INVESTMENT TRUSTS AND INVESTMENT COMPANIES WEDNESDAY, APRIL 10, 1940 UNITED STATES SENATE, SUBCOMMITTEE ON SECURITIES AND EXCHANGE OF THE BANKING AND CURRENCY COMMITTEE, Washington, D. C. The subcommittee met, pursuant to adjournment on yesterday, at 10:30 a. m., in room 301, Senate Office Building, Senator Robert F. Wagner presiding. Present: Senators Wagner (chairman of the subcommittee), Hughes, Herring, and Townsend. Senator WAGNER. The subcommittee will resume its hearing. All right, Mr. Schenker. Mr. SCHENKER. Mr. Chairman, Mr. Smith just has a few words to add to his statement of yesterday evening. Senator WAGNER. All right. Mr. SMITH. I just want to say a few more words Senator WAGNER (chairman of the subcommittee). I had been listening to Mr. Schenker and forgot that possibly you had not completed your statement. You may go ahead. STATEMENT OF L. M. C. SMITH, ASSOCIATE COUNSEL, INVESTMENT TRUST STUDY, SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, D. C.-Resumed Mr. SMITH. I just want to say a few more words about this section 19 (a) of the bill; that is, in respect to dividends. We have provided in that section a moderate provision that dividends can be paid out of capital provided they are allowable by charter and are segregated when paid. Now, there are certain people who feel that dividends should not be paid out of capital at all or in no event if the capital is impaired. There is a good deal to be said for that point of view. I think Judge Healy would like to go into that in some detail when he has the opportunity. However, I think the rest of us feel that if you have a single-class structure-and there are other types of capital structures that must be covered, but I am referring more particularly to commonstock companies-if you have a one-class structure then the problems of dividends are much simpler. You do not have all the problems, as to whether it is fair to senior securities as to paying dividends in good times and slicing off the cream so that in bad times senior securities may be affected. We have made this provision, which is comparable to the provisions of the New York Stock Exchange, to meet the situation, with the further provision that if they do pay dividends out of capital the investor shall have the right to reinvest this capital without a load. Thus they can pay out of capital but must let him put it back again without taking out 6 or 7 percent for load. This provision was was made to meet situations which may and do arise and was suggested by one of the larger trusts. The phraseology may not be complete to meet the situation, but the principle is certainly sound. I might explain that Senator TOWNSEND (interposing). Do you intend to justify the paying of dividends out of capital at all? Mr. SMITH. Can I? Senator ToWNSEND. Yes. Mr. SMITH. Sir, take a one-class company which has invested in equity stocks, we will say it raises $40,000,000 today. That $40,000,000 by reason of fluctuations in the stock market may go down to $15,000,000 and may go up to $60,000,000. It is a very volatile fund. I think there are a great many investors who want to have dividends paid out of capital gains. We have taken the position that it is all right if they are expressly allowable. On the other hand, I think there are a great many people who will tell you that that has worked a fraud on the investor and that no matter how you make it allowable to make payments of dividends out of capital or capital gains, the investor will think it is earnings and be misled by it. There are certain investment companies who have used that practice in their selling campaign. However, we have taken Senator WAGNER (interposing). Mr. Schenker cited a case where $800,000 was taken out of assets to pay dividends, and apparently it was done to make the stock attractive upon the market. Mr. SMITH. That is right. And there was one company that promised a 5 percent dividend right along, forever and ever, whether earned or not. You will find that a great majority of these investment companies do in fact pay dividends out of capital even though the capital is impaired. Section 19 (a) is a provision that we have thought might cover the situation, but it would not bother me for you to make it more rigid. One more point: In regard to existing senior securities we do have here still the problem of existing senior securities. Along that line we have adopted one provision-that if dividends are paid to junior stocks there shall be an adequate coverage, at least a minimum coverage, of assets for the senior securities. In other words, if there is $100 of preferred stock outstanding we have said: You cannot pay any dividends on the common stock unless there is $200 of assets to cover every share of preferred stock; otherwise you might be draining off the assets so far that when bad times came it would be unfair to senior securities. Let us take the Tri-Continental Corporation charter. It says: No dividend shall be declared upon the common stock unless at that time the net assets of declarant, as determined and computed in the manner provided in the agreement of consolidation, as amended, shall be at least 200 percent of the aggregate amount (exclusive of dividends accrued or in arrears) to which all shares of the preferred stock and all shares of stock on a parity therewith, then outstanding, shall be entitled as a preference over the common stock in the event of any voluntary or involuntary liquidation, dissolution, or winding up of declarant. I can show you a number of similar provisions of that sort. The New York Stock Exchange, in the case of one big trust, had a similar provision of 200 percent for preferred stock. We have made the provision of 300 percent for debentures because they are further up the line. Senator WAGNER. But, I take it, that problem does not arise if we provide only for common stock. Senator HERRING. And that provides for existing common stock. Mr. SMITH. That is to take care of companies that are now existing. I showed to you Senators yesterday, although I did not introduce it in evidence, company after company with control stock where 95 percent of the voting power is in stock that has no asset value at all and probably won't have any asset value for years to come. It is to prevent that control from being misused. I do not say that it is adequate to meet the situation, but it is one protective provision. It may be we ought to have more on that. Senator WAGNER. If there were an actual prohibition against paying dividends except out of profits this question would not arise, would it or would it not? Mr. SMITH. This question would not arise then. That is right. But you might interfere with a fairly common practice. Senator WAGNER. I understand that. There are two sides to the question. Mr. SMITH. Yes, and it is a difficult question. I do not think we here have by any means met all the problems that can arise in paying dividends. I think Judge Healy may be prepared at some time to tell you why. I think he is interested in accounting methods which go back to what the original contributed capital was. A difficulty with that situation is this: I know of a number of investment companies that have been organized.with common stock, that started off with a deficit-had no asset coverage at all when formed. To base any historical value upon what the original contract was seems to me not to take into account the inherent difficulty, that the investor did not realize it was unfair to him. Also the stockholders have changed, in 10 years the original investors are out of the picture. It is not a realistic approach to the problem. Mr. HEALY. Mr. Chairman, last night I hoped that this morning I could express myself on the subject of this section dealing with dividends. But I was pressed for time overnight, because I was needed to make a quorum at the Commission, and there were a number of opinions to be written, so that I do not find myself at this time in position to discuss it as I would like to. I think Mr. Smith and I do not understand each other on the subject of dividends, and I would like the subcommittee to postpone my discussion of dividends until a later time. My difficulties center around paying dividends out of capital. I am also not convinced that you can make one rule on the subject of dividends that would apply to all these different types of investment companies, regardless of whether open-end or closed-end, or regardless of whether they have senior securities or not. May I leave it there for the present? Senator WAGNER. Yes; is that all, Mr. Smith? Senator WAGNER. Thank you very much. Mr. SCHENKER. Mr. Chairman, Mr. John Hollands, who has assisted us in the drafting of the recommendations of the Commission, will take up some of the subsequent sections. But before we do that I would like to introduce into the record the chart of J. & W. Seligman & Co. group, which we discussed yesterday. I understand they are examining it for any inaccuracies, but I would like to introduce it subject to correction by them. Senator WAGNER (chairman of the subcommittee.) It may be made a part of the record. (The chart headed "J. & W. Seligman & Co. group, December 31, 1939," is here made a part of the record. Mr. SCHENKER. There is one other thing I would appreciate being done, and that is, for the record to indicate that in my discussion of the Harrison Williams' group of investment companies and the Central States Electric group set-up, that my discussion as to the extent of Mr. Williams' ownership of Northern States Power through his control of Central States was as of December, 1935. There have been some changes since because of the Utility Holding Company Act. I think he has redistributed, or may have liquidated, some stock so that he would not be considered a holding company under the 1935 act. Now, if Mr. Hollands might be heard. Senator WAGNER (chairman of the subcommittee). Give your full name, Mr. Hollands. STATEMENT OF JOHN H. HOLLANDS, ATTORNEY ON THE STAFF OF THE SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, D. C. Senator WAGNER. What page of the bill are you looking at? Mr. HOLLANDS. Mr. Chairman, I will start with section 20, on page 45. Senator WAGNER. All right, Mr. Hollands, you may proceed. Mr. HOLLANDS. Subsection (a) of section 20 contains the proxy provision that is customary in legislation administered by the Commission. Those companies that have securities listed on stock exchanges are already subject to a similar provision in the Securities and Exchange Act of 1934. This provision would make all investment companies registered under this act, subject to the same require ments. The section has been changed slightly from the earlier sections in point of language to make the provisions a little more definite in the light of the experience in administering other proxy sections. Senator TOWNSEND (interposing). Do you mean that you have changed it since the writing of this bill? Mr. HOLLANDS. No. I say that this section of this bill is modeled on other proxy sections in other statutes. In the earlier acts it is slightly different in language. The effect of the changes in this bill is to narrow rather than to enlarge the power of the Commission, I should say. Subsection (b) prohibits a public offering of voting trust securities if the underlying securities in the voting trust are those of a registered investment company. It permits a private offering of voting trust certificates, which means that if a family, for example, wanted to turn |