The opinion of the court was delivered by: Julius J. Hoffman, Senior District Judge.
Exceptions have been taken to the Special Master's Report of
April 5, and Supplemental Report of May 30, 1973. The
exceptions raise issues concerning the following matters:
I. Means of Classification
Transcending all matters is selection of a means for
classifying the assets of and claims against First Securities
Company of Chicago, the estate in receivership. The issue
posed is whether Section 60(e) of the Bankruptcy Act
[11 U.S.C. § 96(e)] would serve as an equitable means for such
classification. With the exception of the Escrow Claimants, all
parties who have addressed the issue agree that Section 60(e)
should be applied, by analogy, to this proceeding. The Special
Master has likewise urged the Court to utilize this section as
a vehicle for classification.
Although the proponents of the application of Section 60(e)
acknowledge that this is a case of first impression, they seek
to bolster their proposal by suggesting that the case of In re
Rosenbaum Grain Corporation, 112 F.2d 315 (7th Cir. 1940),
serves as authority for such an application. They assert that
this case established the broad principle that Section 60(e)
may be applied, by analogy, to situations in which this
section is not, per se, applicable.
In the Rosenbaum case, the debtor, a commodity futures
broker, filed a voluntary petition for corporate reorganization
under Section 77B of the Bankruptcy Act, 11 U.S.C. § 207. The
claimants, marginal grain customers of the broker, filed
priority claims against the estate. The District Court denied
priority to the claimants for the reason that they had not
sufficiently complied with the requirement of tracing their
property into the hands of the trustee in bankruptcy. The 7th
Circuit Court of Appeals reversed and remanded, concluding that
since the relationship of a commodity futures broker and his
customer was analogous to that of a stockbroker and his
customer, the claimants, in fact, had successfully traced their
property to the assets in bankruptcy.
In asserting that the Rosenbaum case established this broad
principle, the Securities and Exchange Commission and the
Receiver rely upon obiter dictum contained in footnote 6 of the
opinion (112 F.2d at 319), which reads as follows:
However, prior to the Chandler Act, courts differed as to
the applicable law. Some applied the "Massachusetts rule,"
which premised recovery upon the debtor-creditor relationship.
Others applied the "New York rule," which was grounded on the
pledgor-pledgee relationship and required tracing.
prior to the Chandler Act, the rights of customers of
insolvent stockbrokers in receivership were determined by
these common law rules. This District, that is to say, the
U.S. District Court for the Northern District of Illinois, has
followed the New York rule.
The Escrow Claimants have taken exception to the Special
Master's recommendation that Section 60(e) of the Bankruptcy
Act be applied, by analogy, to classify the assets and claims
in this receivership. They argue that receivership proceedings
are controlled by principles of equity; equity requires
equality; Section 60(e) establishes priorities; therefore, the
application of Section 60(e) would create inequality. The
Escrow Claimants rely on the Report of Special Study of
Securities Markets of the Securities and Exchange Commission
[H.R.Doc.No.95, 88th Cong., 1st Sess. (1963)], which declares,
"Section 60(e) does not apply to receiverships." However, the
study goes on to say that:
. . [w]hen liquidation is accomplished in this
manner [i. e. through receivership proceedings]
it appears that the old Massachusetts and New
York doctrines may still have vitality and the
capriciousness of result which Section 60(e) was
designed to eliminate may prevail. Part 1, Ch.
III, at 413.
The Report then recommended that Section 60(e) be amended to
empower the Commission to petition to have an insolvent
broker-dealer adjudicated a bankrupt. Thereafter, Congress
enacted the "Securities Investor Protection Act of 1970"
(15 U.S.C. § 78aaa et seq.), which creates a comprehensive plan
for the protection of investors whose broker-dealers are in
financial trouble. The liquidation proceeding in this plan is
patterned after Section 60(e) of the Bankruptcy Act, but the
shortcomings of Section 60(e) have been eliminated. See Report
of Special Study of Securities Markets of the Securities and
Exchange Commission, supra, pp. 410 et seq.; also, 3 U.S. Code
Congressional and Administrative News, p. 5274, 91st Cong., 2nd
This is a receivership. proceeding. It is conducted under
the equity jurisdiction of the District Court. In certain
circumstances, "equity follows the law."
In a broad sense, [this] maxim means that equity
follows the law to the extent of obeying it and
conforming to its general rules and
policies . . . where no countervailing equity
requires different treatment. . . . The maxim is
strictly applicable whenever the rights of the
parties are clearly defined and established by
law, especially . . . by statutory provisions. 30
C.J.S. Equity § 103, at 1066-1068.
In selecting a means of classification, this Court must
choose between an extensively-criticized common law rule [see,
e. g., 3 Colliers ¶ 60.71, at 1158, n. 3 (14th ed. 1964)], and
a statutory provision designed to eliminate the
"capriciousness" of that rule. It selects the latter, 11 U.S.C. § 96(e).
II. Priority of Escrow Claimants
The two decisions by the 7th Circuit Court of Appeals have
made it very clear that First Securities is liable for Nay's
fraud. See 463 F.2d 981 (7th Cir. 1972), cert. denied, McKy v.
Hochfelder, 409 U.S. 880, 93 S.Ct. 85, 34 L.Ed.2d 134 (1972);
466 F.2d 1035 (7th Cir. 1972), cert. denied, McKy v. Union
Bank & Trust of Helena, Mont., 409 U.S. 1041, 93 S.Ct. 528, 34
L.Ed.2d 491 (1972). The issue here is what priority shall the
Escrow Claimants have under Section 60(e). The Section
. . "customers" of a stockbroker shall include
persons who have claims on account of securities
received, acquired, or held by the stockbroker
from or for the account of such persons (a) for
safekeeping, or (b) with a view to sale, or (c)
to cover consummated sales, or (d) pursuant to
purchases, or (e) as collateral security, or (f)
by way of loans of securities by such persons to
and shall include persons who have claims against
the stockbroker arising out of sales or
conversions of such securities. . . .
11 U.S.C. § 96(e)(1).
The recommendation of the Special Master is that the Escrow
Claimants not be deemed customers because their claims did not
arise "on account of securities received, acquired, or held"
by the stockbrokerage firm. The brokerage firm received no
securities for the account of the Claimants; instead, all the
escrow transactions were between the Claimants and Nay
The term "customer" must be construed in light of the
purpose of Section 60(e), not upon the principles upon which
liability is based. The intent of the draftsmen of the
Chandler Act was to give uniformity to the rules applicable to
the liquidation of assets of bankrupt stockbrokers and to
secure equality in distribution to margin customers. The Act
bestows upon customers, as defined, a priority over other
creditors; that is, all of the securities involved in the
stockbroker's transactions with customers are to constitute a
single fund. The creation of a "Single and Separate Fund" was
based upon Congressional acceptance of the custom of security
houses of putting all securities into a "common pot." Thus,
having been a participant in that common pot appears to be
determinative of "customer" classification. See McLaughlin,
Aspects of the Chandler Bill to Amend the Bankruptcy Act, 4
U.Chi.L.Rev. 369, 395-398 (1937); Hearings on Revision of the
Bankruptcy Act Before the Committee on the Judiciary, House of
Representatives, 75th Cong., 1st Sess. (1937).
It is undisputed that the Escrow Claimants sold securities
through their accounts at First Securities, and that the
proceeds were placed in Nay's hands for investment purposes.
However, these proceeds were transmitted by the Claimants,
through their respective, personal checking accounts, to Nay,
individually. Thus, as to the Escrow Claimants, a transition
from "customer" to private investor had clearly occurred.
Subsequent dealings between the Escrow Claimants and Nay
further expose the personal nature of these transactions. For
(1) First Securities did not reflect the
transactions in its periodic accountings to
(2) Interest was paid on the escrow investments
through Nay's personal checking account;
(3) For income tax purposes, Nay sent Treasury
Form 1099 to each of the Claimants, which
indicates that distributions of interest to
them had been reported as deductions on Nay's
personal income tax returns;
(4) Letters of verification of indebtedness had
been signed by the Claimants for purposes of
Nay's internal revenue audits; and
(5) Correspondence between Nay and some of the
Claimants refer to the escrow as a personal
loan; in some instances, the personal
obligations were evidenced by promissory
Consequently, a clear distinction exists between "customers"
of First Securities and the Escrow Claimants. Relative to the
escrow transactions, no securities were held on account by the
stockbrokerage firm, nor were any received from the Escrow
Claimants. The transactions were not even acknowledged by
First Securities. In short, the sum total of the evidence
leads the Court to the inescapable conclusion that the
transactions between Nay and the Escrow Claimants were
personal in nature.
The objective of the Chandler Act was to put all the
customers whose money had gone into the security account on an
equal footing. The Escrow Claimants were not participants in
that common security account; hence, they are not "customers"
within the meaning of Section 60(e) [11 U.S.C. § 96(e)].
III. Allocation of Assets Pursuant to Section 60(e)
The Escrow Claimants assert that the Receiver's allocation
of assets, as reviewed by the Special Master in his
Supplemental Report filed May 30, 1973, is unsupported by
Section 60(e), and that preferences have been granted in the
absence of a hearing. Principally, the Claimants urge that the
Receiver has "misapprehended the command of [Section]
60(e)(2)" [11 U.S.C. § 96(e)(2)], which provides, in pertinent
All property at any time received, acquired, or
held by a stockbroker from or for the account of
customers, except . . . the proceeds of all
customers' property rightfully transferred or
unlawfully converted by the stockbroker, shall
constitute a single and separate fund; and . . .
[these] customers . . . shall constitute a single
and separate class of creditors, entitled to
share ratably in such fund on the basis of their
respective net equities as of the date of
bankruptcy. . . .
The Escrow Claimants interpret this section as prescribing
that the source of the property identified, not the manner of
its ultimate disbursement, is determinative of its allocation.
The Receiver maintains that after "exhaustive and meticulous
examination of the records" and accounts of the estate, the
assets were divided between the Single and Separate Fund and
the General Fund in accordance with Section 60(e); that is,
the terms of that section require allocation of assets to the
Single and Separate Fund on the basis of property "received
from customers" and property held "for the account of
customers." The Court adopts the latter interpretation.
The Escrow Claimants next assert that the claims of banks,
brokers, and mutual funds (totaling $176,468) should be
charged against the General Fund. On the other hand, the
Receiver justifies the classification of these claimants as
"customers" on the basis of privity of contract between
brokers on purchase and sale agreements. Clearly, banks and
similar institutions fall within the "customer" classification
as defined by Section 60(e).
With regard to the hearing held on May 21, 1973, the Court
adopts the Special Master's recommendation to allocate the
checks, there in question, to the Single and Separate Fund.
The Escrow Claimants take exception on the ground that
legitimate claims had not been filed. The Special Master
concluded that the claims on file were legitimate with certain
minor exceptions, including Check No. 33375 which was drawn to
the order of Value Line Securities, Inc. in the amount of
$1,895.20. As to this check, the Special Master has directed
the Receiver to investigate further whether or not a claim was
The checks, in the total amount of $359,624, that were
issued to customers by First Securities but not honored
because of the intervention of the receivership, have been
properly allocated to the Single and Separate Fund.
The Escrow Claimants assert that the sum of $51,894,
representing a check issued by the Continental Illinois
National Bank and Trust Company of Chicago and cleared for the
purpose of purchasing 580 shares of General Electric stock,
should be allocated to the General Fund. The stock was never
delivered because of the interposition of the receivership. A
court order was issued rescinding the transaction. Thus, the
Continental Bank was properly designated a "customer," and
thus the cash has been properly allocated to the Single and
It is further asserted that the sum of $47,870, representing
profits and commissions on transactions, and turned over to
the Receiver by other brokers, should be allocated to the
General Fund. As for this cash amount, the Court adopts the
allocation that has been recommended by the Special Master.
The Escrow Claimants next assert that dividends earned on
which are allocated to the Single and Separate Fund must be
applied to the General Fund. However, it must be recognized
that the accrual of interest and/or dividends on securities
that have been allocated to a particular fund properly accrue
to that fund.
Finally, the Escrow Claimants assert that all interest
earned on Treasury Bills should be allocated in toto to the
General Fund. The Receiver allocated the earned interest
between the General Fund and the Single and Separate Fund in
proportion to their respective percentages of the total assets
of the receivership estate. The Court will adopt the procedure
followed by the Receiver. The entire estate was invested in
United States Treasury Bills; therefore, equity demands an
allocation according to the source of these funds.
IV. Usury as a Defense
The Special Master has recommended that the interest
received by the Escrow Claimants be forfeited as usurious. The
Master found that interest payments paid by Nay ranged from 9%
to 12% per annum; that what are now characterized as "loans"
(presently the Escrow Claims) were not made to a corporation,
but were made to Nay individually. The legal rate of interest
at the time of these so-called loans was 7% per annum.
Ill.Rev.Stat. ch. 74, § 4 (1967).
Thus, two issues are raised: (1) Did the escrow transactions
have sufficient vestiges of bona fide investments; and (2)
Could the First Securities Company of Chicago raise, what will
be termed, Nay's usury defense.
First, Nay induced the Escrow Claimants to invest,
representing that their moneys would be used by a small
corporation as principal to make loans, making it possible for
the investors to realize a high rate of interest. Nay was to
act as a conduit for the transfer of funds to the finance
company. The interest was to be paid by that company, not Nay.
Whether a transaction is usurious is dependent upon the facts,
circumstances, and intent of the parties. Chicago Title &
Trust Company v. Kearney, 282 Ill. App. 279, 286 (1935); 91
C.J.S. Usury § 11, at 579-583. Nay received the moneys of the
Escrow Claimants for the stated purpose of investing so as to
receive a high yield return, not to evade the usury laws. This
was a purported investment with the necessary risks of
investment, that is, loss of the principal sum. The rule of law
is well settled that when the payee takes a risk by which he
runs the hazard of losing the principal sum or of receiving
less than the sum originally due, it is not usurious for him to
stipulate for or receive more interest than is prescribed by
statute. Stevenson v. Unkefer, 14 Ill. 103 (1852). Furthermore,
for use as a defense, usury must be definitely proven. Wilson
v. Kirby, 88 Ill. 566 (1878) Mosier v. Norton, 83 Ill. 519
(1876) Stanley v. Chicago Trust & Savings Bank, 165 Ill. 295,
46 N.E. 273 (1896); Home Building & Loan Association v. McKay,
217 Ill. 551, 75 N.E. 569 (1905); Simon v. South End Cleaners &
Dyers, 246 Ill. App. 14 (1927). Here, the Court finds that usury
was not proven.
Assuming, arguendo, usury was proven, First Securities still
could not avail itself of this defense. The general rule is
that the defense of usury is for the benefit of the borrower
and is personal as to him. 91 C.J.S. Usury § 71, at 648; 55
Am.Jur. Usury § 121, at 409. The courts of the State of
Illinois have long recognized the personal nature of the right
to set up this defense. See, e. g., Maher v. Lanfrom, 86 Ill. 513
(1877). As stated in 91 C.J.S., supra:
Since usury laws are enacted for the protection
of needy borrowers, and not to punish extortion
in money lenders, the defense is purely personal
to the borrower, or those in privity with
him, . . . such as the debtor's sureties,
guarantors, heirs, devisees, and personal
representatives. This is true whether the
statutes declare the contract void in whole or
only to the extent of the usury, or whether a
is given for the taking. In order to question the
validity of a usurious contract, the right must
be based on the original debtor's right.
The 7th Circuit Court of Appeals has held that First
Securities is liable for the conduct of its agent and for its
own failure to comply with the Securities Act. See
463 F.2d 981 (7th Cir. 1972), cert. denied, McKy v. Hochfelder,
409 U.S. 880, 93 S.Ct. 85, 34 L.Ed.2d 134 (1972); 466 F.2d 1035
(7th Cir. 1972), cert. denied, McKy v. Union Bank & Trust of
Helena, Mont., 409 U.S. 1041, 93 S.Ct. 528, 34 L.Ed.2d 491
(1972). However, this does not put First Securities "in the
shoes" or position of Nay. Although there is authority to
indicate that usury laws may serve to protect creditors when
insolvency or bankruptcy intervenes [see, e. g.,
11 U.S.C. § 107(d)(6); Broude, Toward a New Fraudulent Conveyance: The
Trustee in Bankruptcy and the Usurious Lender, 63 Nw.U.L.Rev.
331 (1968)], the burden has not been met in the instant case.
Therefore, having considered the findings and
recommendations of the Special Master and the exceptions taken
thereto, and having considered all the memoranda of the
It is hereby ordered:
(1) That the Receiver shall classify the assets
of and claims against the estate of First
Securities Company of Chicago in accordance
with the provisions of Section 60(e) of the
Bankruptcy Act, 11 U.S.C. § 96(e); and
(2) That the Escrow Claimants, Olga Hochfelder,
et al., be designated "General Creditors" of
the estate of First Securities Company of
(3) The allocation of assets as set forth by the
Special Master in his Supplemental Report
filed May 30, 1973, is in all respects
approved and confirmed.
(4) The Court declines to adopt the
recommendation of the Special Master that the
interest payments received by the Escrow
Claimants, Olga Hochfelder, et al., should be
regarded as forfeited by reason of their
being usurious; the Court therefore orders
that the amounts of such interest payments
shall not be deducted from the Escrow Claims.
It is further ordered that the foregoing shall be and is a
final judgment under Rule 54(b) of the Federal Rules of
Civil Procedure with respect to these matters, there being
no just reason for delay.