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I have seen in the press, that most of the emphasis of these hearings on corporations has been addressed to the business corporation, the problems that business corporations pose. My remarks, too, focus primarily on the business corporation.

But I think I would be remiss not to point out that "corporations” has a broader sense that is important to keep in mind. Indeed, the problems that are posed for our society today stem from corporations of all sorts, from institutions of all sorts; not merely the business corporation, but the union, the pension fund, the university. I stress this because, as my statement

Senator HARTKE. Would you include in that foundations?
Mr. STONE. Indeed, sir.

Senator HARTKE. I was going to say, if you don't include foundations, you omit one fundamental. As you know, I happen to be the chairman of the Foundations Subcommittee of the Finance Committee.

Mr. STONE. My next point would underscore that. I think people tend to consider the business corporation apart from the other corporations by emphasizing that the business corporation is profit oriented. There is some truth to that, but it is a dangerous oversimplification to suppose that the problems we are having with these organizations spring solely from profit. I know of no corporation that is as insensitive to its staff or to those with whom it comes in contact as the ordinary hospital. We know that the Soviet factories pollute.

I emphasize that for this reason: Those who are too quick to assume with the dreamy theory of economics textbooks that corporations are solely motivated by profit can then suppose, wrongfully in my view, that you can control corporate behavior just by raising fines, or more effectively gathering up damages through civil relief of various sorts, like class actions.

Unfortunately, I do not think we can deal with corporations on the assumption they are purely profit sensitive. Part of our problem stems from the fact that corporations are, in fact, moved, persuaded, motivated by a much subtler and complex array of institutional forces. That is why the drift of by testimony today will be toward meeting head on these institutional forces and demonstrating some of the shortcomings of our present strategies.

Now, the present strategies we use to control corporate behavior are basically twofold: One, we address the corporations profit centers. We threaten the corporation with a fine. We threaten the corporation with civil damages.

Two, in some cases we threaten key individuals.

Now let me just briefly touch upon the highlights of why reliance on those two strategies is not adequate and, therefore, why I believe this Congress will have to take steps to introduce a slightly different mode of controlling corporate behavior.

First, consider the strategies that are essentially threats to the corporations' profit centers. What threats are these to the chief officers of the corporations! Their salaries, their compensation schemes are largely independent of the ups and downs of the company for whatever causes, and seem to be quite independent of losses the corporation suffers through the largest fines that the law has meted out. After the Ford Motor Co. suffered a $7 million fine for an EPA violation, a group of law students at U.S.C. doublechecked the salary developments of the top Ford officers.

What one finds is that their salaries continue to rise, above the President's wage guidelines, I will add, including $600,000 bonuses for each of the two top officers. My point is that the strategies of the law that are addressed to the corporation do not necessarily intimidate the top executives. They are going to get paid whatever they are going to get paid. And threats to the profit centers don't necessarily intimidate the people who are working at the lower levels of the corporation, either. That is, a lot of harms are not arising at the directorship level, but at the lowest levels of corporate operations. I think directors would like brakes bolted more securely down on the cars, but these threats to the company again have a relatively small impact on the workers down below, where a lot of these things are taking place. Their aim is to rise up the corporate ladder through whatever compensation strategies have been developed for them, and these internal strategies are only indirectly affected by the threats to the company.

There are other reasons I go into in my book and in my prepared testimony why I doubt that the threats aimed at the profit center are really adequate to induce the company to make the internal changes that are necessary if the company is not going to run afoul of the law.

Second, take the threats to the top executives. There is a lot of emphasis that has been placed on that: Raise the fines, put them in prison. I, too, think we should be tougher. But I caution that is a very limited approach.

To begin with, the people at the top of any company are apt not to know what is going on about a lot of things. They are apt not to know because corporations are very, very large. They can't know everything that is happening at the operating levels.

Second, there develops in many institutions a pattern of not reporting to the chief executive problems that are going on. Indeed, I am sorry to say that it may be the job of counsel to intercept such information on the way up so as to screen and protect the top, especially the outside directors, from taint. And even when cases are brought against executives, and they are found liable, the judgment can often be blunted by indemnification or liability insurance. One wants to say, as I said when I was in law school, well then, here is how you have got to handle the corporation problem, you throw these guys in prison. Indeed, we probably should be tougher. But I am much more persuaded today of the difficulties that come with the complexities of life in a large organization. And in fact if you look at these standards that the ABA and the ALI have established for commitment, you see that usually these top executives do not meet the profile, the sentencing profile, which would lead to commitment. They are not likely to have a prior record, for example, or need rehabilitation, which is another reason why I think the tendency of the law will be not to order commitment of executives, except in the most flagrant and clear-cut cases--and most of the problems corporations cause are not so clear-cut.

For these reasons, I don't think the two basic strategies work adequately, either, the strategies aimed at the corporation's profit centers, or the strategies aimed at the key individuals. We can no longer, in my view, trust to these traditional threats to get the corporations to make changes internally. What then do I think should be done?

We have to start at the beginning, with basic organization and principles. If a corporation is, let's say, producing soup that has botuIism, why is it, and how do you stop it ? Certainly the problem is not going to go away just because the company writes a check to a widow.

The problem is going to go away, it is going to be repaired, only if the company makes certain changes in its internal organization. It has got to improve its purchasing procedures. It has got to improve quality control. It has got to improve its hiring and firing, its supervision. It has got to make these internal changes.

If the present threats of the law are inadequate to induce these changes, then the key is, the law has got to bring them about directly. What do I mean by that?

Take the problem of how roles are defined in the company. We trust almost entirely to companies to establish roles and to define roles within the organization. We let a company that is operating a nuclear facility decide on its own whether it is going to have a vice president in charge of safety.

That is absurd. That is absurd! The law says that a company, to enjoy the corporation privileges, has to have a board of directors, and it stops there. I suggest that the law will increasingly-I am advocating and I am predicting that the law will increasingly—begin to establish roles within companies operating in very critical areas; the law will have to say, Look, if we license you to engage in this highly dangerous and highly critical field, then you have to have a vice president in charge of X-pollution control in highly polluting industries, safety in nuclear or liquid natural gas transport.

Second, it is not enough to have a name on the door and call someone a vice president in charge of safety. They will give him a nice rug and closet away somewhere. The law will have to define the role, its powers and functions. That is not unthinkable.

The new FDA rules on good manufacturing practices have adopted these suggestions; and now will require a company in the pharmaceutical field to have a quality control unit; the regulations say, in effect, it is not up to you to decide whether or not to have a quality control unit if you are producing pharmaceuticals. You have to have a quality control unit. And the regulations go on and establish what the responsibilities of that unit are and what the powers are.

Now if the law will specify the responsibilities within the organization for certain things, then the criminal law can be an effective backup, because by locating and setting resposibility for particular acts within the organization on particular people, the law then has pierced the anonymity that ordinarily obtains in an organization; and if something goes wrong, you, X, under the rules of your company, which were published, are the person who was responsible for monitoring the system; and it puts the heat where the heat belongs, not sort of diffusely on the total organization, not illusory on the people at the top, to be responsible for everything, which they cannot be. It sets responsibility where responsibility can be effective.

My other suggestions go to changes of this sort. There are changes in role definition within the organization, changes in information patterns, such that I would require companies to establish certain patterns of information flow. I think the information controls are particularly important because in all of the cases that were analyzed at U.S.C. under my supervision-cases where there have been some terrible pathology, where corporate behavior had broken down—there was always a clue somewhere in the corporation well in advance, that there was going to be trouble; clues in the laboratory that monkeys were losing their hair, going blind; testing rooms that brakes were not braking. The trouble is, the clues were never passed up, never rose to people who had both the power and authority to do something about it. If that is the problem, then I think the solution is clear.

You require patterns of information flow. You require that organizations establish patterns of reporting such certain counterindications of a pharmaceutical laboratory, whatever, must be reported upward. I would like once more to give credit to the FDA for the new rules published in the Register in February of this year, which have adopted this tact (41 Fed. Reg. No. 31). They are now saying that the company must establish lines of reporting to people in positions of responsibility.

That is the drift of the changes that I outline more fully in my testimony and in my book.

Senator HARTKE. What about the antitrust laws? Do you feel that they have been an effective mechanism to create some responsibility or to alleviate some of the difficulties that have occurred?

Mr. STONE. I think the massive price fixing indictments against the electrical companies in the 1960's did throw a chill into industry, and I think were effective. So far as price fixing is concerned, my sense is that the risks have increased especially with the increased Sherman Act sanctions. Industrial concentration itself, however, does not seem to decrease.

I am not sure this effect of increasing concentration should be ascribed to a weakness of antitrust enforcement more than to the nuances of the tax laws. It is regrettable that the tax laws induce industrial concentration independent of any economies of scale. The way things stand, one cannot infer from increasing concentration that it testifies to greater efficiencies; rather, it testifies to the problems with the present treatment of capital gains, to all the different reasons why, from a tax point of view, it becomes beneficial for companies to merge, even if they do so at the cost of true efficiency, because they or their stockholders gain certain tax benefits.

Senator HARTKE. Well, that is not really what I was addressing myself to as much as whether you find that the antitrust laws, where they have been pursued, have had any demonstrable effect upon the corporations' insistence that the board of directors take more responsibility or that they have a greater feeling inside the corporation that the civil or criminal penalties shall, in fact, affect what actually happens in regard to the corporations relations with its officers and directors ?

Mr. STONE. From that point of view, I think the results have been unfortunate. It is a very critical question for these hearings. What has happened is this: The way the law has gone, especially the law of Delaware, it still may be to the advantage of the directors to know nothing.

Let me give you an illustration in Graham v. Allis-Chalmers. Graham v. Allis-Chalmers was a case that flowed in the wake of the

heavy electrical equipment industry price fixing. After Allis-Chalmers had to make payments, both criminally and civilly, a shareholder brought a derivative suit against the directors, saying it was your responsibility to have attended to the operation of the corporation and kept it out of trouble. All the more so, said the shareholder, because Allis-Chalmers was operating under a consent decree that ought to have put those directors on notice.

Yet when it got to the highest court in Delaware, they ruled that the directors had no obligation to institute a system of espionage that is the way the court put it-to ferret out evidence of wrongdoing. Since the director did not know, in fact, of the price fixing and since they had no obligation, even in light of this consent decree, to institute any monitoring, they would not be liable.

Now how was that read? A direct answer to your question is how did I read that? How did I read that as a Wall Street lawyer?

If you talk to your directors about such gray areas, is the kind way we put it, in any thing but private, you will

be doing them a disservice The law not only is ineffective as to make people alert the directors, I submit that the law is actually counterproductive, that the law is operating—the total system here, taking the antitrust laws, the Delaware laws together—in such a fashion as to dissuade the company from instituting the very sort of informational reporting that we would most want it to have.

Senator HARTKE. In other words, the profit becomes so overriding as a major concern that the penalty which should accrue to the officers and directors is really substituted with a reward?

Mr. STONE. That's right, or they are insulated.

Senator HARTKE. I was wondering, though, in two areas—as I understand the sum and substance of what you are saying, and the thrust of what you are saying is that you anticipate the law”, will take the necessary steps to make some change in the present attitude.

What do you mean by the “law”? The courts? Is that all?

Mr. STONE. Thank you. There are two approaches I see, one involving new rules from the legislature and the agencies, the other from the courts under present law.

Senator HARTKE. Let me stop you a moment there.

Why would not the suggestion of Ralph Nader, for example, of having some type of mechanism which was on the Federal level, be at least a step in the direction toward what

you

think should occur? Mr. STONE. Well, I do not have much faith in Federal corporate chartering. I am not strongly behind it for this reason: Any company that is constitutionally amenable to Federal chartering under the commerce clause could be reached by the Congress under the commerce clause powers already available to it. If one uses Federal chartering to reach companies, and tries to attach the needed conditions to the Federal charter, then the conditions, the constraints, the limits, are attached only to the largest companies that are made subject to charter.

If one goes the direct route, through amending the criminal code in a way which I have recommended, one gets all companies. I think it is an important point, Senator, because my own experience has been that the largest, giant corporations, though they grab the headlines, are far more responsible citizens than the smaller ones.

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