This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
The mortgage, separated from the bond, is more commonly known as a "deed of trust." In ordinary practice, the trustee who holds title to the property mortgaged and is supposed to act on behalf of the bondholders is a trust company. Ordinarily, the trust company, however, is actually chosen, not by the bondholders, but by the corporation which issues the bonds. It is always expected at the outset that its duties will be of a purely formal character, and in the comparatively rare instances where it has been necessary for the trustee to take some active steps in order to protect the interests of the bondholders, there has been considerable complaint that its duties as a trustee were not performed with sufficient vigor. It would seem that some effective remedy for this complaint ought, if possible, to be found. The investment bankers of the country who have a moral responsibility in the matter, in hat they sell corporate bonds in large quantities to the general public, might well consider the advisability of using their powerful influence to insure closer vigilance on the part of the trustees of large corporate mortgages.
The deed of trust for important bond issues is apt to be an extremely complicated and detailed document. To the lay reader its phrasing - like the phrasing of many other legal documents - appears cumbersome and unnecessarily redundant; but it must be borne in mind that thousands of cases have been adjudicated, each one of which has helped to interpret the exact shade of meaning of certain combinations of words. After the interpretation has once been made, it is safer by far to use that combination of words in the future, rather than to introduce new difficulties. As the result of long experience, corporate deeds of trust now tend to follow customary models and usually contain practically the following information:
1. A preamble which sets forth the legal status of the corporation; the amount of the bond issue and also of its other bond issues; the authority given by the stockholders and directors for granting the mortgage; the full text of the bond and other similar information.
2. The granting clause which transfers the property to the trustee; describes the duties of the trustee; and contains the covenant of the corporation to pay principal and interest on the bond issue as due.
3. The obligation of the corporation to maintain the property in good condition; to keep it insured; to pay taxes and the like.
4. The procedure of the trustee in case of default.
Usually there is no technical default until 30 days or more after a payment has become due. The percentage of bondholders - usually 20 to 25% - at whose request the trustee shall proceed to foreclose the mortgage or to take such steps as may be prescribed.
5, The responsibilities, liabilities, and compensation of the trustee are presented, and provision is made for the resignation or removal of a trustee, and for the appointment of a successor.
Many corporate mortgages contain what is known as the "after acquired property" clause, which makes the mortgage cover not only the specific pieces of property described therein, but also such other property as may later be acquired. The object clearly is to furnish further protection to the bondholders and to make it difficult for the corporation to embark upon new expenditures without giving full protection to the bondholders. When this clause is missing, there is always the possible danger that the property covered by the mortgage may deteriorate or at least become of secondary importance as compared with other property later acquired. Suppose, for instance, that a manufacturing corporation mortgages one of its plants but later purchases another plant which is better located; in that case the first plant would probably be neglected and would rapidly deteriorate.
There is the opposite danger to the corporation in case the "after acquired property" clause is included in the mortgage. The company may later wish to purchase property essential to its business and which will tend to increase the value of the property mortgaged. In order to purchase the new property, it will need to borrow more funds. But the "after acquired property" clause covers the new property with a first lien so that it may be impracticable to use it as security for the new loan. The usual solution of this particular problem seems to be to evade the provisions of the mortgage by turning over the newly acquired property to a subsidiary corporation which is then able to give a first mortgage and go ahead with whatever borrowing is required.
The question as to whether to include the "after acquired property" clause or not, is clearly a choice between evils. There is no universal answer. The circumstances and probabilities in each case must be considered. This is a problem that would be more easily solved if the trustees of corporate mortgages were willing to assume a greater responsibility, in which case the bondholders would doubtless be willing to leave them a considerable amount of discretion.
Another question in connection with most corporate mortgages and bond issues, is whether they shall be "closed" or "open." They are "closed" when a given amount of bonds is at once issued under the mortgage, but no more may later be issued. The "open" mortgage, which is not customary except with railroad companies, leaves the total amount indefinite, although some restrictions are imposed. The most common arrangement is to permit the issue of bonds at a fixed rate per mile of track. The "closed" mortgage, like the "after acquired property" clause, may prove a serious hindrance to the financing of new purchases which may be in every respect desirable. The "open" mortgage is subject to obvious abuses. In the practice of railroad corporations, a compromise has been found in recent years through the creation of what is known as "limited open end" mortgages, which authorize the ultimate issue of a much larger amount of bonds than it is intended to issue immediately. In this way, the future is provided for to a reasonable extent and yet the bondholders are protected from a reckless overissue which would dangerously reduce the margin of safety back of their holdings.
These "limited open end" mortgages may even cover bonds all of one issue but bearing different rates of interest. This has been the case with a number of railroad mortgage issues. Both the Chicago and Northwestern Railroad, and the Chicago, Milwaukee and St. Paul Railroad, have general mortgages protecting some bonds that bear 3 1/2% and others that bear 4% interest.