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parenthetically that the main provisions on conflicting interests appear in sections 6, 7, and 9 of the Lea bill.

It provides some assurance that those acting in fiduciary and representative positions will be free from conflicting interests. We have pointed out at length in our reports the evils and abuses that have flowed from the disregard and violation of this fiduciary principle. The manner in which these conflicts have inhibited proper performance by committees of their functions can be best illustrated in the case of committees dominated by the management and the investment bankers.

CONFLICTS OF MANAGEMENT Where committees have been dominated by such groups, the question of legal responsibility of the management for its acts of omission and commission has been rarely questioned by those committees. Though assets may be brought into the estate by the investigation and enforcement of all claims against officers and directors, it has obviously been to the self-interest of managements to resist their assertion and enforcement. This they have been able to do by virtue of the control they have obtained over protective committees. Again, although in many cases no legal responsibility can be spelled out against existing officers and directors—we all know that many of these failures are honest failures in a legal sense—their conduct of the corporation's affairs may have been so reckless or so inefficient as to justify or require the installation, in whole or in part, of a new management. On the other hand, it is to the self-interest of the management to stay entrenched in the business, for the sake of fees, salaries, and bonuses which come to them from their positions, and for the other important patronage which can be dispensed to their affiliated interests.

Mr. KENNEY. Mr. Chairman,
The CHAIRMAN. Mr. Kenney.
Mr. KENNEY. Will this bill speed up reorganization?

Mr. Douglas. This bill will, in my judgment, not speed them up. It will in effect, I think, make for a more careful scrutiny of the past activities of the management, the history of the corporation, the antecedents of the default, for the purpose and with the objective of bringing out of the default situation a better, more thorough-going reorganization.

Now, to the extent that a thorough-going reorganization takes more time than a stream-lined whitewashing reorganization, this will slow it up; but such slowing up as will take place will, in my judgment, be to the ultimate advantage of investors by affording greater assurance of efficiency and fairness.

Now, incompetence and questionable activities on the part of officers and directors will tend to be a closed book if the management can control the protective committees that are operating. As a result, the very causes of failure are often perpetuated in the new and reorganized business. The searching investigation of management that is of primary importance in every reorganization is blocked and prevented. The harm to security holders from such practices is incalculable. The only remedy is to insure, so far as practicable, that persons with such conflicting interests are not members of, nor control, protective committees.


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Adverse interests have frequently arisen also because of the connection of investment banking firms with reorganizations. They, together with managements, have had a virtual

monopoly over lists; as I have said they have had inside knowledge of impending defaults; they have had great familiarity with the techniques and strategy of reorganization. These, and other factors, have given them a position of dominant importance in the processes of reorganization. Though they have explained their participation in terms of the performance of a "moral obligation" which they profess toward those who purchased defaulted securities from them, our investigations and reports have demonstrated that this obligation is more often than not merely an excuse for the investment banker being active in the reorganization.

Mr. KENNEY. This bill prevents investment banker's participation?

Commissioner Douglas. As respects investment bankers serving on protective committees, that is true. That is covered in lines 15 to 19 on page 25 in the case of judicial reorganizations; in line 20 and following, page 27, in the case of voluntary reorganizations, and in line 2 and following, page 29, in the case of municipal debt rearrangements, and foreign debt rearrangements.

Mr. KENNEY. How about management?

Commissioner Douglas. Pardon me. Management is, to a very practical degree preserved in the picture in the case of voluntary adjustments, such as recapitalizations, readjustments, and so on, and that is indicated beginning in line 2, on page 27.

Now, in other types of situations, that is reorganizations in the courts, a different treatment is given in the Lea bill as indicated in lines 14 and 15, page 25.

There are other aspects of management participation I will go into when I get down to the specific provisions of the bill, if you would like.

Now, the active participation in reorganization of the company's investment bankers has been rife with conflicting interests. Their control or influence over protective committees, even though shared with the management of a corporation, inevitably leads to the suppression of claims which may exist against both those goups. The diligent investigation into possible misrepresentation and fraud in the sale of securities, which I mentioned earlier as a notable function of committees, goes by the board when committees are subject to the influences of the very persons who sold those securities. Further, the very close connections between the investment bankers and the management has led to mutual support in the perpetuation of their positions. Partners in the banking houses are frequently directors of the corporation. Often, too, they are a part of the management though they or their representatives hold no official position as officers or directors. The management's liabilities may frequently be their liabilities also. And just as in the case of managements, so do investment bankers desire to continue their connections with the company for the sake of the emoluments to be derived from such connection. The latter means to the underwriter getting the business of originating and distributing the corporation's securities, inside information as to the course of its business, profitable market operations, and a veritable host of other business patronage. In sum, if control of the corporation

is shifted to the new group, the prospect, apart from liability for past misconduct, is one of loss of future profits because the banker's connection with the corporation has not been continued.

Then, also, underwriting houses may have an existing financial stake in the securities of the corporation, in the form of outstanding short term credits, or securities of the corporation other than the securities which committees controlled by them ostensibly represent. Their self-interest in such cases has made them poor fiduciaries. Through control over committees they have been able to reduce the risk that such claims would be excluded from the reorganization plan, or in other ways given treatment which they consider unfavorable. Over and above all else is the desire to "save face”, a factor which in my judgment has done more to produce unsound reorganization plans than any other single factor.

Mr. MARTIN. Mr. Chairman-
The CHAIRMAN. Mr. Martin.
Mr. Martin. How far does the liability of underwriting go?

Commissioner Douglas. At common law, the liability of the underwriter was spelled out in the causes of action for fraud and for deceit and in causes of action for rescission.

Now, under the Securities Act of 1933, there is a little broader base than that and the underwriter is redefined so as to include a somewhat broader class.

The burden of proof on investors is made a little less heavy, and some of the strictures of proof to satisfy the requirements of the common law action are taken away.

Now, all of these factors combine to make the representation on, and control over, committees by houses of issue an undesirable, and in many ways, a definitely harmful practice. This observation is equally applicable to all types of reorganization situations whether foreign or municipal debt rearrangements, voluntary readjustments, or reorganizations in court proceedings.

There is no other way, as we visualize it, that the problem can be adequately treated, since there are available no definite criteria by which a selection of the various degrees of fitness and badness in any class can be measured.


Now, the foregoing conflicts of interest are largely sui generis so far as the management and the houses of issue are concerned. There are other conflicts of interest which are applicable to all types of committees. Thus not infrequently stockholders are found serving on bondholders' committees and bondholders on stockholders' committees. The result has been that the pecuniary self-interest of the committee members has been opposed to the pecuniary interests of the beneficiaries of these trusts, that is, the security holders. As a consequence, representation by the committee has not been vigilant and aggressive in the cause of the security holders. The loyalty of the committee has been diluted by the incentive to serve their own selfish ends first.

Further, members of the committee have at times acquired their securities at such low prices as to create a grave conflict of interest. A committee which has purchased bonds at 10 cents on the dollar can make a 100-percent profit by effecting a settlement at 20 cents. But investors who had purchased at or near par would under those circumstances be suffering grave losses.

Out of such circumstances are serious conflicts of interest born. These are merely illustrative. They indicate the nature of one important problem with which the Lea bill deals.

As I have previously said, the Lea bill touches on this in sections 6, 7, and 9.

TRADING BY COMMITTEES Now, coming to the activities of protective committees; that is activities of the committees after they are formed: One type of conduct by committees and their affiliates which has resulted in injury to security holders is trading in the securities. By reason of inside information, committee members have frequently been able to profit from their position of trust by buying or selling securities. This practice has permeated the whole field. It has been incompatible with the ancient standards for trustees. But committees have attempted to legalize it by virtue of contractual provisions in their deposit agreements, whereby the depositing security holders are presumed to waive the legal disabilities which the committee members otherwise would have.


Another serious departure from fiduciary standards has been common in connection with the charges for fees and expenses of protective committees. By and large, committee fees constitute a substantial source of revenue; they may at times be the major motivation in the organization of committees. The striking fact has been that, with such exceptions as allowances under section 77B of the Bankruptcy Act, committees have been able to fix their own fees, without independent supervision or review. They are themselves the arbiters of the value of their own services. This shocking lapse from the standards of fiduciaries would no longer be possible under the Lea bill.

I think that section 10 of the Lea bill would provide for a check and restraint on that practice.


Another phase of committee activities which requires thoroughgoing regulation is their solicitation practices. One item of this is the use of paid solicitors in the marshalling of assents to plans, or the solicitation of proxies or deposits authorizing the committee to act generally on behalf of the security holder. Special solicitors employed on a commission basis contact security holders; almost inevitably this practice results in "high pressure" salesmanship tactics. In other ways, too, pressure is frequently exerted on uninformed investors, as, for example, by threats of discrimination and undesirable consequences if they fail to assent or deposit their securities with a committee. A catalog of tricks and dodges utilized by committees to exert pressure upon security holders is set forth in our recent reports to the Congress on this subject. I will not stop to go into them.

Mr. KENNEY. What is the name of those reports?

Commissioner Douglas. Reports transmitted are part 1, which deals with the strategy and techniques of protective and reorganization

committees; part 3, which is a specialized study of real estate protective committees; part 4, a specialized study of municipal protective committees; part 5 which is a specialized study of committees representing holders of foreign bonds; part 6, which is a study of corporate trustees.

There are still to be transmitted three reports which will be over shortly. That will complete the series. Copies of those reports, I notice, are here in the hearing room.

Mr. COLE. Are you speaking now of investigations and reports of the Securities and Exchange Commission?

Commissioner Douglas. Yes, sir.

Mr. COLE. Dealing with the same subject as the Sabath committee investigated?

Commissioner Douglas. To some extent, sir. The Sabath committee, as I recall, was originally authorized to make investigations of real estate committees, but about the same time that that authorization was given to the Sabath committee, the Commission was directed by the Congress to make a study of reorganizations and protective committees in all sorts of situations, not just real estate committees, but every kind.

Mr. COLE. So, in your work you duplicated to some extent the work of the Sabath committee?

Commissioner Douglas. To a certain extent they were overlapping.
Mr. MAPES. Mr. Chairman-
The CHAIRMAN. Mr. Mapes.
Mr. MAPES. Did you personally have charge of this investigation?

Commissioner Douglas. At that time, sir, I was Director of the Protective Committee Study and after the termination of that study, I became a member of the Securities and Exchange Commission.

Mr. MAPES. Then it was under your control and jurisdiction that these investigations and reports were made?

Commissioner Douglas. The investigations were made by me with the assistance of a staff, from October 1934, to January 1936.

The reports are reports by the Commission to Congress.


Another source of oppression of investors is the one-sided contract known as the deposit agreement. These are complicated documents which the average investor would rarely understand even if he saw one, which he seldom does. These agreements fix the authority and the powers of the committee. Since they are prepared by committees and their counsel, their terms inevitably give to the committee almost complete dominion over deposited securities and at the same time immunize them from any real responsibility. But there is no mutuality in these agreements. The security holder, once he deposits his bond or stock with a committee, finds withdrawal either impossible or difficult and expensive. By and large, committees through the vehicle of deposit agreements exercise an arbitrary power over the investor's right to withdraw, and over every other right that the investor would otherwise possess by reason of his ownership. For example, a committee controlled by a house of issue may succeed, if it obtains deposit of securities, in effectively cutting off rescission rights of depositors. The form and content of such agreements, and the occasions for their use must be carefully regulated in the interests


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