(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

SEC Concerned Over Investment Banks Serving Clients in Bankruptcy

SEC Chairman William H. Donaldson recently sent a letter to Sen. Paul Sarbanes and Sen. Patrick Leahy opposing a proposed change in the bankruptcy law that would allow investment banks to advise former clients during bankruptcy. Current law prohibits judges from considering investment banks that have served as underwriters or distributors of securities for a company that subsequently files for bankruptcy. The Commission told the senators that it would be a mistake to eliminate the exclusion in a "one-size-fits-all manner" at a time of fragile investor confidence.

The provision is included in the bankruptcy reform bill, H.R.975, that passed the House of Representatives. Section 414 would amend the disinterested person definition in the conflict of interest standards in the bankruptcy code to remove the specific provisions covering investment bankers. It would thus allow judges to consider investment banks on the same terms as other entities in determining who can advise a company seeking bankruptcy protection.

The provision has the support of House Judiciary Committee Chairman F. James Sensenbrenner, Jr., who believes that removing it would amount to an automatic disqualification of the incumbent investment banker, which in turn would compel the hiring of a new investment banker who would have to get up to speed on the issues at a time when the debtor is trying to preserve its assets.

Mr. Sensenbrenner has also indicated that Section 414 prevents conflicts of interest from occurring by authorizing the court to remove an investment banker that does have a conflict of interest. In the letter, the Commission urged Congress to proceed very cautiously before loosening any conflict of interest restriction in the code. The current standard was adopted in part to respond to a 1938 SEC study providing extensive documentation of abuses in corporate reorganizations. The study concluded that a firm serving as underwriter for a company's securities should not advise the company on shareholder distributions in a reorganization plan, nor should it advise on potential claims against those involved with the company pre-bankruptcy since this could involve an assessment of transactions in which the firm participated.

The SEC did note, however, that, since issuance of the 1938 study, bankruptcy procedures have improved significantly, citing the establishment of the U.S. Trustee's office, a dedicated judiciary, and active creditors' committees. While recognizing that the current exclusion may be too broad because it covers firms that participated in any underwriting of the debtor, the Commission remains concerned that the general statutory protection, mentioned by Rep. Sensenbrenner, may be insufficient if the exclusion is eliminated entirely.