The opinion of the court was delivered by: DIMOCK
The Reorganization Trustee has moved for a determination of the status of $ 5,681,500 of First Refunding Mortgage bonds held by him. They are bonds of Third Avenue Railway Company to which company the debtor, Third Avenue Transit Corporation, is successor by merger. They will hereinafter be sometimes referred to as the Treasury Bonds. The debtor and its predecessor, Third Avenue Railway Company, will be referred to interchangeably as the debtor.
The Right of a Trustee in Reorganization to Enforce Mortgage Bonds of the Debtor Corporation Held by it.
The .reorganization Trustee and parties whose interests are junior to those of the holders of First Refunding Bonds contend that the Reorganization Trustee has a right to enforce these bonds against the mortgaged property for the benefit of the junior interests. The Indenture Trustee of the First Refunding Mortgage and the holders of the bonds secured by it contend that the Reorganization Trustee has no such right. They say that the Treasury Bonds, in the event of foreclosure of the First Refunding Mortgage, would not share in the proceeds of the security thereunder or in any deficiency judgment obtained.
The Reorganization Trustee, in support of his position, says that all of the Treasury Bonds were duly issued and were from time to time repurchased by the debtor with the intention that they should be kept alive and therefore that, so far as their enforcement against the mortgaged property was concerned, they should be treated just like bonds in the hands of the public. The most fundamental contention of the First Refunding Mortgage interests in opposition is that, even granting that the Treasury Bonds were duly issued and were repurchased with the intention that they should be kept alive, they were, from the instant of repurchase and as long as held by the debtor or the Reorganization Trustee, unenforcible by either of them.
It may be well at this point to make clear my intention in entertaining this motion. It seems to me that it will be of value to all parties in the consideration of a plan of reorganization if they know the court's view as to the legal rights of the claimants. Those rights must necessarily be translated as best the court can into the distribution of the securities under any plan of reorganization.
Carrying out that intention, I will consider just what the contention of the Reorganization Trustee would mean in the event of liquidation. Liquidation would involve the foreclosure of the First Refunding Mortgage. The proceeds would be distributable to the bondholders. Under the contention of the Reorganization Trustee, a ratable share of these proceeds would be applicable to the Treasury Bonds and, since the Treasury Bonds are held by the Reorganization Trustee free of the lien of First Refunding Mortgage, the ratable share of the proceeds of the mortgaged property applicable to the Treasury Bonds would be assets distributable to the junior creditors as their interests might appear. Insofar as the holders of the publicly held First Refunding Mortgage bonds were not paid in full, they would be general creditors entitled to share in the proceeds of the mortgaged property applicable to the Treasury Bonds along with the rest of the free assets. If, on the other hand, the Treasury Bonds are not enforcible in liquidation, the proceeds of the security which would otherwise be applicable to the Treasury Bonds will be applicable to the publicly held bonds to the same extent as the rest of the proceeds of the mortgaged property. The controversy thus is one which concerns only the creditors, despite elaborate briefs filed on behalf of the stockholders. The question to be determined is simply the order in which certain of the assets would be applied in case of liquidation among the various classes of creditors. No assets will be created for the stockholders by an answer to the question either way. If the assets are insufficient, so that nothing would be left over for the stockholders, a decision that the holders of the publicly held bonds are not entitled to a lien upon the property represented by the Treasury Bonds will not help the stockholders. If the assets are sufficient, so that there would be a surplus for the stockholders, a decision that the holders of the publicly held bonds are entitled to all of the mortgaged security will not harm the stockholders.
As a matter of common sense, the First Refunding Bondholders' position that the Treasury Bonds cannot be enforced against the mortgaged property seems unassailable. A man cannot owe himself money; hence there is no debt represented by the Treasury Bonds. There can be no security without a debt; hence the Treasury Bonds have no interest in the security under the mortgage.
In spite of the unassailable logic of the position of the First Refunding Bondholders, however, there are business practices which afford a specious argument against it and -- even more important -- court decisions that, to say the least, give the First Refunding Bondholders an uphill fight.
Corporations do buy their own bonds and treat them as investments. They sometimes even go through the solemn formality of entering on their books the payment of the interest ostensibly payable on the corporation-held bonds and the receipt of that very interest as investment income. That practice is not limited to cases where the bonds are held by the corporation in some trust capacity, such as is required by some sinking fund agreements, but is followed in some cases where it would seem to be an idle gesture. Perhaps the usual motive for such treatment of repurchased bonds is to give them as many as possible of the indicia of life so as to support the claim that they have not been cancelled. That question becomes important in the event of a subsequent desire to resell the bonds. The usual trust indenture limits the amount of bonds which may be secured thereunder and does not permit the authentication and delivery of more than the amount of bonds so limited even though the excess is to be issued to replace bonds which have been repurchased and cancelled. Thus the question has often arisen whether the corporation had the right to reissue repurchased bonds or whether the mere possession of the bonds by the corporation prevented their subsequent issue. That question, in essence, is only whether, under the terms of the particular mortgage, the corporation may thus again give the security of the bonds to a new loan after it has, in effect, paid the old loan by repurchasing the bonds. To reach the decision that the corporation may thus reissue repurchased bonds it is not necessary to hold that the bonds, while in the corporation's possession, could have been enforced against the mortgaged property. There is thus not much light to be obtained from the decisions dealing with the impact of mortgage restrictions where bonds have been repurchased and are desired to be reissued. See Pruyne v. Adams Furniture & Mfg. Co., 92 Hun 214, 36 N.Y.S. 361, affirmed 155 N.Y. 629, 49 N.E. 1103. The holding that bonds may be so reissued can be reached without doing violence to the axiom that a man cannot owe himself money. It is only when the question of enforcing repurchased bonds before reissue arises that we run head on into that homely truth.
There are only three or four decisions which deal with the status of repurchased bonds before reissue but all but one of them favor the right of mortgagor-held bonds to share in the security in case of foreclosure. American Brake Shoe & F. Co. v. New York Rys. Co., D.C.S.D.N.Y., 277 F. 261; Westinghouse Electric & Mfg. Co. v. Brooklyn R.T. Co., D.C.S.D.N.Y., 288 F. 221; Crawford v. Washington Northern R. Co., 9 Cir., 233 F. 961, 964-965. The opinion in Claflin v. South Carolina R. Co., C.C.S.C., 8 F. 118, 126, contains the dictum with respect to repurchased bonds: 'When in the hands of the company their lien under the mortgage was suspended; but the moment they were out in the usual course of business, it again took effect as of the time the mortgage was given.' Cases are to be distinguished where the bonds have never been issued and bonds which were unissued up to the time when they were delivered under a pledge are treated as unissued when returned to the pledgor on payment of the pledge. Westinghouse Electric Mfg. Co. v. Brooklyn R.T. Co., D.C.S.D.N.Y., 288 F. 221, 236, 247, supra; New York Security & Trust Co. v. Equitable Mortg. Co., C.C.D.S.D.N.Y., 77 F. 64.
The New York Railways case, supra, is one where the mortgagor had repurchased one-eighteenth of an issue of bonds and then pledged them to secure a loan of $ 400,000. Judge Mayer directed that, upon foreclosure, the proceeds should be allotted seventeen-eighteenths to the publicly held bonds and one-eighteenth to the repurchased bonds. He directed that the loan of $ 400,000 be repaid out of this one-eighteenth of the proceeds and that the 'balance, if any, will go to the Railways Company, and will be applicable to the payment of general creditors' claims'. (277 F. 282.) The case might be distinguished from that at bar on the technical ground that the bonds were outstanding rather than held by the mortgagor. Judge Mayer seems to have had something like that in mind when he said, 277 F. at page 282, 'But a bond cannot be outstanding and yet not outstanding. It is either dead or alive. If alive, it is entitled to share in the proceeds of the foreclosure sale.' If the court there had, however, felt bound by the logic of the proposition that a corporation cannot be a creditor of itself, it could have treated the bonds as outstanding but only for the purposes of the pledge, and directed that the surplus go to the holders of the publicly-held bonds.
The Brooklyn Rapid Transit case, supra, where the question again came up in this district, offers, however, no possible ground for distinction. There, at 288 F. at pages 236 and 247, Judge Lacombe, as Special Master, found that: (a) $ 1,650,000 of the bonds had never been issued and were not entitled to share in they mortgaged assets; (b) $ 3,422,000 of the bonds, which had been used as collateral for loans and returned to the treasury upon payment of the loans, had the same status as unissued bonds; and (c) $ 20,000 of the bonds, which had been bought in the market by a subsidiary (subsequently merged) of the B.R.T., were entitled to share in the mortgaged assets.
On the motion to confirm the Special Master's report, it was contended that the ruling as to the $ 20,000 of bonds was unsound but Judge Mayer rejected ...