Mersick v. Hartford & West Hartford Horse Railroad , 76 Conn. 11 ( 1903 )

The mortgage to the plaintiff trustee was executed and recorded in accordance with the laws of this State permitting a street railway company to so mortgage all its property, including its franchise, to secure the payment of its bonds, and providing for the foreclosure of such mortgage in the same manner as ordinary mortgages of real estate. General Statutes, § 3848; Whittlesey v. Hartford, P. F. R. Co., 23 Conn. 421, 435.

The funds in the hands of the receiver represent thecorpus of the property thus mortgaged. They are the proceeds of a sale of the mortgaged property, under a judgment in an action instituted by the trustee of the bondholders, as their authorized representative, after he had taken possession of the railroad in accordance with the provisions of the mortgage. In this action he asked for the appointment of a receiver and for a foreclosure by sale.

By the judgment of the Superior Court distributing these funds, the mortgagees of the railroad company receive no part of the proceeds of such foreclosure sale, made by the receiver by order of court and approved and confirmed by the court; but the entire avails of the sale, after the payment of the expenses of the receiver and trustee, and certain unquestioned claims, are applied to the payment of the unsecured claims of the intervening supply-creditors, and of Mersick and Patterson, before described, all of which were contracted since the execution of the mortgage and before possession was taken for the bondholders.

It is the claim of the Farmington Street Railway Company, one of the appellants — which was made a coplaintiff in the foreclosure suit since the commencement of that action, and is now the owner of all the bonds secured by the mortgage — that neither the said supply-creditors, nor Mersick or Patterson, are entitled to payment of their claims from the proceeds of the sale of the mortgaged property, until after payment of the mortgage debt; while said intervening supply-creditors, and Mersick and Patterson, insist that their claims should take precedence, in order of payment, over the claims of the bondholders.

As supporting this claim of the supply-creditors, and of Mersick and Patterson, and as sustaining the judgment of distribution in so far as it gives priority to the supply-claims, and to certain items of the claims of Mersick and of Patterson, the leading case of Fosdick v. Schall, 99 U.S. 235, and numerous other cases which are said to follow the rule laid down in that case, are cited.

Assuming that the doctrine of Fosdick v. Schall, regarding the respective rights of the mortgagees and of the unsecured creditors of a railroad company as to priority of payment from the mortgaged property, or from the proceeds of its sale, at the time the trustee for the bondholders, or a receiver, takes possession of the railroad, is the law of this State, it becomes important to ascertain, first, just what was decided in that case, and second, whether the rule as there laid down is applicable to the facts of the present case.

Fosdick v. Schall was decided in 1878. In the opinion by Chief Justice Waite (p. 252) it is said: "The income out of which the mortgagee is to be paid is the net income obtained by deducting from the gross earnings what is required for necessary operating and managing expenses, proper equipment, and useful improvements. Every railroad mortgagee in accepting his security impliedly agrees that the current debts made in the ordinary course of business shall be paid from the current receipts before he has any claim upon the income. If for the convenience of the moment something is taken from what may not improperly be called the current debt fund, and put into that which belongs to the mortgage creditors, it certainly is not inequitable for the court, when asked by mortgagees to take possession of the future income and hold it for their benefit, to require as a condition of such an order that what is due from the earnings to the current debt shall be paid by the court from the future current receipts before anything derived from that source goes to the mortgagees. . . . This, not because the creditors to whom such debts are due have in law a lien upon the mortgaged property or the income, but because, in a sense, the officers of the company are trustees of the earnings for the benefit of the different classes of creditors and the stockholders; and if they give to one class of creditors that which properly belongs to another, the court may, upon an adjustment of the accounts, so use the income which comes into its own hands as, if practicable, to restore the parties to their original equitable rights. While, ordinarily, this power is confined to the appropriation of the income of the receivership and the proceeds of moneyed assets that have been taken from the company, cases may arise where equity will require the use of the proceeds of the sale of the mortgaged property in the same way. Thus it often happens that, in the course of the administration of the cause, the court is called upon to take income which would otherwise be applied to the payment of old debts for current expenses, and use it to make permanent improvements on the fixed property, or to buy additional equipment. In this way the value of the mortgaged property is not unfrequently materially increased. . . . Under such circumstances, it is easy to see that there may sometimes be a propriety in paying back to the income from the proceeds of the sale what is thus again diverted from the current debt fund in order to increase the value of the property sold. The same may sometimes be true in respect to expenditures before the receivership. . . . Whatever is done, therefore, must be with a view to a restoration by the mortgage creditors of that which they have thus inequitably obtained. It follows that if there has been in reality no diversion, there can be no restoration; and that the amount of restoration should be made to depend upon the amount of the diversion."

In Burnham v. Bowen, 111 U.S. 776, decided in 1884, it was held that a debt for current expenses and payable from current earnings, the mortgage interest being then in arrear, was a charge in equity on the continuing income "as well that which came into the hands of the court after the receiver was appointed as that before," and that a diversion of the current income for the improvement of the mortgaged property, by the trustee in possession or by the receiver, created in equity a charge on the property for its restoration in favor of the current-debt creditor. The opinion concludes with the statement that it was only intended to decide what was decided in Fosdick v. Schall, "that if current earnings are used for the benefit of mortgage creditors before current expenses are paid, the mortgage security is chargeable in equity with the restoration of the fund which has been thus improperly applied to their use."

In St. Louis, etc., R. Co. v. Cleveland, etc., Ry. Co., 125 U.S. 658,673, decided in 1888, the court, speaking by Justice Matthews, said: "But here there is no question in respect to current income. The fund in court is the proceeds of the sale of the property, and represents its corpus; and it cannot be claimed that ordinarily the unsecured debts of an insolvent railroad company can take precedence in the distribution of the proceeds of a sale of the property itself over those creditors who are secured by prior and express liens." After stating that there are cases where, owing to special circumstances, unsecured creditors may be entitled to priority of payment, even from the proceeds of a sale of the corpus of the property, citing Fosdick v. Schall, Burnham v. Bowen, and other decisions of the Supreme Court, the court says: "The rule governing in all these cases was stated by Chief Justice Waite in Burnham v. Bowen as follows" (quoting the concluding words of the opinion in that case, as above stated), and adding: "There has been no departure from this rule in any of the cases cited; it has been adhered to and reaffirmed in them all."

In Kneeland v. American Loan Trust Co., 136 U.S. 89,97, decided in 1890, it is said: "The appointment of a receiver vests in the court no absolute control over the property, and no general authority to displace vested contract liens. . . . One holding a mortgage debt upon a railroad has the same right to demand and expect of the court respect for his vested and contracted priority as the holder of a mortgage on a farm or lot. . . . No one is bound to sell to a railroad company or to work for it, and whoever has dealings with a company whose property is mortgaged must be assumed to have dealt with it on the faith of its personal responsibility, and not in expectation of subsequently displacing the priority of the mortgage liens. It is the exception and not the rule that such priority of liens can be displaced."

In Virginia Alabama Coal Co. v. Central Railroad Banking Co., 170 U.S. 355, 365, 368, decided in 1898, it was said that where the claim for supplies furnished to continue a railroad as a going concern was, as between the party furnishing them and the holders of bonds secured by a mortgage, a charge in equity on the continuing income, it was immaterial, "in determining the right to be compensated out of the surplus earnings of the receivership, whether or not during the operation of the railroad by the company there had been a diversion of income for the benefit of the mortgage bondholders;" and further, that "the dominant feature of the doctrine, as applied in Burnham v. Bowen, is that where expenditures have been made which were essentially necessary to enable the road to be operated as a continuing business, and it was the expectation of the creditors that the indebtedness created would be paid out of the current earnings of the company, a superior equity arises in favor of the material man as against the mortgage bonds in the income arising both before and after the appointment of a receiver from the operation of the property."

The cases above cited, and others upon the same subject, are reviewed in the recent cases of Lackawanna Iron CoalCo. v. Farmers' Loan Trust Co., 176 U.S. 298, 313, andSouthern Ry. Co. v. Carnegie Steel Co., ibid. 257, 285, decided in 1900, in the latter of which the court, in the opinion by Justice Harlan, says: "It may be safely affirmed, upon the authority of former decisions, that a railroad mortgagee when accepting his security impliedly agrees that the current debts of a railroad company contracted in the ordinary course of its business shall be paid out of current receipts before he has any claim upon such income; . . . and that when current earnings are used for the benefit of the mortgage creditors before current expenses are paid, the mortgage security is chargeable in equity with the restoration of any funds thus improperly diverted from their primary use."

Debts contracted not in the ordinary course of the operation of a railroad, but for the purposes of construction, are not entitled to priority of payment over the mortgage debt, under the rule in Fosdick v. Schall, 99 U.S. 235; Wood v.Guarantee T. S. Deposit Co., 128 id. 416; LackawannaIron Coal Co. v. Farmers' Loan Trust Co., 176 id. 298.

From the language quoted from the cases above cited, it would appear that the foundation principle of the rule ofFosdick v. Schall, and the other cases referred to, by which a certain preference is given a particular class of unsecured creditors over the mortgagees of a railroad, is an agreement upon the part of such mortgagees, in accepting such security for the payment of the bonds, that current debts contracted in the ordinary course of the business of the railroad company shall be paid from the current earnings of the railroad before such mortgagees shall have any claim upon such income. It is by virtue of this implied agreement that the current debts, as between the supply-creditors and the mortgagees, become a charge in equity upon the continuing income, both before and after the appointment of a receiver, and whether or not there has been a previous diversion of the income for the benefit of the mortgagee.

But the superior equity springing from such implied agreement, in favor of the current-debt creditors, is in the current income derived from the mortgaged property, and not in the body of the mortgaged property itself. None of the cases above referred to go so far as to imply an agreement upon the part of the mortgagees, in accepting their security, that the body of the mortgaged property may be used to pay the current expenses of operating the railroad. The power of a court of equity to apply the corpus of mortgaged property to the payment of such unsecured claims against the railroad company, is always made to rest upon the fact that in some manner the mortgagees have received the benefit of those earnings, which, by their implied agreement, should have been applied to the payment of current expenses.

We are not prepared to accept as law the rule which seems to have been adopted in some of the cases cited by counsel, that those who have rendered services or furnished supplies to keep a railroad in operation, even after the mortgage interest is in arrear and the bondholders have the right to take possession under their mortgage, are entitled to priority of payment over the mortgagees, from the corpus of the mortgaged property, or the proceeds of the sale thereof, when there has been no diversion of the earnings of the railroad to the benefit of the bondholders.

Assuming, without deciding, that the doctrine of Fosdick v. Schall is applicable to a street railroad like that of the defendants, how does it affect the rights of these intervening creditors? They are not asking that income in the hands of the receiver be used to pay their claims. There are no earnings of the railroad in his hands. The expense of operating the road during the receivership has exceeded the receipts. To entitle the intervenors to payment from the proceeds of the sale of the mortgaged property, it must therefore be shown that there has in some manner been a diversion of the current income for the benefit of the mortgagees.

But it does not appear that the mortgagees have received any part of the income of the road which should have been devoted to the payment of these claims, or that the action of the bondholders in taking possession of the road has prevented the payment of these claims from the earnings of the railroad. On the contrary, it appears that no interest has been paid on the bonds from the earnings of the railroad since August 1st, 1896, and that since that time the receipts from the road have been inadequate for the payment of the ordinary operating expenses, and that large sums have been borrowed by the company to enable it to meet its current obligations. There has been no diversion and there can be no restoration. The claims of the supply-creditors, and the principal part of the Patterson claim, are not debts of the bondholders, but of the railroad company, contracted either upon the credit of the company itself or upon the credit of its earnings. As there has been no diversion of such earnings for the benefit of the bondholders, there can be no payment of such claims, under the doctrine of Fosdick v. Schall, from the mortgaged property or the money derived from its sale, until the mortgage debt is satisfied.

The claims described in the above statement of facts are entitled to priority of payment from the proceeds of the sale, over the bonds, only as below stated.

The first four claims named, amounting to $2,086.97, are, as we understand, conceded to be privileged. As the last of these four unquestioned claims is the only one allowed by the trial court as a preferred labor claim, under General Statutes, § 1051, it is unnecessary to decide whether, under that statute, such a labor claim would be entitled to priority of payment from the proceeds of the sale of the mortgaged property, over the mortgage debt.

For the reason already stated — that there has been no diversion of income — none of the claims of said class of supply-creditors, amounting to $4,196.47, are entitled to preference over the mortgage bonds.

The entire claim of Mersick, trustee, amounting to $4,304.04, is entitled to priority over the bonds, and should be paid as expenses properly incurred by the trustee while in possession of the mortgaged property for the benefit of the bondholders, and should stand in the same rank as to preference as the item of $980, expenses of receiver and trustee.

It appears from the record that the second item of said claim of Mersick ($1,448.08) was money paid by the trustee for wages of employees while the trustee was in possession, at the request of the bondholders, and under the mortgage which expressly empowered him to "operate and conduct the business of said railroad company." No question is made as to the reasonableness of the amount so paid.

The first item of Mersick's claim ($2,855.96) was money paid employees for wages covering a period of about three months before the trustee took possession.

It is said that these claims of Mersick are made for the benefit of Patterson. The finding is that both these sums were advanced by Patterson at the request of Mersick. We must therefore treat them as money paid out by Mersick.

The mortgage deed under which Mersick as trustee took possession expressly provides that "the trustee shall be entitled to be reimbursed for all outlays of whatever sort or nature to be incurred in this trust," and that his "compensation and disbursements shall constitute a first lien upon the mortgaged property." That this outlay for wages due employees before the trustee took possession was a reasonable outlay and incurred in the trust, we must regard as determined by the finding that "it was practically impossible to resume the operation of said railroad" without first paying said "striking employees the wages then due them."

Of the claim of James T. Patterson, only the third item ($138.46) for rent of the Plainville line during the period the trustee was in possession, is entitled to priority of payment over the mortgage debt. That was a debt properly incurred by the trustee. As we read the finding, the trustee, while in possession through his agent Patterson, operated the Plainville line in connection with and for the benefit of the mortgaged property, and under a contract to pay the above sum as rent. Upon the facts this item of $138.46 must be regarded as an expense properly incurred by the trustee while in possession for the bondholders, and should rank in order of payment with the other expenses of the trustee and receiver.

The first item of the Patterson claim, $3,956.52, money advanced April 14th, 1898, to the railroad company to pay taxes, is not a preferred claim over the mortgage bonds. Patterson was under no obligation to pay these taxes, and it does not appear that he was either requested or authorized to do so by the bondholders. It was the duty of the railroad company to pay the taxes, and Patterson, at the request of the company, paid its debt. The railroad company could not, by their agreement with Patterson, give him a lien or claim upon the body of the mortgaged property which would take precedence over that of the bondholders. The transaction was a loan by Patterson to the company, and he did not thereby acquire such lien upon the mortgaged property as the State may have had. Sperry v. Butler, 75 Conn. 369,372.

For the reasons already given, neither the second item of the Patterson claim ($11,031.65), money advanced by him to the company in April, 1898, to pay wages of employees and other pressing claims against the company, nor the fourth item of said claim ($1,176.92), for rent of Plainville line prior to the time the trustee took possession, are privileged claims over those of the bondholders.

After payment to the receiver of the sums which may be allowed for his services and expenses, and to the plaintiff trustee of the costs and proper expenses of this appeal, and of the claims as above directed, the remainder of the fund should be paid to said Farmington Street Railway Company.

Apparently the finding in the judgment-file, that the value of the mortgaged property at the time of the sale exceeded $150,000, is not sustained by the record, from which it appears that no evidence was offered upon that subject, and that the demurrer to the pleading containing such an allegation was sustained.

There is error in the judgment distributing the proceeds of the sale of the mortgaged property, and said judgment is set aside, and the case remanded for the entry of a judgment distributing said funds in accordance with the law as above stated.

In this opinion the other judges concurred.