Mr. STONE. That is correct, and thus cannot feasibly be made to know what is all that is going on. In support of this point, what I was trying to say earlier-I was anticipating the response that some people make and say, "Well, if companies get larger and larger, it is because there are efficiencies in management, because there are economies of scale." I say, "Nonsense, companies get larger and larger because of the tax laws, because of the nuances of the tax laws to a large degree."

I represented, when I was in practice, some very major conglomerates. I was impressed by how little there were economies of anything. They were loosely associated units. The management barely met one another the day before the board meeting.

There are no economies of operation that should be imputed to these giant corporations.

Senator HARTKE. They brought their loss forward?

Mr. STONE. That is part of the problem. You see, if the tax laws were other than they are, when a company began to get inefficient, it would increasingly be paying dividends back to the shareholders. The shareholders would reinvest it in a more profitable area of the economy.

The way the tax laws work now, the shareholder will be taxed if he receives a dividend. He would rather the company reinvest the money. Therefore, everybody is willing to let management just pick up other companies, even at some cost inefficiency.

Senator HARTKE. I hear you. I think you made a very valuable contribution, sir. I appreciate your testimony.

Senator Stevens?

Senator STEVENS. I am intrigued by your concept of limited public directors. To your knowledge has any State followed that concept? Mr. STONE. This is my proposal of the limited public directors? Senator STEVENS. Yes.

Mr. STONE. There has been no decision of any State that has done that. The SEC has, on occasion, and is apparently increasingly arranging the instatement of special independent directors as an afterthe-fact remedy of various securities problems.

Special directors have not been instituted in support of a program to avoid repetition of antitrust offenses or to clarify problems associated, say, with polyvinyl chloride. The SEC is, rightly in my view, arranging the instatement of independent outside directors, and has even arranged for committees of the board to be formed such as independent-director-dominated nominating committees, and independent-director-dominated audit committees.

Senator STEVENS. What about your suggestion concerning the disability of certain directors if the directors were found guilty or the corporations themselves have suffered a conviction? Which is it? Mr. STONE. Yes; the latter. Let me address myself to that.

In cases in which a top officer has been convicted, the way I see the law going, Senator, there is not much chance that the executive will be committed to prison. There are a number of reasons for that, some of which I don't like, but some of which I think I would support. It is very hard to send the top executive to prison to the extent that one believes, as I would like to believe, that the purpose of commitment

is rehabilitation. The fact is that most top executives have no prior record. Most top executives who get in trouble with the law manage to stay clear of the law thereafter. Sentencing an executive is a very hard thing for a judge. Quite likely the judge is not going to commit an executive to prison and quite likely the forces that motivate the judge are rather persuasive ones.

Then I asked myself, well, what sort of disability will we attach? You can fine the director or top officer and very often the fine is simply reimbursed through D. & O. insurance, directors and officers liability insurance. The director can seek indemnification under law such as that of Delaware. The director can even have his fine repaid under certain circumstances.

I then ask myself, what is going to be an effective remedy? The most effective remedy, I suggest, might be to disqualify the executive the way we disqualify labor union racketeers. If a labor union executive is convicted, he is suspended for a period from being able to manage large funds that come into the hands of a labor union. I think that is a good idea.

I am saying that on a parity of reasoning, one ought to attach the same disabilities to a top executive and also make clear he doesn't get a fat, cushy consulting contract to circumvent it.

Senator STEVENS. You speak about your proposed legislation. Have you actually drafted some proposed legislation?

Mr. STONE. I have. Senator. The staff has copies of it. It is a model which could be drafted by States or could be drafted into Federal law rather easily. Copies of it-copies of some of the salient points are attached to the testimony I have distributed.

Senator STEVENS. This is my last question. Do you propose this for State law or Federal law?

Mr. STONE. I believe it could be both, because it would be attached to the sentencing procedures of whichever jurisdiction the company was, say, convicted before. So the drift of what I am recommending there, is that if a company gets convicted of a crime, and it is a repeater-a recidivist-you treat it specially. A recidivist human being, you can put in prison. You can't put a corporation in prison. A recidivist human you can put on probation and make him report to a probation officer. Now, we don't have well-developed analogs to that where the convict-and I want to use that word-is a corporation. Therefore, what I am saying is when a company is convicted-take Richardson-Merrill, for example, a company that got in trouble for distributing Thalidomide, having also gotten in trouble for MER-29, a cholesterol depressant that caused blindness. In a situation like that, under present law the company is fined $80,000 and told, "Go on your way, do a better job next time."

I am saying that won't do. The law ought to empower the Federal courts to say, "We are going to put you on probation. Even though you, the corporation, can't report to a probation officer, we can send a probation officer in to you."

I recommend that the company in the first instance, rather than the State-because the company always should be trusted in the first instance to find out what went wrong-that the company should be made to come to the court with a report conducted by outside independents if need be, and report to the court. Twice in a row there have been

problems with these drugs. Why for the eighth time in about a dozen years have you been convicted of price fixing?

They should locate responsibility and suggest to the court what I call a rehabilitation agenda. You tell us what you are going to do. The directors have to see that document and think about that document and agree, "This is what we are prepared to do to prevent it from reoccurring."

Then there would be a hearing under my proposal, and the Federal prosecutors, representatives of the SEC, whoever, could appear, look over the rehabilitation agenda, and complain if it were inadequate in their view. They would have a hearing on the agenda and finally agree upon an agenda, and certain officers of the company would be responsible for implementing that agenda, for seeing that the company did what it undertook to do.

I think it is incredible that, considering the importance of corporations in our society, there is no such procedure today. Corporations are treated much easier, much less sensibly than human beings. Though I am not sure that the way in which the law deals with human beings is satisfactory to my colleagues who deal with humans primarily, rather than, like me, institutions.

Senator STEVENS. I find that interesting. I would like to visit with you about that.

Mr. STONE. Thank you for the opportunity.

Senator HARTKE. Thank you, sir.

[The statement follows:]

STATEMENT OF CHRISTOPHER D. STONE,' PROFESSOR OF LAW, UNIVERSITY OF SOUTHERN CALIFORNIA

THE FEDERAL ROLE IN CONTROLLING CORPORATE BEHAVIOR

My name is Christopher D. Stone, I am Professor of Law at the University of Southern California, where I teach in the Corporations area. The past few years, with the support of the National Science Foundation, I have been working to identify why it is the law can not do a better job of controlling corporate behavior. In the light of these shortcomings, what new control measures can be, and must be, adopted?

WHAT IS THE MATTER WITH OUR LAWS?

My thesis, in a nutshell, is this: it is no accident that the principal measures we rely on to control corporations fall short; the law simply refuses to recognize that business corporations as a quarry of the law are distinct phenomena, demanding special and distinct legal treatment.

This defect is a legacy of the way the law developed. When the law was in its formative stages, it was individual persons, operating outside of complex institutional frameworks, who created nuisances, engaged in consumer fraud, controlled the work environment. The law responded with rules and concepts built upon contemporary notions about individuals—about what threats motivated, what steered, what was just toward them.

When the first corporations came on the scene, the law pretty much ignored them as deserving any special legal attention. There weren't many of them. Their

1 Professor Stone received his A.B. from Harvard and his law degree from Yale in 1962. He was Fellow in Law and Economics at the University of Chicago and practiced with a Wall Street law firm before joining the faculty at U.S.C. He is past Chairman of the Association of American Law School's Committee on Law and the Humanities, and has done work in the environmental and alternate energy fields, as well as in corporations. Professor Stone is the author of Where the Law Ends: The Social Control of Corporate Behavior (Harper & Row 1975); his other writings on this subject include: "Cracking the Corporate Shell." The Nation (Aug. 2, 1975): "Corporations and the Law: Ending the Impasse." Los Angeles Times (Oct. 6, 1975): "Law and the Culture of the Corporation, Business and Society Review (Fall, 1975): "Public Directors Merit a Trv," Harvard Business Review (March-April 1976); "Stalking the Wild Corporation", Working Papers (Spring 1976).

functions were limited. There was the old doctrine about a corporation being a persona ficta, and therefore itself incapable of liability. And besides, in these early days their size and organizational structure were so unprepossessing, that in the cases in which responsibility had to be lodged, it was usually possible to reach into the organization and locate a meaningfully responsible individual— a culprit-and apply the sanction of the laws to him.

The change came with the industrial revolution. With a sudden onrush of corporations and far larger and more complex corporations, at that-the law could no longer ignore them. Unfortunately, the law did not adjust to their presence by revising some of its conceptions and approaches. Instead-where we went wrong-we simply eased the corporation into the preexisting body of law. This was done, over some years, by withdrawing, one by one, the earlier doctrinal qualms about whether a corporation-a persona ficta-could be a person, too. Through this device, whenever the law spoke, expressly or impliedly, in terms of "no person shall...." that rule was smoothly, if unreflectively, transferred to corporations without distinction.

This was the easiest way to adjust to this powerful new breed of social actor. But it was not the best. Many possible approaches to controlling corporate behavior, that would have taken special account of their special institutional natures, were never developed as they might have been.

Through his default of the imagination, neither of the two basic strategies we use to confront corporations makes any realistic allowance for the way a complex organization operates.

THE FAILURE OF THE COUNTERORGANIZATIONAL STRATEGIES

First, we confront the corporation, as we confront the man in the street, with a negative profit contingency (a civil judgment, a criminal fine) should the organization wander outside the law-a threat, in other words, to the corporation's pocketbook.

This makes the mistake of treating the corporation as an ordinary bookkeeper, the "rational economic man" writ large. The assumption is too simple minded. The possibility that the comptroller of the company may have to write a check to a widow is a small reality to the employees who are designing and turning out the defective products and the dangerous drugs. While the law makes its feints at some distant, abstract "corporate profit" their immediate concern is with the targets and objectives for their shop, department, plant or division. The way the companies operate, the lower levels know that their advancement up the corporate ladder depends upon making those short-term targets-and if it involves cutting corners, somebody else, most likely the stockholders, are going to pay, somewhere down the road.

The top executives are less faceless; but one ought not to bet that threats to the corporate treasury are going to intimidate them into instituting the necessary changes. History shows us that the salaries of top management, as well as their positions, are relatively secure from the financial ups and downs of the corporation from whatever cause and certainly seem to be independent of the most major damage awards the law has ever meted out. In 1972, for example, Ford Motor Co. got caught for violations of the Environmental Protection Act and was fined what by any standard would seem to be an enormous sum: $7 million. Yet, if you go back to check Business Week's annual executive compensation survey, the second and third highest paid executives in the United States in that year was Ford Chairman Henry Ford, II ($887,795, up 27.4 percent over 1971) and Ford President Lee Iacocca ($873,852, up 27.1 percent over 1971); both went still higher in 1973. When the corporation runs afoul of the law, it is the stockholders who get left holding the bag. Indeed, from limited liability to bankruptcy-we have arranged things so that the people who are calling the shots do not have to bear full brunt of the risks.

THE FAILURE OF THE COUNTERPERSONNEL STRATEGIES

True, in a narrow range of highly visible wrongdoing, where the injuries are foreseeable, we can and do threaten key individuals directly. But the law's counter-personnel strategies, even where they can be applied, are no sure guaran

2 Probably more significantly, that salaries were "only" about $260,000 each; they divided between themselves $1,220,000 in "additional compensation" in the year of the huge fine.

tee that the corporation will stay in line. People at the highest levels of management can always claim, and usually fairly, that they "didn't know what was going on" in the day-to-day operations where so many corporate problems originate. They are "protected," too, by the natural screening of bad news that exists in every organization. Too often, the lower levels feel (rightly or wrongly) that the top executives don't want to hear that the tests on a promising new drug are producing cataracts in laboratory animals, or that next year's automobile model has a tendency to roll over. In this regard, it is ironic that the law itself often results in the systematic insulation of top-level officers from information of possible wrongdoing. Knowledge of a sort that might taint the top officers with legal liability can be diplomatically concealed from them. Or divulged only in private, verbally, without leaving a trace.

As a result, responsibility in an enormously complex organization is difficult to establish even when we are using the term in its ordinary moral sense. To assign responsibility legally is all the more difficult, especially in criminal actions, where the burden of proof rests on the prosecution. In those rare cases where judgments are successfully invoked against executives, many state lawsmost extravagantly Delaware's-allow indemnification and liability insurance to blunt the thrust of the legal proceedings.

THE ANTIQUATION OF THE WHOLE LAW

In this list of the present law's shortcomings, there is one final problem of considerable, and increasing significance.

Our present legal system is becoming, quite frankly, antiquated in the context of modern commercial life.

Consider for example a model tort case of a sort the law grew up around. Smith, who is walking across the street, is accidentally but negligently driven into by Jones. This is well suited to our traditional legal machinery: (a) Smith knows the fact that he has been injured; (b) Smith knows who has injured him; (c) one can assess, fairly well, the nature and extent of his injuries; (d) the technical inquiry involved in analyzing the accident is not too complex, i.e., simply laws of physics are involved, not beyond ordinary human experience. (The model also assumes (e) that if the legal damages can be laid at the feet of the responsible actor, he is likely to adapt with appropriate changes in his behavior in the future, which, as I have already testified, is a questionable assumption where the wrongdoer is a corporation.)

But contrast that "model" case-a case in which present remedies seem fairly satisfactory-with the sort of situation that is increasingly of concern in the society today. The food we eat tonight (grown, handled, packaged, distributed by various corporations) may contain chemicals that are slowly killing us. But (a) we cannot know with certainty the fact that we are being injured by any particular product; (b) it is difficult determining who might be injuring us— that is, even if we know that our bodies are suffering from accumulations of mercury, we are faced with an awesome task of pinning responsibility on any particular source; (c) we would have a difficult time proving the extent of our injuries (the more so proving the extent attributable to any particular source); and (d) the nature of the evidence that would have to be evaluated by the court is far more complex and technical than those in the "model" case aboveperhaps too technical realistically to trust the courts or even agencies to unravel.

WHAT IS CALLED FOR: DIRECT PRESSURE ON THE INTERNAL VARIABLES

It seems to me obvious that we can not continue to rely so heavily upon threats to the organization as a whole, allowing the corporation to adjust, as it sees fit, according to its calculus of profits and losses. Nor can we count on threats to key individuals in the hope that they will crisply bring about the internal institutional changes that are necessary. I am not, certainly, saying that these traditional strategies should be abandoned altogether. But we have to go well beyond them to a new, more institutionally sophisticated approach. In certain areas, the law will have to locate the critical points of organizational breakdown and, reaching into the company's inner world, require the necessary configurations directly.

That sounds, I know, awfully abstract. Let me give some examples of institutional variable that could be directly influenced by law.