, by this proviso, imposes certain restrictions, in that connection, upon a trust company which has outstanding guaranteed obligations. This language falls far short of indicating an intention to add to the then existing powers of trust companies the power to enter into such contracts as are here involved. At most, it refers to a trust company which has exercised a power which it already had. The "guaranteed obligations," therefore, to which it thus refers, must, in my opinion, have been such obligations as were not declared, in the Metropolitan Trust Company Case, to be beyond the powers of such a trust company, as, for example, the power to make a contract of guaranty "in order to raise funds with which to carry on a trust business." The contention to the contrary cannot be sustained.

It is further argued that each of these certificates constitutes a primary obligation of the trust company in the nature of its debenture secured by a pledge of the notes and mortgages to which it refers, and that therefore the execution thereof by the trust company was but an exercise of its power, under said section 12018 of the Michigan Compiled Laws of 1929, to "loan money upon real estate and collateral security, and execute and issue its notes and debentures, payable at a future date, and to pledge its mortgages on real estate and other securities as security therefor." This same contention was presented in the Metropolitan Trust Company Case and overruled by the court, as its opinion already quoted shows, and therefore need not be discussed or further considered here beyond the statement that, for reasons hereinafter mentioned, as such contention involves a question as to the construction and effect of a state statute and of corporate powers and contracts thereunder, the decision of the highest court of that state will be followed by the federal court, where, as here, it is applicable.

Whether the Metropolitan Trust Company Case involved one guaranty or two (one a guaranty of the notes and mortgages and the other of the certificate itself) is not entirely clear, but, in my opinion, is immaterial and need not be determined, as it is plain from the opinion of the Michigan Supreme Court there that what rendered the provisions in question void, under the facts to which the court referred, was the circumstance that they constituted guaranties by the trust company of the obligations of another person, and it can make no legal difference whether the obligations of one or of two persons were so guaranteed.

It seems equally immaterial, as regards the applicability of that case here, that there each certificate related to an undivided interest in several notes and mortgages, while in the present case each certificate relates to only one note and mortgage. As already pointed out, the facts and contractual provisions in the two cases are in all substantial respects the same, and the real nature of the clauses in question does not depend upon, and is not affected by, the number of notes and mortgages which they assign and, in effect, guarantee.

The provisions of these mortgage participation certificates here under consideration having been declared to be ultra vires and contrary to public policy by the highest court of the state of Michigan, its decision, thus determining the powers of a Michigan corporation under the laws of that state and the resultant effect upon contracts made by such a corporation and upon the rights of the parties to such contracts, will, at least in the absence, as here, of any federal statutes or decisions to the contrary, be followed by this court. Bucher v. Cheshire Railroad Co., 125 U.S. 555, 8 S.Ct. 974, 31 L.Ed. 795; Hartford Fire Insurance Co. v. Chicago, Milwaukee St. Paul Railway Co., 175 U.S. 91, 20 S.Ct. 33, 44 L.Ed. 84; Fifth Avenue Coach Co. v. New York, 221 U.S. 467, 31 S.Ct. 709, 55 L.Ed. 815; Hummel v. Warren Steel Casting Co., 5 F.2d 451, 453 (C.C.A.8); Prudential Insurance Co. v. Liberdar Holding Corporation, 72 F.2d 395 (C.C.A.2).

It is urged that even if these contractual provisions be void, yet recovery may be had, under the common counts, of the amounts paid to the debtor thereunder. As, however, the said provisions are illegal and void as not only ultra vires but also contrary to public policy, there becomes applicable the settled rule of the federal courts to the effect that neither party to such a contract may obtain any relief with respect thereto, either by recovery thereon or by recovery of the sums paid thereunder, at least where, as in this case, both parties are chargeable with knowledge of such illegality and such parties are in pari delicto. St. Louis, Vandalia Terre Haute Railroad Co. v. Terre Haute Indianapolis Railroad Co., 145 U.S. 393, 12 S.Ct. 953, 36 L.Ed. 748; Harriman v. Northern Securities Co., 197 U.S. 244, 295, 25 S.Ct. 493, 49 L.Ed. 739; Second Russian Insurance Co. v. Miller, 268 U.S. 552, 45 S.Ct. 593, 69 L.Ed. 1088; Levy v. Kansas City, 168 F. 524, 22 L.R.A. (N.S.) 862 (C.C.A.8) and cases therein cited.

Finally, the contention that the debtor corporation is estopped to raise this defense of invalidity, and that therefore such defense is not here available against holders of these certificates, is, in my opinion, without merit, for the reason, if for no other, that the objections to claims of such holders seeking recovery of amounts agreed, by the clauses of the certificates in question, to be paid by the Bankers Trust Company or of amounts paid by such holders to said trust company under such certificates, were raised, as already stated, not by the debtor, but by certain of its creditors, as the latter were, of course, entitled, in this bankruptcy proceeding, to do, under section 57 of the Bankruptcy Act (11 U.S.C.A. § 93) providing that objections to the allowance of claims may be made by "parties in interest"; it being too well settled to require the citation of authorities that creditors of the bankrupt are such "parties in interest."

It results that the prayers of the petitions of the aforementioned creditors, praying for the disallowance of all of said claims filed herein, must be granted, and all of such claims must be disallowed. As already noted, no other question is here involved and therefore no such other question is hereby determined.

I recommend that an order be entered accordingly.