mands, demands that are inconsistent with the historical role of directors in American corporations. It is easy to say that directors have responsibility whenever an enterprise goes "bust," whenever the shareholders suffer harm, whenever tribulations assault the enterprise they serve.

I would strongly disavow any such notion. Outside directors are necessarily limited in the time and energy they can devote to the enterprise on whose board they serve, and to judge them as if they were full-time employees is in my estimation a mistake. Similarly, they have not the time nor the opportunity to review every particular of the enterprise to ascertain whether management is honest, forthright, candid, straight. They must, as has been recognized in many states' corporation laws, rely upon the reports of management and auditors in carrying out their responsibilities.

But in achieving the necessary balance, it is wrong to impose upon directors so low a standard that the shareholders and potential investors really derive from the presence of outside directors no strength at all. Where perhaps once directors were conceived of as desirable to bring outside expertise to the running of the business, there has unquestionably been a shift in the direction of more emphasis upon the protection their presence affords shareholders and investors in general. And it is in this role that their danger lies.

Undoubtedly many of the corporate disasters of the recent past could not have been avoided if the boards of the involved companies had been the most astute to be found. But in many cases the perils would sooner have been known and many losses suffered by investors could have been avoided had the directors acted in the manner they should have. If confidence in American corporations is to be sustained and strengthened, there is much for directors to do. I repeat they are not insurers of success or even honesty, but there is open for them opportunity for much greater contributions to the success of our corporate economy.

AN ADDRESS BY A. A. SOMMER, JR., COMMISSIONER, SECURITIES AND
EXCHANGE COMMISSION

(Colorado Association of Corporate Counsel, Denver, Colo., Feb. 21, 1974)

DIRECTORS AND THE FEDERAL SECURITIES LAWS

(By A. A. Sommer, Jr.*)

It is axiomatic to say these days that society is demanding constantly more from those who occupy positions of trust and who have control over the resources of the nation. Despite the recurrence of shameful events in the political world, still one cannot help but be struck by the contrast between our standards today and those of yesterday. At the turn of the century corruption of people in public life was all but taken for granted and high officials were commonly "bought." We may still have instances of such corruption, but at least we expect more of those in public life, even if occasionally our expectations are disappointed.

Similarly in corporate life, expectations are constantly rising. We no longer tolerate conflicts of interest that in the twenties were epidemic; we demand of everyone concerned with corporate life adherence to high standards of integrity and honesty and increasingly we use the word "fiduciary" to summarize the sort of conduct we expect. These expectations extend throughout the process. Accountants are under frequent attack in the courts because of charges that they failed to measure up in their work-not that they were dishonest, or venal, or corrupted (and it should be noted that in those particulars the accounting profession certainly has an enviable record of integrity) but because they failed to afford the public the protection their skills and positions are expected to provide.

Similarly attorneys are increasingly called upon to serve broader interests than just those of their clients, at least when they are involved in the disclosure process under the federal securities laws. The public, speaking through regulatory bodies like the Securities and Exchange Commission, the courts, the Congress, is asking more and is seeking expensive compensation when it secures less than it expects.

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.

Increasingly the focus is upon those who, at least theoretically, have the ultimate control over the vast corporate wealth of this country-the directors of publicly-held corporations. In the wake of the horrendous debacles of the last decade-Webb and Knapp, Penn Central, Equity Funding, IOS, and countless others-innumerable pillars of the business community who served with pride on the boards of public corporations find themselves defendants in scores of lawsuits seeking millions upon millions of dollars in damages.

This flood of litigation, flowing from the increased demands upon everyone having responsibility, has spotlighted the role of directors to an extent not seen since the early thirties when the sordid events of the twenties called American corporate enterprise before those ultimate judges, the American people.

In general I think it fair to say that historically directors have not been held to an excessively high, or even very high, standard of conduct. The landmark case, decided by Judge Learned Hand in 1924, Barnes v. Andrews, has over the years been a source of consolation to corporate directors. In it Judge Hand spoke with his customary eloquence of the dangers of placing too heavy a burden of care on directors.

This case has clearly been the mainstream of the law since there are very few decided cases which suggest that directors be held monetarily liable for simple negligence in the performance of their duties.

State corporation laws do not appear to erect an unreasonably, or again, even very high, standard for directors. The relatively recently enacted New Jersey Corporate Law specifies that:

"Directors... shall discharge their duties in good faith and with that degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in like positions."

The tough questions concerning the responsibilities and liabilities of directors have not in recent times arisen under state statutes, but rather have their origins in federal securities law. The impact of these federal cases has led to a renewed interest in the statutory delineation of directors' duties and responsibilities. The Corporate Laws Committee of the ABA Section of Corporation, Banking and Business Law has appointed a special panel on Functions and Responsibilities of Directors. This group is considering the frightening generality of such statutory notions as that usually expessed in corporation codes that directors must "manage" the corporation, as well as the other anomalies posed by the analytical work of Myles Mace describing what directors really do.

There have been suggested recently fascinating proposals for rather significant changes in the traditional structure of the board. Some have suggested a two tier approach similar to that common in Europe, with management constituting one board responsible for running the corporation and other board consisting of non-employees exercising a very general oversight function. Arthur Goldberg made headlines with his proposal after serving on the TWA board that there be established in publicly-held corporations a staff to assist the outside directors in carrying out their responsibilities, a proposal that, as you might expect, met with prompt and, in many instances, very thoughtful repudiation in many quarters.

Some corporations have done more than talk about these problems. Texas Instruments has established a post called "officer of the board." This is an outside director who is selected to function you might say halfway between an active board member and an officer of the corporation. In this role he has special responsibilities and resources for monitoring for his fellow board members the conduct of the officers. General Foods, I understand, has an assistant secretary assigned the duty of securing such information as the directors wish in connection with their roles. And I am sure other corporations have moved imaginatively to make the role of director more meaningful.

In many instances corporations are seeking this more meaningful participation, not simply to insulate their directors against unwanted liabilities, but to afford them the opportunity to contribute more fully to the functioning of the corporation. After all, the notion of the outside director is founded on the idea that he will bring to the corporation's affairs a different perspective that will be helpful to the officers whose insights may be foreshortened by the intimacy of their involvement in the day-to-day affairs of the corporation. Many an alert management is realizing the potential that exists around the board table. Fewer and fewer, I would suggest, are doing what an officer of a multi-billion dollar corporation dominated by a very aggressive chief executive officer told me happened at

their board meetings. He said that upon entering the board room each member found at his place a formidable stack of attractive appearing documents. While the members leafed through them out of curiosity, the chairman ran through the agenda of the meeting and usually had it timed to be completed about the time the directors got to the bottom document in the stock.

Unfortunately, notwithstanding heightened concern with liability and effectiveness of directors, in many instances the words of the Michigan Supreme Court in 1926 remain sadly apropos :

"It is the habit in these days for certain well-to-do men with influence in their respective communities to accept positions on boards of directors of corporations as honorary directors, and then never render any service except to sign on the dotted line, vote as requested by the one in charge and afterwards to cash their director's check for attending the meeting. They give no thought to the affairs of the company, exercise no judgment upon questions of business policy, and make no investigation of the real financial condition of the company. It is this kind of service by directors that helps to extract such a tremendous annual toll out of the public who happen to own industrial securities. The law requires a different kind of service of them."

As I mentioned the current attention to directors and their responsibilities has had its principal stimulus in litigation arising under the federal securities laws. Consequently, I think it would be helpful to review the problems of directors as they have been developing under federal law.

Section 11 of the 1933 Act is one of the few places in the 1933 and 1934 Acts where "director" is mentioned as such. That section provides that the director of a corporation may be held liable for a deficient registration statement unless he establishes that after a reasonable investigation he had reasonable grounds to believe, and did believe, that the registration statement did not suffer from the alleged deficiency. It was this section that was involved in the BarChris case. However, it is not the 1933 Act which has been the source of most of the concern of directors. It is that voracious demon, Rule 10b-5. And neither that Rule, nor the statutory provision from which it derives, makes any mention of directors as such.

Rules 10b-5 makes it unlawful for "any person" to do certain things, and of course, that includes directors whether acting as such or not. Unfortunately, the problem is much subtler than that and involves a good deal more complexity than might be indicated by the simple words of the Rule.

First, of course, is the very generality and vagueness of the language of the Rule. This vagueness has given rise to the mountain of litigation involving the problem of scienter, the degree of knowledge required for liability and the amount of care which must be exercised. This varies considerably depending upon the type of action (injunctive relief sought by the Commission generally requires no showing of scienter), the identity of the defendant, the circuit in which the action is brought. This problem has, as will be seen in a moment, been of particular moment in determining the responsibility of directors under the Rule.

Then there are the provisions of the 1933 and 1934 Acts which hold those in control of a wrongdoer liable unless they can establish the statutory defenses. This concept of control has also given rise to litigation with varying outcomes, all the way from the conclusion of the court in Myzel v. Fields that all directors per se are in control of the corporation, to the opposite conclusion in Mader v. Armel and Moerman v. Zipco that whether a director is in control depends not simply on the office, but the circumstances of the case, the relationship of the individual to the corporation, and the extent of control by others.

Add to these uncertainties the common law doctrines of conspiracy and aiding and abetting and it is little wonder that there is confusion, uncertainty, and

concern.

Like beauty, I suppose the import of cases involving directors under the federal securities laws is in the eye of the beholder. Viewed in one way, they do not appear disconcerting; viewed another, they are troublesome. Certainly they can be described as inconclusive, but then that word could be applied to most of the problems under these laws.

In the BarChris case, which might be characterized as the first in the modern series of cases involving directors under federal laws, the court determined that all of the directors were liable under Section 11 of the 1933 Act, including two directors who had relatively recently joined the board and whose presence on the board appeared to have something of a self-serving motivation. In my

estimation, given the facts of that case, the outcome was not surprising; what is perhaps more surprising is the reaction to the case by many commentators who seemed to feel that the court imposed an excessively strict obligation on the outside directors. It should be noted that in a Section 11 case there is no necessity of showing any control: all that must be shown is that the director was such at the time the registration statement became effective and then the burden is upon him to prove he made a reasonable investigation and had a reasonable belief that the registration statement was in compliance with the law. Judge McLean in the BarChris case rather clearly established that under the 1933 Act directors are held to varying degrees of responsibility depending upon their closeness to the affairs of the corporation, their skills and other such factors. Thus, Mr. Grant, who was outside counsel for the corporation and who had participated in preparing not only the defective registration statement but others as well, was clearly held to a higher standard of care than his fellow outside directors because of those circumstances. The case also indicated rather clearly that directors cannot satisfy their responsibility under Section 11 by relying upon the representations of management, but rather have some responsibility to make their own investigation of material facts. How far this investigation should extend, the depth to which it must be pushed, is left largely unclear by the BarChris case, although commentators have sought to explicate these matters. Certainly it would appear that a casual leafing through a registration statement is not sufficient.

Does the BarChris case, and for that matter Section 11 of the 1933 Act, have any relevance with respect to the day-to-day functioning of directors, particularly under Rule 10b-5? I would suggest they do. James M. Landis stated succinctly that "much of what is ordinarily regarded as 'common' law finds its source in legislative enactment."

It seems to me that there are evidences in the cases that indicate some disposition on the part of the courts, without even articulating it in these terms, to import into other contexts the standard of care that it expressed in the 1933 Act, although I would emphasize again that this has not yet been made explicit. Two recent cases point up rather clearly, in different ways, the problems of directors under the federal securities laws. In the first case, Gould v. American Hawaiian Steamship Company, a federal district court in Delaware held three outside directors of McLean Industries liable for material omissions from a proxy statement circulated to shareholders of the company. The court analyzed the proxy rules, came to the conclusion that negligence was sufficient to establish a claim for damages as a consequence of a misleading proxy statement, and thus established a very high standard of responsibility for directors in connection with proxy solicitations.

In the other case, Lanza v. Drexel & Co., the Second Circuit, sitting en banc, by a six to four vote and speaking through Judge Moore, concluded that under the facts of that case, Mr. Coleman, a partner of Drexel & Co. who was on the board of BarChris, was not liable in damages to plaintiffs who had received BarChris stock in exchange for stock in a company acquired by BarChris. The court articulated the issue in this manner:

"What duty, if any, does Rule 10b-5 impose on a director in Coleman's position to insure that all material, adverse information is conveyed to prospective purchasers of the corporation's stock where the director does not know that these prospective purchasers are not receiving all such information?" (Emphasis supplied.)

In this case it appeared that Coleman had an awareness that the company was moving into troubled waters and as a matter of fact not long before the acquisition was closed there had been a dramatic meeting at which the ills of the company were fully ventilated. Notwithstanding Mr. Coleman's awareness of the declining fortunes of BarChris, the court held that he was blameless for the failure of BarChris' management to make proper disclosure to the company to be acquired.

Judge Hays in a strong dissent took issue with the majority and concluded that Mr. Coleman should have been held liable on the grounds that his financial sophistication coupled with his awareness of the increasing misfortunes of BarChris should have made him vigilant enough to at least inquire (not insure, be it noted) whether the company being acquired by BarChris was fully informed. Judge Hays said:

"Despite Coleman's experience, important corporate position, and knowledge of corporate adversity, he made no attempt to inquire as to the course of the

negotiations Kircher was conducting with plaintiffs and Shulman or as to the information about BarChris being conveyed to the Victor shareholders on which the negotiations were based. He did not inquire at the 'point of crisis' meeting or subsequent thereto, whether the Victor shareholders had been informed of the unfavorable position of BarChris."

And Judge Timbers, who also dissented, said:

"The following facts in my view demonstrate that Coleman acted in reckless disregard for the truth. He was added to the BarChris board of directors at the behest of Drexel to protect its substantial investment in BarChris. He was the most experienced member of the board with regard to financial and business matters. He was aware that BarChris was acquiring Victor through an exchange of stock since he had voted for the acquisition in his capacity as a director. He was aware that BarChris had suffered many business reversals and that it suffered from severe intracorporate dissension. Yet he did not know whether this unfavorable position had been disclosed to Victor.

"It became clear at the 'point of crisis' meeting held on December 6, 1961 that one of the symptoms of BarChris' lack of effective leadership was a 'refusal to accept the fact that basic problems exist [ed] within the Company.' Until that time not even the board of directors had openly recognized 'the management's inability to cope with the existing problem.' Moreover, it was revealed at that meeting that only recently had certain mistakes and problems 'come to light.' Coleman's experience should have told him that, since neither the board nor the management of BarChris would openly admit to themselves until the 'point of crisis' meeting that they had serious problems, and since certain mistakes and problems had just recently been discovered, management obviously had not revealed these matters to outsiders such as Victor. But Coleman made no effort whatsoever to discover whether such information had been disclosed." The Lanza case has been a source of great comfort to the corporate bar and their director clients. I would respectfully suggest that perhaps it is not as strong a reed to lean upon as many think. And I would suggest that subsequent developments may very well find the better rule-a duty of inquiry if nothing more-in Judge Hays' dissent.

Of all the outside directors of BarChris, Mr. Coleman should have been the most sensitive to the affairs of the corporation and to what was involved in the issuance of stock by the company. He was aware that the company was troubled, that there was internal dissension and this should have given rise to the conclusion that anyone accepting BarChris stock in exchange for value was making a highly risky investment decision. In fact, I would suggest that perhaps he should have wondered how, if all the facts were known to the shareholders of the company being acquired, they were ever induced to take stock of BarChris, and shouldn't this wonderment have led him to some skepticism with regard to whether all the facts had been told to the soon-to-be shareholders of BarChris? Mr. Coleman was an investment banker and as such it is likely that his counsel was of particular value to the company in connection with acquisitions. I suggest that the court dealt too gently with Mr. Coleman.

The majority discussed Mr. Coleman's potential liability largely in terms of negligence, recklessness and wilfulness. Judge Hays in his dissent dismissed such analysis:

"It is not profitable in considering a case such as this merely to characterize the allegedly unlawful conduct as either negligent or wilful and to impose liability only if the conduct was wilful. Neither the Act nor the Rule creates such a simple dichotomy. The purposes of the Act and the Rule are not furthered by a mechanical application of labels. The relationship of the parties and the transaction involved must be analyzed in order to determine whether the Act and the Rule impose a duty on one party with respect to the other and the nature of that duty...."

I would agree that the question is not whether the appropriate standard is negligence or recklessness or what have you. Regardless of the name that is put on his conduct, I would suggest that in the circumstances posed by the Lanza case there was indeed a duty on a director with Mr. Coleman's skills, experience and insights to take some measures to determining whether those who were accepting the corporation's stock had been apprised of the risks inherent in that act.

I would emphasize, and I think it is becoming apparent in the cases, that directors cannot be dealt with on an undifferentiated basis under the federal