- The Washington Times - Friday, April 25, 2003

As a professor of legal ethics, I have long favored bankruptcy-reform legislation. I believe reform is crucial to restoring personal responsibility and to preserving integrity in both individual and corporate bankruptcies. Current law encourages "opportunism" that benefits a few unscrupulous bankers, lawyers and corporate executives at great cost to millions of honest consumers and lenders in the form of higher prices and interest rates.

On March 19, when it passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2003, the House of Representatives provided a very welcome breath of fresh, ethical air.

Except for Section 414 of the bill, that is. That section amends the definition of "disinterested persons," those allowed to contract with a bankrupt concern, by removing from the excluded list the category "investment banker."

Therein lies a tale of a section at odds with the philosophy of bankruptcy reform. If Congress truly wishes to encourage transparency and ethical behavior, the Senate must remove Section 414 from the bill.

Current law bars firms that served as underwriters for a company's securities within two years before the bankruptcy from serving as advisers to the same company after bankruptcy. Such restrictions on "interested parties" have been in the bankruptcy code since 1898.

And for very good cause. Bankrupt companies must be run in the interest of creditors and shareholders. This means that a bankrupt company must, through the experts it hires, take a hard look at all prior transactions. If any prior dealings were a fraud on the company, for example as a result of connivance between an executive and a third party professional (a lawyer or an investment banker), the deal could potentially be rescinded to the benefit of shareholders and creditors alike. Having the same professionals who recommended, or performed, past services, review their own work is not likely to yield a penetrating inquiry.

Just as important as the prevention of conflicts is the encouragement of public confidence in the integrity of the bankruptcy system. Section 414 will certainly not bolster consumer and creditor confidence. The New York Attorney General's Office and the Securities and Exchange Commission are putting finishing touches on a $1.4 billion settlement with Wall Street underwriters over claims that they misled investors with biased stock research. Unsurprisingly, the New York office is opposed to Section 414, which would allow these same firms, which allegedly helped drive companies to bankruptcy, to earn additional fees advising these same companies on their best future moves.

Some advocates of Section 414 might argue that Section 101 of the bill passed by the House continues to exclude from consultancy status those with "an interest materially adverse to the estate." But the automatic exclusion eliminated by Section 414 made all the difference. Automatic exclusions save the Bankruptcy Court from costly case-by-case findings about disinterestedness under Section 101. Such findings increase the time, costs and attorneys' fees for every single bankruptcy case, to the detriment of the bankrupt firms.

The National Bankruptcy Commission's 1997 report, which was the genesis of current bankruptcy reform, argued strenuously in favor of retaining the "disinterestedness" standard. From the New York Attorney General's Office to former SEC Chairman Arthur Levitt to Dean Nancy Rapoport of the University of Houston Law Center to Fifth Circuit Judge Edith Jones to Professor Elizabeth Warren of Harvard Law School, renowned bankruptcy experts have condemned Section 414. The Wall Street Journal has spoken out strongly in the same vein. Yet mysteriously, perhaps as a result of lobbying efforts by investment banks, Section 414 appeared in the House bill with no fanfare. All the while, from Enron (whose investment bankers have just been charged with securities fraud) to WorldCom to HealthSouth, corporate banking scandals harming millions cry out for increased vigilance against conflicts of interests. Now is not the time to reverse course.

The basic direction of the new bankruptcy bill is good. The thrust of Section 414 is just awful. Come on, Congress; don't tear down with one section the hard-earned credibility gained through bankruptcy reform. Pass bankruptcy reform without Section 414.


Michael I. Krauss is a professor of law at George Mason University.

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