National Union Mortgage Corp. v. Potomac Consolidated Debenture Corp.

Mitchell, J., delivered the opinion of the Court. During the period preceding the nation-wide depression which broke in 1929, what were commonly known as mortgage companies sprang into existence and proved to be attractive outlets for millions of dollars then held by investors. The plan under which these companies operated was that of issuing bonds against the security of mortgages upon real and leasehold property held by them and selling these bonds to the investing public. To add to the attractiveness of the class of investments above indicated, the companies elicited the co-operation of surety corporations, to the end that the latter, for an agreed premium, would guarantee said bonds, both as to the payment of the interest accruing thereon, and the principal upon the maturity thereof.

In the course of its regular surety business, The Maryland Casualty Company (hereinafter called Maryland) was one of the surety companies which extensively engaged in the mortgage bond guaranty business, there being in 1933, the period in which the depression reached its climax, approximately 850,000,000 of mortgage company bonds outstanding, back of the security of which the guaranty of Maryland was pledged. The rapid shrinkage in the value of the property securing the mortgages and the consequent loss of income to the mortgage ⁶⁶² companies resulted in the practical insolvency of many of the latter companies, and demands upon sureties for the fulfillment of their guaranties. As a result of that situation Maryland suffered and paid losses of approximately §17,000,000 on account of its mortgage guaranties, for which it received unliquidatable assets of uncertain value. In line with the general depression then existent the surety had suffered substantial losses in other branches of its business, and its guaranties upon the bonds were accordingly regarded as being of little, if any, financial value.

The guarantor was therefore confronted with losses which, unless in some way averted, were, with reasonable certainty, destined to bring about its own liquidation. The same situation, to a greater or less degree, confronted other large surety corporations, which under prosperous and favorable conditions had engaged in the business of guaranteeing mortgage bonds. To meet this crisis, certain investment banking houses • which had been active in marketing mortgage bonds guaranteed by Maryland, as well as like bonds guaranteed by United States Fidelity & Guaranty Company (another large surety corporation in the City of Baltimore), in conjunction with the mortgage companies involved, with interests representing bondholders, and with representatives of the two surety corporations above mentioned, thereupon sought the aid of the Reconstruction Finance Corporation, a federal agency, with a view of securing such financial assistance as would enable the obligors and their sureties to formulate a refunding plan for submission to bondholders. At the incipiency of negotiations looking to an ultimate refinancing plan, the outstanding bonds guaranteed by said two surety corporations aggregated §86,461,900, and at that time these bonds were selling at from thirty to forty cents on the dollar.

The plan contemplated an offer to the holders of said bonds whereby the holders were to exchange their bonds for either: ⁶⁶³ Option 1: An equal principal amount of mortgage secured bonds of a new mortgage bond company to be organized; the new bonds to mature in twenty years, and to bear interest at the average rate of 3.5 per cent, and to be guaranteed both as to principal and interest by the surety of the issue exchanged for the new bond; said bonds were to be secured primarily by pledge of the collateral trust bonds surrendered by holders accepting Option 1, or a pro rata amount of the mortgages constituting part of the security for the bonds of such issue. Option 2: An amount of cash equal to thirty per cent of the principal amount of the bonds surrendered, plus an unsecured debenture, of a new debenture company to be organized, in an amount equal to seventy per cent of the principal of the bonds surrendered; the debentures were to mature in twenty years, to bear interest at the average rate of 4.35 per cent over the twenty year period, and were to be guaranteed by the surety as to fixed interest only. One group of six mortgage companies, for which the plan contemplated the formation of a single debenture corporation, had outstanding $9,698,300 aggregate principal amount of bonds; and the debenture corporation, later formed in consummation of the plan for these six companies, is one of the defendants herein, Potomac Consolidated Debenture Corporation. The plan was submitted by the refunding plan managers to the holders of said $9,698,300 mortgage bonds by circular dated June 7th, 1933, which explained the plan with detailed description of Option 1 and Option 2, and urged bondholders to deposit their bonds immediately under one or the other of said options.

Of the aforesaid $9,698,300 bonds, $1,750,400 were deposited under Option 1, and $7,781,400 were deposited under Option 2. (The percentage basis thus was, Option 1, 18.1 per cent.; Option 2, 80.2 per cent.; undeposited, 1.7 per cent.) The plan was declared effective and Potomac Consolidated Debenture Corporation was formed. It secured loans from Reconstruction Finance Corporation in the ⁶⁶⁴ amount of $2,567,862, and paid in cash, by way of thirty per cent on account, to old mortgage bonds deposited under Option 2, the sum of $2,384,420, and also paid on account of accrued interest on said bonds the sum of $177,536.85. With reference to the plan as applied to the approximately $50,000,000 old bonds identified with the guaranty of Maryland, over 99 per cent were deposited under the refunding plan; approximately 24.5 per cent thereof were deposited under Option 1, and approximately 75.5 per cent thereof under Option 2.

Pursuant to the plan, $11,524,800 principal amount of new mortgage bonds were issued to persons electing Option 1; and $26,127,430 principal amount of new debentures were issued, and $11,197,470 in cash principal was paid, to persons electing Option 2. To effectuate the refunding plan the Reconstruction Finance Corporation first loaned the sum of $17,500,000 to the surety for its own rehabilitation and, secondly, loaned to new debenture companies, identified with the guaranty of Maryland, approximately $12,000,000; which loans were secured by a pledge of the assets of the debenture companies and the guaranties of the surety. The holders of original mortgage bonds, of the six mortgage companies comprising the group to which reference has been made, thereupon deposited those bonds with Maryland Trust Company as depository, and on June 10th, 1933, became parties to a deposit agreement entered into by and between the Potomac Consolidated Debenture Corporation, a newly created corporation (hereinafter called Potomac), Maryland Trust Company, depository, and the depositing bondholders. The above deposit agreement fixed the terms and conditions under which bonds deposited under Option 1 were to be exchanged for new mortgage bonds, and those deposited under Option 2 for cash and new debentures.

A debenture agreement, as of December 1st, 1933, between Potomac and Maryland Trust Company, trustee, was thereupon executed, and to that agreement Maryland ⁶⁶⁵ also became a party, as guarantor of the fixed interest only, upon the debentures to be issued thereunder. Under the terms of its agreement with Reconstruction Finance Corporation, all assets of Potomac were pledged to the former as security for loans aggregating 82,567,-862; and that indebtedness having thereafter been fully repaid through the liquidation of its pledged assets, the remaining assets of Potomac were returned to it on July 28th, 1938, discharged from the obligations of the above pledge. Since said date that corporation has been directly receiving the proceeds accruing from the liquidation of its remaining assets. Article III, section 2, sub-section 4, of the debenture agreement of December 1st, 1933, to which reference has been made, provides as follows: “4.

That after the repayment in full of the indebtedness of the (Potomac) corporation to the Reconstruction Finance Corporation, all principal collections and amounts received in liquidation of its assets shall be used only for any or all of the following purposes and within said limitations the Corporation shall designate such use, viz. : “(a) For the redemption of debentures in the manner hereinafter provided in Article V of the agreement; “ (b) for the purchase of debentures at the lowest price offered, not exceeding par, after advertisement for tenders. Such advertisement to be as provided in Article V hereof as regards time, place and length of notice. “(c) For the purchase of debentures at public or private sale at a price not to exceed par.” In the final analysis, the decision in the instant case rests upon the construction of the above-quoted subsection; the proceedings in said case having originated from two actions instituted in the Circuit Court No. 2 of Baltimore City, under the provisions of chapter 294 of the Acts of 1939, known as the Uniform Declaratory Judgments Act, which cases were thereafter consolidated. Both of the original suits were instituted by the National Union Mortgage Corporation, the appellant, ⁶⁶⁶ and were brought against Potomac, Maryland, Maryland Trust Company, trustee under the debenture agreement with Potomac, dated December 1st, 1933, and Maryland Trust Company and Joseph A. Wherrett, trustee under an indenture of trust, dated January 1st, 1934, from National Union Mortgage Corporation, securing an issue of twenty-year collateral trust bonds, Series A, of said mortgage corporation. Upon the petition of the Reconstruction Finance Corporation, the latter corporation was thereafter permitted to intervene as a party defendant in each case.

The allegations in the respective bills of complaint filed in the two original cases are in effect similar, except that in the last suit brought the bill prays, in addition to the relief sought in the first complaint, that Potomac may be enjoined from purchasing with funds derived from the process of liquidating its assets, any of its outstanding debentures at a price or prices in excess of the fair value thereof, as measured by the fair salable value of the assets held by Potomac at the time of such purchase. With the latter distinction as between the two complaints, in addition to some of the facts hereinafter detailed, the bills of complaint allege that, at the time the. suits were brought, there were §3,590,000 face amount of twenty-year debentures of Potomac issued and outstanding, under the debenture agreement to which we have referred, and in the hands of more than 1500 owners; that the plaintiff, the appellant corporation in this appeal, is the owner of §453,880 of said debentures, which said debentures are pledged by it with Maryland Trust Company and Joseph A. Wherrett, trustees under an indenture of trust, dated January 1st, 1934, from the plaintiff; that Potomac was formed for the purpose of carrying into effect the refunding plan hereinafter outlined ; the pledge of its assets to Reconstruction Finance Corporation for loans made to it by the latter corporation in accordance with the terms of the debenture agreement; the full repayment of said loans from proceeds derived from the liquidation of its assets, and that its remaining ⁶⁶⁷ assets were then held by it. Furthermore, that Potomac had at all times conducted its business solely for the purpose of the liquidation of the assets acquired by it pursuant to the general refunding plan; that its business and operations were limited to such liquidation and that it was, under the general refunding plan, intended to be a liquidating company charged with the liquidation of assets acquired by it, for the benefit of the owners and holders of its debentures. It is then alleged that Potomac is owned and controlled, through ownership of its entire capital stock, by Maryland ; that the latter dictates and controls the selection of its board of directors and officers; directs the management of its affairs, including, but not by way of limitation, the liquidation of its assets and the application of the proceeds of such liquidation; that the value of the assets of Potomac is considerably less than the amount of its liabilities; and that the obligation of Potomac under the debenture agrément to pay the principal of its debentures, when and as such principal becomes due and payable, has become impossible of performance.

Generally, it is charged that Potomac and Maryland occupy a fiduciary relationship to the plaintiff and all other holders of Potomac debentures; that said owners are the equitable owners of the assets of Potomac; and that while occupying such relationship, Maryland and Potomac, on or about August 9th, 1938, caused to be sent, to all known owners of Potomac debentures, a call for tenders thereof, accompanied by a computation sheet which, as to debentures of Potomac, based upon the then liquidating value of the remaining assets of the corporation, as compared with its remaining liabilities, fixed the liquidating value, as of said date, of Potomac debentures, at §43.69 per §100. And it is submitted that any use of the funds realized from the liquidation of the assets of Potomac, after the repayment of its loan from Reconstruction Finance Corporation, to acquire debentures at a price in excess of the actual liquidating value, would be in violation of the terms of the debenture agreement; ⁶⁶⁸ of the rights of Maryland Trust Company, trustee for the debenture owners under said agreement; and of the plaintiff and all other owners and holders of debentures similarly situated, as well also as in violation of the alleged fiduciary duties owed by the defendants, Maryland and Potomac, to Maryland Trust Company as trustee, and to the owners of said debentures. While, therefore, the bills of complaint do not question the legal right of Maryland to purchase with its own funds debentures issued by Potomac, in any amount and at any price it elects, they nevertheless submit that Maryland cannot exact from Potomac, either directly or through its wholly-owned subsidiaries, upon the occasion of any call for tenders or at any time, á price greater than the actual liquidating value of said debentures, as of the time of their purchase by Potomac. In this connection the complainant sets forth that, pursuant to said call for tenders by Potomac, a large block of its debentures was purchased by Maryland, at prices in excess of the liquidating value thereof as estimated by the defendants, Maryland and Potomac, at the time of said call.

It is further alleged that, in said transaction, so much of the purchase price of said debentures as was in excess of the liquidating value of the same was advanced by Maryland or its wholly-owned and controlled subsidiary or agent, and that the remaining purchase price, based on the actual liquidatng value of the assets securing said debentures, was paid by Potomac. Furthermore, that Potomac has entered into an agreement with Maryland to reimburse Maryland or its subsidiary or agent the excess liquidating value incident to said transaction*, at such time and in such manner, and from such assets, as may be authorized by a court of competent jurisdiction in an appropriate action brought for the purpose of determining the rights and duties of Potomac with reference to the use and application of all principal collections realized in the liquidation of its assets. In “Stipulation A,” which appears in the record, it is shown that Maryland, as a result of calls for tenders under the debenture agreement identified with Potomac, ⁶⁶⁹ purchased §1,679,370 face amount of Potomac debentures at a cost of §962,707.31, which was at that price §228,990.50 in excess of the liquidating value of the debentures so purchased. These debentures were sold or resold by Maryland to Potomac at cost, under contracts, copies of which are filed with Maryland’s answer to the first bill of complaint, upon the terms alleged in said bills as above set forth; and it is submitted, by both Maryland and its subsidiary Potomac, that under the true construction of article III, section 2, sub-section 4, of the debenture agreement, as hereinbefore quoted, the contract designed to secure Maryland’s excess payments as indicated are valid, and consequently legally enforceable.

The decree of the chancellor is to the effect that under the true meaning and construction of the debenture agreement dated December 1st, 1933, cash in the hands of the defendant, Potomac, representing principal collections upon or proceeds of liquidation of its assets, can, and must within a reasonable time after being realized by said defendant, be used (a) for redemption of debentures in accordance with article Y of the debenture agreement, or (b) for the purchase of debentures at the lowest price offered, not exceeding par, after advertisement for tenders, or (c) for the purchase of debentures at public or private sale at a price not to exceed par, all as provided in article III, section 2, sub-paragraph 4, of said agreement; and that such use and application of said principal cash for the acquisition of debentures shall be made within the limitations as to price, namely, that the price of debentures shall not exceed par, expressly set forth in the debenture agreement, and without regard to the pro rata share of the asset value or liquidating value of the debentures at the time or times of acquisition thereof, and without regard to any other restriction or limitation not expressly stated in said article III, section 2, sub-paragraph 4, of the debenture agreement. By the decree the bills are dismissed in so far as they seek to enjoin Potomac from acquiring its debentures at a price in excess of the liquidating value thereof, or to enjoin the defendant Maryland from insisting upon Po ⁶⁷⁰ tomac’s obligation to acquire its debentures through the use of principal cash coming into its hands at prices not in excess of those fixed by the above article, section and sub-paragraph, but which may exceed the liquidating value of said debentures. And by said decree all agreements or contracts between Maryland and Potomac designed to obligate the latter corporation to pay for debentures in the future sums aggregating $228,990.56 are construed to be in conflict with article III, section 2, paragraph 1, of the debenture agreement, which prohibits Potomac from voluntarily incurring obligations, other than those to Reconstruction