Maryland National Bank v. Merson

Finan, J., delivered the opinion of the Court. Following a trustee’s sale of 2,000 preferred shares in the-Baltimore Brick Company which comprised part of the trust corpus, three separate suits were filed in the Circuit Court for Baltimore City. These were consolidated for trial, and it is from the decree of the Circuit Court ordering part of the proceeds from the sale to be paid the life tenants that the trustee and remaindermen have appealed. The appeal raises important issues of proper trust management and the relative duties owed, by a trustee to the life tenant and the remainderman.

Frank Novak, by deed of trust (inter vivos) dated July 28, 1937, modified by a supplemental agreement of July 10, 1938, conveyed certain property to the Maryland Trust Company, now known as the Maryland National Bank, as trustee. By these instruments income was to be paid to settlor for life, and thereafter, the corpus was to be divided into two equal parts, the income from each half to be paid respectively to Flossie V. Merson and Gertrude F. Herr, now Gertrude F. Rosenthal (appellees). Upon the death of each life tenant, her half of the corpus was to be paid in equal shares to the remaindermen, Johns Hopkins Hospital and the Roman Catholic Archbishop' of Baltimore. Included in the assets conveyed by the settlor were 2,000 shares of Baltimore Brick Company non-callable first preferred 5% cumulative stock, par value of $100 per share.

The history of dividend arrearages and payments is most critical to this case, since it reflects the increasing financial stability of the Company from the middle 1950’s through 1961, when the shares were sold. The fundamental question in this case, whether the trustee acted with partiality when it sold the stock, must be answered in the context of the soundness of the Company. ³⁵⁶ When the trust was created in 1937, each share contained .a dividend arrearage of $104.25. Between 1937 and October 11, 1945, the date of the settlor’s death, only $16.50 in dividends had been declared, and none for 1943, 1944 or 1945. As ■a result, when each appellee received her 1,000 shares in trust, ¡the accumulated dividend arrearages were $131 per share or •'$131,000 for each trust.

This increased to $143.50 per share in 1951, at which time the Company began the regular annual pay■ments of $5.00 per share. Beginning in 1954, however, the Company also made payments on the arrearages, which arrearages Tave continued to diminish: Dividend Payments (Including $5.00 Year Annual Payment) Arrearages 1954 $10.00 $139.75 1955 10.00 134.75 1956 12.50 127.25 1957 13.00 119.25 1958 22.50 101.75 1959 15.75 93.00 1960 16.25 81.75 1961 36.75 50.00 1962 30.00 25.00 Furthermore, in every year between 1955 and 1960, it was the practice of the Company to pay the dividends on a quarterly basis. Certainly these figures, as well as other evidence in the record, indicate that the Company underwent a marked finan•cial recovery in the 1950’s and was experiencing a good earnings record as of 1961. The trust committee of the corporate 'trustee was well aware of the Company’s financial position because one of its members, Mr. Gordon, also sat as a director of the Baltimore Brick Company.

Appellants allege, without evidentiary support, that the trustee had been looking for an opportunity to sell the stock at a reasonable price for almost 24 years. However, when the Company offered to redeem the stock at $85 per share in 1953 when arrearages stood at $143.50, the trust committee rejected the •offer “in view of the fact that although the Company had not ³⁵⁷ reduced the accrued dividends in recent years, it was now paying the regular dividend.” (Minutes of trust committee of November 5, 1953). The record also shows that as far back as that date, the trustee recognized the satisfactory operations of the Company, and that the intrinsic value of the stock was greater than $85. There is also evidence that at various meetings of the board of directors of the Company prior to 1961, some concerted but unsuccessful efforts were made to authorize even higher payments on dividend arrearages.

Certainly Mr. Gordon realized that the sound position of the Company would be reflected in greater dividend payments to the life tenants. 1 In 1958 a group of prospective purchasers took an interest in the preferred stock, primarily for the reason that the holder of first preferred 5% cumulative non-callable stock could control the Company by electing six of the nine directors. Before the negotiations eventually broke down, Mr. Gordon sent a memorandum to the president of the bank in which he stated in part: “Later in the morning, Mr. Flanigan [a representative of the prospective purchaser] called me and I told him that while our Trust Committee was rather reluctant to accept any discount on the stock because it felt that all of the arrearages would ultimately be paid, the Committee had finally authorized us to go along at $190 per share.” (Emphasis supplied.) In January of 1961, further offers were made, one by Joseph Mullan, who operated a competing brick company, the other by Baker Watts & Co., which was acting for an undisclosed principal. The trust committee requested Alex. Brown & Sons, a highly respected investment firm, to make a financial analysis of Baltimore Brick Company and determine the fair valuation of the preferred stock. 2 The firm answered on January 25, 1961: ³⁵⁸ “In our judgment the Preferred Stock, exclusive of dividend accumulations, would be fairly valued on a yield basis of 6 percent, or a price of $83.00 per share.

Based upon the Company’s past dividend record, it is a fair conclusion that dividend arrearages on the Preferred Stock will be paid off over the ensuing years. An optimistic assumption of such period of time would produce a present value of the dividend arrearages of approximately $77.00 per share. “The sum of the aforementioned figures of $83.00 and $77.00, or an aggregate of $160.00, constitutes our opinion as to the fair market value of the subject shares of Preferred Stock of Baltimore Brick Company.” Shortly after receiving the appraisal, the trustee sold all 2,000 shares to the undisclosed purchaser, which was later ascertained to be the Arundel Corporation, at a price of $162.50 per share, and properly allocated the entire proceeds of $325,000 to corpus. The record indicates that this sale was made without advance notice of any type given to the life beneficiaries. Afterwards Mr. Gordon sent an office memorandum to other members of the trust committee on February 3, 1961.

A portion of this memorandum reads: “From a legal standpoint, I should think that you would recognize the advantage of this sale as it relates to the remaindermen of the particular trusts. That is to say, in normal course the accumulated dividends might have been paid off over a reasonable period of years, thus resulting in diminution of the trust corpus. From the standpoint of the life tenants, it is true that ³⁵⁹ there is a temporary diminution of income; however, once the dividend arrearages had been paid off, the diminution of income would have been even greater. (Emphasis supplied.) “The only thought that occurs to me is that perhaps we should write to the life tenants expressing to them in a diplomatic way the results of this sale.

If you are of the same mind, perhaps you could either prepare letters along the lines which I have indicated, or, on my return from New York, 1 could sit down with you and we could work the letters out together.” Ten days later, Mr. Gordon sent another memorandum, this time to another officer of the corporate trustee. In part it read: “I think that the only pending matter, other than the investment of the proceeds of sale in the usual way, is the consideration of notice to the income beneficiaries of the various trusts. I have discussed the matter of such notice informally with Mr. Machen. His curbstone opinion that letters to beneficiaries of the two trusts which he represents are not necessary.” (Emphasis supplied.) Each life tenant received an income of $18,450 from the subject trust in 1960.

In 1961, appellee Rosenthal received $5,-675, and appellee Merson $3,700. It was only through an inquiry prompted by the diminution of income, that the life tenants learned of the sale of the stock. The corporate trustee and each life tenant filed separate petitions requesting the lower court to determine the proper apportionment of the cash proceeds from the sale. These actions were consolidated on February 19, 1964.

After testimony in open court and submission of legal memoranda, the court held that, although the proceeds were properly allocated to trust corpus, the trustee “acted in good faith but erroneously” in selling the preferred stock, and thus deprived the life tenants of substantial income for the sole benefit of the remaindermen. By way of equitable relief, Judge Harris ordered that $77,000, representing the appraised value of dividend arrearages for 1,000 shares, be paid to each life tenant from her half of the corpus, ³⁶⁰ less any sums earned by the trust which were distributed since the date of the sale. This amounted to a net payment of $59,-939.18 to appellee Rosenthal, and $64,901.58 to appellee Merson. The decree further absolved the trustee from liability to the remaindermen for diminution of the trust estate, since the court found the trustee to have acted in good faith.

Before discussing the legal issues presented it should also be noted that after the memorandum opinion in the court below was handed down, appellants filed a petition for rehearing, in order to offer evidence that appellees were also life income beneficiaries of other trusts established by Frank Novak, and that the total loss of income to appellees has been either minimal or entirely non-existent. Appellants were troubled by Judge Harris’ observation in the memorandum opinion that the stock in question comprised 82% of the corpus and produced 83% of the income of the trust. After a hearing and proffer of evidence, Judge Harris, by a separate opinion, denied the petition on the ground that the evidence proffered by the appellants was in their possession at the time of the first hearing, and that appellants were in essence asking for a new hearing. The appeal is also taken from this order.

The appellants contend that the lower court erred in holding that the trustee acted with partiality toward the remainder-man by selling the stock, and furthermore, by decreeing an apportionment between life tenants and remaindermen, it circumvented settled Maryland law. The “Pennsylvania Rule” of apportionment gives the life tenant a portion of the sale proceeds attributable to retained earnings of the corporation. See Waterhouse’s Estate, 308 Pa. 422 , 162 A. 295 (1932); Nirdlinger’s Estate, 290 Pa. 457, 139 A. 200 (1927). That rule is almost totally confined to Pennsylvania, and certainly has never become part of the Maryland law.

In Safe Deposit & Trust Co. v. Bowen, 188 Md. 482 , 53 A. 2d 413 (1947), this Court adopted the rule that an exchange of stock held in trust for other stock pursuant to a corporate recapitalization was essentially a sale, and that proceeds from this sale were applied to corpus. Any increase in the value of the stock resulting from the exchange was considered a capital gain, even if the increase was attributable to retained earnings ³⁶¹ of the corporation. See also Smith v. Hooper, 95 Md. 16 , 51 A. 844 , 54 A. 95 (1902). Contrary to appellants’ contention, the lower court correctly applied the Maryland law, holding that Bowen was “conclusive of the question raised here.

Whether or not the Trustee acted properly in selling the stock, once it was sold the proceeds of the sale were properly allocated to the corpus of the trust.” The distinction between Bowen and this case lies in the propriety of the trustee’s sale, an issue which was never raised in Bowen . Although the proceeds from the sale must become part of the corpus, are we to hold that the life tenant cannot later obtain redress if it is established that the action of the trustee was in derogation of his fiduciary duty? We think not. Certainly where there is evidence of bad faith on the part of the trustee, the life tenant should be able to obtain reparation by taking direct action against the trustee.

However, where there has been an action of partiality committed, but no evidence of bad faith, then certainly the courts should consider action which would require the trustee to make a distribution from the corpus to remedy the inequity. Before resolving the question of what type of equitable relief would be appropriate in the instant case we feel it necessary to discuss further the nature and quality of the action of the trustee in disposing of the stock on February 2, 1961. We agree with the lower court in its findings that the trustee, while acting in good faith, nevertheless acted with partiality in favor of the remaindermen. We cannot discount the intent manifest in the memorandum issued by the chairman of the trust committee under date of February 3, 1961, wherein the effect which a sale of the stock would have on the remaindermen appeared to be his primary concern and its effect on the life tenants, a secondary consideration, stating: “* * * I should think that you would recognize the advantage of this sale as it relates to the remaindermen of the particular trusts. * * In addition there was evidence that the chairman of the trust committee, Mr. Gordon, as well as the financial analyst who prepared the stock appraisal for ³⁶² Alex.

Brown & Sons, expressed a strong conviction that all of the cumulative dividends, then in arrears, would eventually be paid. The record discloses that the trust officer, Mr. LeRoy Lewis, on cross examination, when presented the hypothetical question of whether a 5 to 1 ratio of current assets over liabilities was good, admitted that he considered a 2 to 1 ratio to be good. The financial statements of the Company introduced as exhibits revealed the Company was conducting a successful manufacturing and sales operation with a well equipped plant. In addition, the real estate which it had acquired for a source of its clay deposits was increasing substantially in value, and as of March 1, 1961, the ratio of current assets to current liabilities was 5 to 1.

The only flaw to which the trustee could point, with regard to the stock as an acceptable security, was its lack of marketability and the absence of diversification in the trust portfolio, due to the fact that 82 °/o of the corpus consisted of Baltimore Brick Company stock. However, it would seem unlikely that these considerations motivated the trustee to make the sale. The facts reveal that the stock was a more attractive investment at the time of the sale than at any time during the sixteen years it had been held in the trust. Furthermore, paragraph 5(a) of the trust agreement specifically authorized the trustee to retain any securities constituting the corpus without liability for any decrease in value.

The quality of the trustee’s action with regard to this sale becomes somewhat disturbing from the disclosures in the record which reveal that the marketability of, and desirability for, the stock became obvious, almost simultaneously, to both Mr. Gordon, who served in a dual capacity as a director in Baltimore Brick as well as chairman of the trust committee of the Maryland National Bank, and