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that corporations have been regulated in relation to other social goals, it has been through special legislation that at least nominally is unconcerned with whether the prohibited conduct is through the medium of the corporations: antitrust laws; pollution and environment laws; legislation protective of employees.
It was thought by some that increased shareholder participation tbrough the proxy machinery would be a means of controlling the corporation's relationships with the external world as well. These thought that the social sensibilities of shareholders might rise higher than those of management and thus through the exercise of their right to elect directors, and thus influence the selection of the managers, those sensibilities might impact the corporation's conduct.
It is at best doubtful whether events have justified these expectations. While there has developed the notion of the "ethical investor” whose universe of interests ranges more broadly than the narrow economic welfare of the corporation, still there is ample evidence that shareholders are animated for the most part by the desire for the economic profitability of the enterprise in the most conventional sense, although certainly many shareholders would probably rebel strongly if their management flaunted grossly developing social concerns. In general it is doubtful if more effective participation of shareholders in the control of corporations' affairs will significantly better their performance or conduct in terms of meeting social requirements and responsibilities, although certainly strong vocal demands by segments of the shareholder population have influenced at least marginally the course which many managements have taken.
The first issue we should confront, then, is whether indeed there is a need for strengthening the restraints on the prerogatives, the control, of management vis-a-vis the shareholders of the corporation. If, as Professor Hurst explains, the once expected restraint that shareholders might, because of their economic interests, place upon management, are not effective, and if "shareholder democracy" has not afforded an answer, and if the restraints of the market are not sufficient, then should the policy implicit in state corporation laws favoring largely unfettered management control be modified? Remember that the pattern existing in state laws derived from notions which related the legitimacy of the corporation to its utility. Have events ordained that the principle of utility be subordinated to other considerations of fairness, equity, economics, social concern? And if that is desirable, what is the most efficient, effective way of doing that? Should we simply look to the courts to continue the task they have undertaken, not only under the securities laws, but through the application of general fiduciary principles and common law development? Or should we look to a federal enactment for relief, either a federal corporation law or the federal adoption of standards which would be minimums which would be effective if state law failed to reach them?
The second major question we must confront is how the affairs of corporations, these aggregations of economic power, should be related to the total social fabric, to what extent should the economic interests of management and shareholders alike be subordinated to larger considerations? These questions revive the classic Berle-Dodds debate about whom the corporation must answer to, a debate Professor Berle conceded Professor Dodd, who said it must be responsible to interests beyond those of the shareholders, had won, if judged by events : "Transition of the large corporation from a private enterprise to a social institution has now been accomplished and is generally recognized.”.
Professor Hurst has suggested there is a need to further legitimize corporate power otherwise than through the utility of the corporate structure:
"For all the brave talk of a new stockholder democracy and a new corporate statesmanship, it is unlikely that we would find satisfactory adjustment of the large corporation to the social context through new controls built into the corporation's own constitution; this aspect of legal development since 1890 would likely endure. But there would be insistent continuing demand to legitimize corporate power by its responsibility as well as its utility. To this end we would ultimately require a more comprehensive legislative response than any we had achieved by 1970."
The prime method proposed by those who seek to carry out Professor Hurst's suggestions for a “more comprehensive legislative response" is federal incorporation. The response they urge is not simply the substitution of a federal enabling statute, similar in many respects to those of the states, but with more stringent demands upon management in its allocation of the fruits of the enterprise between themselves and the shareholders, but rather a regulatory statute that might, as Professor Schwartz suggests, deal with the problem of "bigness", the participation in the governance of the corporation by constituencies beyond that of shareholders, the creation of a new regulatory function that would enforce the various mandates of the statute.
Almost universally hopes for reform of corporate control, whether those expressed by Professor Cary or the wider ranging ones entertained by Professor Schwartz and Ralph Nader, look to the federal government for realization. This, of course, reflects a broad strain in American thought. As Professor Hurst has said, “The more important any legal theme is in United States history, the more likely it is that it has been significantly affected by the coexistence and interplay of the national and state governments." Any answers we derive must inevitably include recognition of this American phenomenon. In some measure this turning toward Washington reflects a philosophical conviction that these matters, being of national concern, should be dealt with through national means. And then there is the despair that state law can be molded to the pattern needed. It is not expectable that states will, confronted with the possibility that one state will not conform and thus become the favored haven of corporations, significantly harden their demands upon those controlling corporate enterprise, either in their relations with shareholders or with the social totality of the nation. This is recognized by many, perhaps most notably by Professor Folk who had the unique opportunity of observing the dynamics of state corporation law-making as Reporter for the amendments to the Delaware Corporation Law in the sixties.
The issues we confront at this conference are not newly identified or newly arrived in the American consciousness. Concern with corporate power and corporate control has a long history. As the corporate mode of enterprise has become commonplace, as the size of corporations has expanded, as scholars reexamine the history of corporations and their theoretical foundations in our own and other societies, solutions satisfactory to other generations are called into question. Any conclusions of our time which may be expressed in statutes and court decisions will be questioned by the next generation, and theirs by the one after that. This is the stuff of which life is made.
Enough of the questions. Let us now seek answers.
AN ADDRESS BY A. A. SOMMER, JR., COMMISSIONER, SECURITIES AND
(American Bar Association 97th Annual Meeting, Honolulu, Hawaii,
August 14, 1974)
THOUGHTS FOR THE INSURANCE COMPANY DIRECTOR
(By A. A. Sommer, Jr.*) Discussing the impact of federal securities laws on the responsibilities and the duties of insurance company directors is in a sense something of a melding of uncertainties.
Because of the McCarran-Ferguson Insurance Regulation Act which was intended to preserve the regulation of insurance to the states the general feeling has existed that the federal securities laws have minimal importance to insurance companies. Surely it has always been clear that insurance companies were subject to the registration provisions of the Securities Act of 1933. However, the amendments to the Securities Exchange Act in 1964 reinforced in the minds of many the minimal relevance of the federal securities law scheme to insurance companies when insurance companies were exempted from the proxy, insider trading and reporting provisions of the 1934 Act provided they satisfied comparable provisions in the laws of their state of incorporation.
I would suggest that the true scope of applicability of the federal securities laws to the insurance industry began to appear in the case of SEC v. National
• The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or speech by any of its members or employees. The views expressed here are my own and do not necessarily reflect the views of the Commission or of my fellow Commissioners.
Securities, Inc. in 1969 when the Supreme Court gave a fairly narrow reading to the McCarran-Ferguson Act and determined that indeed Rule 10b-5 did have applicability to the conduct of insurance companies and those who managed and controlled them. The conclusion was rather decisively reinforced in the case of Superintendent of Insurance v. Bankers Life & Casualty Co., decided by the Supreme Court in 1971, in which, while the Court made law of significance to many more than those involved in insurance companies, it made clear that the requirement of Rule 106-5 that prohibited conduct be "in connection with the purchase and sale of securities” was satisfied by dealings of an insurance company in its portfolio securities and not only by dealings in securities issued by itself. This, of course, meant that even mutual insurance companies which have technically no shareholders nonetheless might, along with their officers, directors and controlling persons, find themselves in violation of Rule 106–5 if in some fashion they committed fraudulent, manipulative, deceptive or other kinds of improper conduct which resulted in harm to their corporations in connection with their dealings in portfolio securities.
I mentioned at the beginning that the relationship of Rule 106–5 and the insurance industry involved a melding of uncertainties. The second uncertainty melded together is, of course, Rule 10b-5 itself. Despite extended litigation over a period exceeding three decades, despite case books bulging with procedural and substantive decisions involving Rule 100–5, despite the abmirable effort of Professor Alan R. Bromberg in his three volume work on Rule 106-5 to bring together and rationalize all of the disparate elements, vast areas of uncertainty exist. These uncertainties are, to use the phrase increasingly found in decisions involving Rule 10b-5, "aided and abetted” by the peculiar structure of American jurisprudence which devides up appellate jurisdiction not only into a Supreme Court but among 11 circuits, each of which, in keeping with traditional common law theory, by its decisions binds only the district courts within its circuit. Rule 10b-5 is undoubtedly one of the most prolific sources of litigation presently found in the United States Code or the Code of Federal Regulations. It is not suprising then that it has fomented innumerable conflicts among the circuits. While I do feel that many of the conflicts have gradually been reduced in significance, nonetheless many remain.
It is both fortunate and unfortunate that Rule 100–5 has grown in significance to the extent that it has. It is fortunate because it filled a raher gaping voidor more accurately a number of gaping voids which if some means had not been found to fill them might have had extremely adverse social consequences. Any of us who have read Professor William Cary's recent masterful article entitled, Federalism and Corporate Law: Reflections Upon Delaware, knows the sad deficiencies in our state corporation laws. We also know how ineffective have been proposals for a federal corporation law. We all know the manner in which involvement of the public in securities matters has grown over the last 30 years. We all know of the increasing public demand for higher standards of performance on the part of corporate executives, directors, accountants, lawyers. And we all know the profound distaste which has grown among the members of the public for overreaching and inside dealing among corporate officials, ethical reactions which have now spread to other countries, notably the United Kingdom. I would suggest that in many respects Rule 106–5 has been the safety valve which has prevented the buildup of these pressures to intolerable proportions and which has permitted the Securities and Exchange Commission in a remarkable fulfillment of its role as an administrative agency, and the courts in fulfillment of their common law tradition, to relieve these pressure by constructive and imaginative lawmaking. Without Rule 106-5 and its flexible ability to respond to the ethical conceptions which the public demanded be translated into legal mandates, and given the counter pressures which in my estimation would have prevented sufficiently timely and effective state action to deal with these demands, I think we would have had an even greater erosion of confidence in corporate responsibility and corporate decency than we have had with many misfortunes following from that.
I spoke of Rule 106-5 being both fortunate and unfortunate. I think it is unfortuate that we have, because of the circumstances that I mentioned, been impelled to load so much on this Rule, which after all was admittedly adopted in haste, expressed with bewildering and sometimes even angering breadth and generality, and which is only 115 words long. Responsible commentators have suggested that it is wholly inappropriate for the Commission and the courts to try to draw through some alchemy out of those few words a whole code of conduct for the legal profession, the accounting profession, directors, corporate officers, insiders
of all types, financial analysts and a host of other people. It would perhaps indeed be better if through the debative process by which legislation is developed greater particularity had become a part of this endeavor and perhaps it would have been better if there had been at some point in time a more comprehensive realization of what was being done, rather than a piecemeal, case-by-case manner of achievement that has characterized the growth of the Rule 10b-5 concept. While such an ordered structural development has much to commend it, I think there would also be within that a severe disadvantage : inflexibility. Social commentators have repeatedly warned that the pace of change in our life is steadily accelerating and that our institutions, our psyches and even our bodies must develop a capacity to change more quickly. The corporate world is not immune to this rapidly accelerating pace of change and it is extremely important that the means of social control of this terribly important part of our national economic life be flexible and relatively swift in reaction. Through Rule 10b-5 I think we have accomplished a great deal of that flexibility and the ability to adapt that is so necessary.
The price that is paid for such flexibility and adaptability, of course, is the inability to have a photographic rendition of the state of law at any given moment which is fixed, clear, delineated, sharply focused and reliable.
This reminds me somewhat of the physical principle which stated, as I recall it, that it was impossible to calculate the position of a particle and at the same time chart its motion. Consequently, it is extremely difficult to determine from the relatively meager precedents that we have available today the exact extent of a director's responsibility; this in part has been the reason why the Commission has been so dilatory in preparing and publishing guidelines for the conduct of directors, as it promised it would do for some time. Similarly, the task of trying to predict what future lines may be drawn is difficult; there must be in such a venture a liberal mixing of prophecy with legal analysis.
Obviously a starting point in this analysis should be the Securities Exchange Act of 1934. Section 10(b) of that Act gives the Securities and Exchange Commission extremely broad power to adopt rules to thwart manipulative and deceptive activities. Thomas Corcoran during his testimony before the Congressional Committee considering Section 10 (b) very aptly characterized it as saying in effect "thou shalt not devise any other cunning devices.” Section 10(b) has been for the Commission a rich source of power to deal with a variety of problems as they arose, and being one of the partisans of the administrative process and flexibility in its exercise, I must say that the power has been most beneficial to the effective administration of the securities laws.
The most all-embracing of the rules adopted under this statute is Rule 10b-5, with which I think most of you are probably quite familiar. Rule 105–5 is addressed to "any person" and it makes it unlawful to engage in various types of conduct "in connection with the purchase or sale of any security.” The types of forbidden conduct are set forth in three clauses :
(1) To employ any device, scheme, or artifice to defraud,
(2) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(3) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person. There are several ways that the director of a corporation can be brought within the embrace of this rule. Obviously the first way is if he does himself, directly, personally, not through any corporate entity to which he has a relationship, any of the forbidden acts in connection with the purchase or sale of a security, or if he participates directly in the doing of any such conduct.
A second way in which he may be implicated would be if he were considered to be in control of a corporate entity that committed an offense, or was a member of the controlling group of such entity. This source of liability is set forth in Section 20 of the 1934 Act which provides :
“Every person whq, directly or indirectly, controls any person liable under any provision of this title or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable ..."
A third way in which he may be involved is through the invocation of the ancient doctrine of aiding and abetting. This is nowhere defined in the Securities Exchange Act of 1934, but rather is contained in the more general legal provisions. One who "aids and abets" a violation of the securities law may be subject to administrative proceedings, injunctive actions or conceivably financial and criminal liability.
This much is fairly clear and I would think that it is now beyond cavil that directors may have responsibility under Rule 10b-5 for actions they take in their role as directors of corporations. Unfortunately, in the few cases in which these determinations have been made the courts have not been fastidious in delineating the conduct of directors in accordance with the categories I have mentioned above, although in some cases there has been explicit discussion of the responsibility of directors as controlling persons.
The standard of care applicable to directors in their role as controlling persons is fairly clearly set forth in Section 20 of the 1934 Act. This section says that a controlling person has the same liability as the person he controls "unless the controlling person acted in good faith and did not directly or indirectly in. duce the act or acts constituting the violation or cause of action."
Of course, the problem of determining whether a director is indeed a con. trolling person is not free of difficulty. The classical understanding of the term "control" is the power to control, or the actual control of, the affairs of another entity, usually a corporation. This control can derive from a number of sources, including share ownership, office, contractual arrangement and a variety of other relationships with the corporate entity. A person may be deemed to be a controlling person because he is a member of a group that, although not formally bound together, nonetheless functions in a manner that effectively controls the affairs of the corporation.
In Myzel v. Fields, the Court of Appeals for the Eighth Circuit held that all directors per se were controlling persons for the purposes of the 1934 Act. I think this is much too sweeping a statement. Rather, I would suggest that for purposes of advising clients the appropriate test is this: a director is presumed to be a controlling person or a member of a controlling group-subject to a rebuttal. What would that rebuttal consist of? It seems to me that if a person is a director of a corporation in which, say, the chief executive officer owned 55% of the stock, that person might well be able to sustain the burden of showing that he was not a member of the controlling group because of the clear-cut control vested in the chief executive officer. However, I would caution that, given the trend toward the expansion of directoral responsibility in favor of shareholders and investors in general, it may well be that despite the presence of such overwhelming voting power a director might still, if he customarily supported the wishes of the dominant shareholder, be deemed to be a member of the controlling group.
Thus, if a corporation commits a violation of the 1934 Act, and particularly Rule 106–5, then a director who is a controlling person or a member of a controlling group, failing to make the statutory defense, would have the same liability as the corporation.
The last way in which a director might be deemed liable would be as an aider and abettor of the offense of the corporation. The classical definition of aider and abettor provides that whoever aids, abets, counsels, commands, induces or procures the commission of an offense is punishable as a principal.
This concept of aiding and abetting which is not spelled out expressly in the federal securities laws is nonetheless a real hazard to directors, even though the courts have not dwelled upon this notion extensively in dealing with the liability of directors. As we all know, aiding and abetting can take a multitude of
forms. At one time a fairly active course of conduct was thought to be essential for a finding of aiding and abetting; however, since the Brennan v. Midwestern United Life Insurance Co. case, decided by the Seventh Circuit in 1969, something less than affirmative action may be sufficient, and as a matter of fact it would now appear that passivity or inaction in the face of a duty may be sufficient to invoke the doctrine.
The most pervading argument, not only with respect to directors' libility, but with respect to that of accountants, lawyers and others as well, is : what standard of care is applicable with respect to either liability because of direct participation or because of aiding and abetting? Not surprisingly, there has been a great deal of dispute among the circuits and commentators concerning this. Professor David Ruder of Northwestern University Law School in a most able article entitled, Multiple Defendants in Securities Law Fraud Cases: Aiding and Abetting, Con8piracy, In Pari Delicto, Indemnification and Contribution, has argued very persuasively that with respect to aiding and abetting the proper standard should not simply be negligence but something more than that. His argument was mentioned and rather sharply rejected by the court in S.E.O. v. Spectrum, Ltd., de