Story Case

The Blue Valley Irrigation Company owned irrigation property worth $500,000. It was capitalized and had outstanding $500,000 in capital stock. Against the objection of the minority stockholders, the corporation bonded its property in the year 1910 for $100,000. This it had the legal right to do, notwithstanding the minority objection. The company deeded the property to the California Trust company and then issued bonds in the denomination of $100 each, based on the trust deed. To these bonds coupons were attached, reciting that seven per cent interest was due on each semi-annually. The bonds also provided that it was essential to their validity that each bond should contain a certificate of issue, authenticated by the trustee. By accident, the trust company failed to sign the coupon bonds, acknowledging the existence of the trust arrangement. The Guaranty Trust Company purchased $20,000 worth of these bonds six months after they were issued. It paid only $15,000 for the entire lot purchased. It held them for three months and then sold the entire issue to the Marshall Gorham Estate for $17,000. At the time of the sale to the Gorham estate the first interest coupon was due and unpaid. Subsequent coupons also were not paid, and in 1915 the irrigation company became insolvent. The unsecured creditors and minority stockholders now maintain that the bonds were not a preferred claim against the property, since they were not properly issued, and therefore, all of the bondholders whose bonds were not sold by the company until after an interest payment was due must come in with other unsecured creditors and share equally in the proceeds from the sale of the property. To this the Gorham estate objected on the ground that the bonds were negotiable instruments, and that it was a bona fide purchaser for value and, therefore, took free of defects. Is this correct?

Ruling Court Case. Mason Vs. Frick, Volume 105, Pennsylvania State Reports, Page 162

Mason owned a bond of the Denver City Water Company, in which it promised to pay the bearer $1,000 in twenty years. The payment of this bond, as well as that of all the others of the series of 250, or total issue of $250,000, was secured by a deed of trust of the property and franchises of the company, and these facts were recited on the face of the bond.

Mason's safe was broken into and the bond stolen. Subsequently it was identified, by its number, in the possession of Frick, who had bought it in good faith, with no knowledge of the theft, from one Freeman, who was an accomplice in the theft. This suit was brought by Mason to recover the bond or its value. The defense of Frick was that this was a promissory note of the corporation and, being payable to bearer, was negotiable so that a purchaser in good faith, even from a thief, acquired a good title. The answer of Mason was that this was not a note, but a sealed obligation which did not come within the rules of commercial paper. The fact that it showed on its face that it was a part of a mortgage debt was also urged as distinguishing it from a negotiable instrument.

It was held that the bond was negotiable and that the purchase of Frick would be protected. The court said, in an opinion delivered by Mr. Chief Justice Mer-cur: "It is true the bond is under seal and the payment thereof secured by a first lien mortgage on the works of the company. As, however, it is payable to bearer, the manifest intention was to make it transferable by delivery, and to have it pass as negotiable paper. With the language of negotiability on its face, the seal impressed thereon did not destroy its negotiability. The holder may maintain an action in his own name, and every transfer to a new holder, if for value and without notice, gives the latter a good title which is not affected by the want of title in the former holder."

Since the bond stood upon the same basis as a bill of exchange, the title of Frick was not affected by the fact that Mason had been robbed of the bond and had never transferred his property in it. The purchase was a protection, and judgment was given for the defendant, Frick.

Ruling Law. Story Case Answer

Public Utility Bonds are usually made payable to the trustees named in the mortgage and indorsed by him, or made payable to bearer and, therefore, pass by delivery from hand to hand and are, in fact, as strictly negotiable as bank bills.

Justice Nelson, pronouncing the decision of the United States Supreme Court in White vs. Vermont Railroad Company, Volume 21 Howard (United States) Reports, said: "We think the usages and practice of the companies themselves and of the capitalists and business men of the country dealing in them, as well as the repeated decisions or recognition of the principle by courts and judges of the highest respectability, have settled the question. Indeed, without conceding to them the quality of negotiability, much of the value of these securities in the market, and as a means of furnishing the funds for the accomplishment of many of the greatest and most useful enterprises of the day, would be impaired. Within the last few years large masses of them have gone into general circulation and in which capitalists have invested their money, and it is not too much to say that a great share of the confidence they have acquired as a desirable security for investment is attributable to this negotiable quality, as well as on account of the facility of passing from hand to hand, as the protection afforded to the bona fide holder."

To the same effect Justice Greer said in Volume 1, Wallace, United States Reports, page 83: "Usages of trade and commerce are acknowledged by the courts as part of the Common Law, although they have been unknown to Brocton or Blackstone, and this malleability to suit the necessities and usages of the mercantile and commercial world is one of the most valuable characteristics of the Common Law. When a corporation covenants to pay to bearer a bond, negotiable, with negotiable qualities, and by this means obtains funds for the accomplishment of the useful enterprise of the day, it cannot be allowed to evade the payment by parading some obsolete judicial decision that a bond, for some technical reason, cannot be made payable to bearer. That these securities are treated as negotiable by the usages of the whole civilized world, and have received the sanction of judicial recognition, not only in this court, but in nearly every state of the union, is well known and admitted."

Since it is admitted that these bonds have the characteristics of negotiability, a purchaser in good faith and for value, in the usual course of business, is not affected by any irregularity in the original issuing of the bonds, or any misapplication of them by the immediate transferee of which the purchaser had no notice. This rule prevails also in those jurisdictions where a mortgage is said not to be incidental to a note, and where, therefore, the purchaser of a negotiable note, secured by a mortgage, takes it subject to all the defenses which existed in favor of the mortgagor against the mortgagee. The distinction is made on the ground that bonds are thrown upon the public market to circulate as money, and to be used as securities for permanent investments. Therefore, a mortgage, in all states, is incidental to the bond issue.

The holder of a negotiable note is presumed to be the rightful holder and the burden is not upon him to show how any previous holder obtained it. Thus, a purchaser in good faith from a thief is protected. In the same way, one who has purchased bonds from other than the corporation, is protected, although they were issued in violation of charter restrictions. Thus, where bonds are sold by a company at less than par, when the charter provided that this could not be done, the first buyer has no protection, but a bona fide purchaser from him is protected. The fact that negotiable coupons, attached to a bond, are past due and unpaid, does not alone destroy the bond's negotiability.

"To hold otherwise," said Justice Fields, speaking for the Supreme Court of the United States, "would throw discredit upon a large class of securities issued by municipal and private corporations, having years to run, with interest payable annually or semiannually. Temporary financial pressure, falling off of expected revenue or income, and many other causes, having no connection with the original validity of such instruments, have, heretofore, in many instances prevented a punctual payment of other installments of interest on them as it matured, and similar causes may be expected to prevent a punctual payment of interest in many instances thereafter. To hold that a failure to meet the interest as it matures, renders them, though they may have years to run, and all subsequent coupons, dishonored paper, subject to all defenses, good against the original holders, would greatly impair the currency and credit of such securities, and correspondingly diminish their value."

As in the case of negotiable paper, however, the bonds must have all the characteristics of negotiability as to certainty of time, certainty of payment, payment in money and words of negotiability. Thus, the negotiability of bonds may be destroyed by stipulations rendering payment subject to contingencies, as when the majority holders of like bonds may change, alter, or postpone, from time to time, the payment of the principal sum. In the same way, where bonds were made payable to a person named, "or assignees" and not "or bearer," they were merely assignable and not negotiable, and the holder could maintain an action in his own name only by a statement in writing to that effect by the last previous holder.

Also, if fraud or illegality exists at the very making of the bonds which acts against their validity, these may be shown against a bona fide purchaser. Thus, where a corporation officer's name is forged to a bond, or it is issued without the proper authority, it is, in fact, not a bond, and a bona fide purchaser is not protected. If the certificate of the trustee is necessary to the validity of a bond, and the bond is stolen without such certificate, if this is forged, and later the bond is sold to a bona fide purchaser, he is not protected. And it has been held that the failure of a corporation, whose incomplete bonds were stolen, to notify the public that they have been stolen, does not constitute such negligence as would make the company liable.

In the Story Case, the bonds were actually issued by the company, but they did not have the authority of the trustees. The mortgage security, therefore, has not been properly executed, and the bonds are an unsecured claim against the company. The bondholders can have payment only on a pro rata basis with the other general creditors of the company. They share, however, not on the basis of money paid for the bonds, but on the face of the bonds. Therefore, the estate has an unsecured claim for $20,000.