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I think they have served a useful purpose. I wish I knew a way by which the ones that didn't have the earmarks of responsibilities are weeded out, but as we know, the courthouse doors are open to anybody.
Senator DURKIN. I sometimes suspect if we could get disclosure, rigorous enforcement of the antitrust laws, the fear of the class action in the board room, no matter who else is there, in the long run we might not have more effective enforcement procedures.
Mr. SOMMER. Well, I would not argue with that. I have been of the belief that the SEC's mandate on disclosure is confined to the investment process—and I have spoken on that. Whether other disclosure outside that context would be desirable is another matter.
I think the requirement of disclosure with respect to social policies is separate from the question of disclosure for investors.
I think too much disclosure can impede public understanding. In many instances disclosure has the effect of concealing rather than putting the spotlight on important matters. However, disclosure can serve a very significant social role. As everyone has heard, almost ad nauseum. Justice Brandeis said the electric light is the best policeman and sunlight the best disinfectant, and I think that is true.
Senator DURKIN. I want to thank you on behalf of the committee for your time.
Mr. SOMMER. Thank you, Mr. Chairman. [The statements follow:]
STATEMENT OF A. A. SOMMER, JR., PARTNER, JONES, DAY, REAVIS & POGUE,
WASHINGTON, D.C. Mr. Chairman, committee members, my name is A. A. Sommer, Jr. I am presently a partner of Jones, Day, Reavis & Pogue, Washington, D.C. From August 6, 1973 to April 2, 1976 I was a member of the Securities and Exchange Commission. During that time I had occasion to express myself publicly concerning the responsibilities of directors and management and the role of corporations in American society. With the permission of the Chairman and the Committee, I would like to submit for inclusion in the record of these hearings copies of some of those statements.
I would like to discuss today two problems: first, developments with respect to the role of directors in American corporations; and second, the desirability of federal incorporation.
Until recent years, it is fair to say that far too little attention was given to the role of directors in publicly held corporations. Before 1933 the only law which governed the relationships between directors and their corporations and the shareholders of the corporations was state corporation law and in the eyes of many, that law did not impose upon directors heavy burdens. The first assault upon the primacy of state corporation law was the Securities Act of 1933 which established the then revolutionary principle that those not in privity to purchasers of securities, including directors of an issuer, might be held liable for losses suffered by purchasers who were denied full and fair disclosure. The legislative history of that Act clearly demonstrates the radical nature of this proposal and the efforts made to turn it back.
Since then, and particularly since 1946, when the right of private individuals to maintain actions under Securities and Exchange Commission Rule 105–5 was established, directors have had increasingly to be alert to the strictures of the federal securities laws. While the number of cases determined adversely to directors under the federal securities laws has been relatively small, nonetheless the impact of those cases, pronouncements of the Securities and Exchange Commission and other developments have heightened the awareness of all involved in the corporate community that indeed severe liabilities might be inflicted under the federal securities laws upon directors who are not attentive to their duties, particularly when their responsibilities touched upon the issuance and sale of securities.
Until fairly recently, certain patterns were clearly discernible in many publicly held corporations: the directors were the personal choices of the chief executive officers; some directors frequently regarded directorships as pelts to be displayed proudly on their belts; directors frequently regarded board memberships as sinecures, honors, pleasant experiences and paid scant heed to the responsibilities that attended such office. The Securities and Exchange Commission's staff study of the Penn Central collapse clearly indicated the routine, ineffectual manner in which some of the directors of that corporation approached their responsibilities; one result was three of the directors were named as defendants in the action brought by the Commission stemming from that debacle.
Happily it is possible to see in the corporate world today strong evidences of dramatic change in the functioning of boards of directors. This has come about as a consequence of many forces. Certainly litigation has been a significant one, both that initiated by the Securities and Exchange Commission and by private litigants. I have mentioned the Penn Central case as a singular instance of the Commission's activities. Another was its release accompanying the filing of an injunctive action in the Stirling-Homet matter wherein the Commission criticized sharply the inattention of the outside directors of that hapless corporation to their responsibilities, their failure to pursue lines of inquiry when a reasonable man would have done so, their near-total reliance upon the representations of management even when warning signals about their credibility confronted them. There has been a vast outpouring of writings, both books and magazine articles, discussing and delineating the responsibilities of directors, and invariably the thrust of these writings has been that there is indeed a heavy burden upon someone who undertakes this responsibility, Heightening both concern about the role of directors and awareness of directors that their duties are indeed substantial, have been the disclosures with respect to illegal political contributions and overseas payments. The evidence at hand would indicate that invariably the outside directors of the corporations had no knowledge that the corporation and its officers were engaging in reprehensible activities. Apparently the directors never made inquiries with regard to these matters and management never volunteered the information. The disclosures that now are occurring have not only raised anew questions about the role of outside directors, but have also been an embarrassment to many who have served on the boards who now find that indeed they were like the proverbial mushroom-kept in the dark. All of these problems are highlighted in the article about the Gulf Oil Corporation appearing in the current issue of Fortune.
As we witness these sorry events, and we realize that in many particulars the conduct of directors has been deficient, well may we inquire why this has been. Certainly one of the factors has been the relatively lax standards exacted by state corporation law and the dearth of litigation under that law. Had there been greater insistence by shareholders in the courts that directors perform properly, it is not unlikely that the state courts would have responded and imposed upon directors greater fiduciary duties. Another circumstance has been the widespread uncertainty and confusion among many directors concerning their appropriate role: were they to manage the business? were they to monitor? were they to be on-board policemen? were they simply to listen to management presentations and critique them? Certainly another element contributing to poor performance has been the circumstance that in many instances the directors were selected by the chief executive officer from among his friends, such people are not likely to be boat rockers. And directors simply have not thought enough about their duties; in this, perhaps, they have been abetted by corporate personnel who should have given them guidance but didn't.
The situation is changing dramatically and drastically. I would suggest that persons asked to join boards of publicly held companies now do so only after reflecting carefully upon the responsibilities they assume and the availability of time to perform adequately; gone are the days when it would be regarded as a badge of merit for an investment banker to be on half a hundred or more boards of directors. Corporations, aware of the necessity of greater board involvement in their affairs, have developed a number of devices to achieve that. Audit committees are becoming routine and numerous conversations with both auditors and members of boards of directors have indicated the utility, nay, the necessity, of this mechanism. Many corporations are strengthening the influence of the outside directors by involving them not only on the audit committee but other committees as well, and by expanding the number of board members without significant financial affiliations with the corporation. Many boards have added so
called “professional directors” (a term which I regard as a misnomer) who are expected, usually for additional compensation, to spend more time on the affairs of the corporation than the typical director; two significant examples of such people have been Robert Haack, formerly president of the New York Stock Exchange, now head of Lockheed, and Joseph W. Barr, formerly Secretary of the Treasury. I speak of the term “professional director" as a misappelation ; rather I think of those men commonly called that as simply directors who expend larger amounts of their time on the affairs of the corporation and thus can constitute a helpful bridge between the other outside directors and management.
Some corporations such as Texas Instruments have developed elaborate means of bringing to their boards qualified persons imbued with a sense of responsibility and an abundant opportunity to exercise it. The recent disclosures with respect to overseas payments have thrust boards into new roles: the outside directors have typically been called upon to conduct investigations when improper conduct has been suspected or ascertained and they have in many instances become the mechanisms for monitoring future activities.
We approach this problem of directors in modern American public corporations at a time when vast changes are already underway, when old patterns are being broken, when significant experiments are being undertaken, when there is an abundance of concern in the board room—much of it stemming from fear, no doubt-about the proper role of the outside director.
In these circumstances, it seems to me it is imperative that two dangers be avoided : the first is the danger that action be taken which might very well stifle initiatives already started, that would change radically the relationship between the Federal Government and corporations as creatures of the individual States and that might be an unnecessary, even harmful, intrusion into affairs that have traditionally been private; the second is the danger that everyone lapses into unconcern about this problem and allows present healthy trends to be reversed or slowed.
In considering the desirability of governmental action to strengthen the capacity of directors to function effectively, it is imperative, I think, to start with a clear understanding of what directors should be expected to do, and that of course requires some notion of what corporations are and how they fit into our total social scene. Corporations are associations of people and aggregations of capital accorded certain advantages by law; they are the principal means by which in this capitalistic society wealth has been gathered voluntarily from the savers in society and put to productive uses. With all of their faults they have been massively successful as producers, albeit at times at social costs unrealized. While it is important that corporations not be polluters of the environment, not be bribers of public officials, not be violators of the law, not be indifferent to their public responsibilities, it is also extremely important that they function effectively in their prime role as the preeminent producers of goods and services in our society and as the mechanisms through which capital wealth can be utilized for the economic benefit of society. This is obviously a very inadequate elaboration of the "concept of the corporation", which has been the subject of innumerable excellent works by scholars such as Peter Drucker, but I think it is sufficient to give us hints about the role of directors in these entities.
There are those who would conceive of directors as simply policemen on the premises, there to assure that management does not transgress any laws or pursue policies that are socially undesirable. There are those who would suggest that the outside directors should conduct a continuing ongoing investigation of management conduct to a similar end. A related, but somewhat different, misconception has its origin in State corporation laws which frequently state that the board shall “manage" the corporation. And while to my knowledge no one has said this explicitly, there does occasionally appear to be underlying litigation directed against directors when a corporation stumbles, the notion that in some fashion the directors are guarantors of the success of the enterprise.
I would suggest that the first responsibility of directors--not by any means to the exclusion of other responsibilities—flows from the nature of the corporation as an economic entity. Preeminently the directors should be the monitors of the manner in which the corporation is functioning as a corporation in the sense in which we generally regard it. Thus directors must be concerned with the economic and other goals that the management has established-and as a matter of fact, the directors themselves should be involved in the articulation of those goals. And then the directors should be concerned with the extent to which the management of the company is achieving those goals, and if management fails for reasons that seem to be related to their competence in accomplishing the goals established, then it is incumbent upon the directors to initiate whatever measures are necessary to permit the corporation to accomplish its legitimate objectives. Thus the prime responsibility of directors is to assure, consistently with their position as monitors and not as managers, that the corporation functions in an economically productive and useful fashion.
But that certainly does not exhaust the res onsibilities of directors: hey also have some responsibility to see that the corporation conducts itself as a good citizen, that it does not pursue policies that are at variance with society's objectives and goals, that management uses the shareholders' money in a manner that is consistent with their stewardship and with the laws of the countries in which the corporation conducts business.
Quite obviously, those with no economic dependence upon the corporation are in the best position to engage in an objective, careful, unbiased analysis of the manner in which the corporation is serving its economic function and acting its role of good citizen. Does this mean that only outsiders should be allowed as members of the board of directors? I would suggest that it does not mean that but rather that it does imply that the representation on the board of outsiders be substantial and not token, that it be large enough to constitute a visible and telling presence in the deliberations of the board. In two ways this might be accomplished: one, by a requirement, either enacted by legal authority or by such quasi-legal authority as the stock exchanges, that a majority of the board consist of persons with no economic dependence upon the corporation; a second way would be a requirement that a certain minimum number of the directors have such characteristics—thus, for example, at least four or five of the members of the board would have to be outsiders regardless of the size of the board. The presence of substantial representation by outsiders would make it impossible for management to ignore their presence and the presence of a substantial number, such as four or five, would result in a mutual drawing of strength each from the other. I would strongly urge that the least desirable way to change the constitution of the corporate board would be through federal legislation laid atop state requirements; at the moment, given the widespread responsiveness to proposals for change, I would think the most desirable way would be to urge such a course on the exchanges and upon corporations directly, and then judge the effectiveness of that means before venturing further.
I would reject as ill-founded, especially now, when so much beneficial change is occurring through processes other than governmental mandate, such proposals as that made by the Corporate Accountability Research Group that boards be made up of persons representing various constituencies-labor, environment and so on. Much better in my estimation is a board consisting of directors each of whom is fully responsible with respect to the entire gamut of corporate activity and must be alert to the legitimate claims of employees, of society, of the government, of the environment, as well as investors, in making judgments; such specialization on the board would in my estimation result not in better boards, but in less capable, less effectively functioning boards. Similarly, the appointment by public authority of one or more directors of the corporation would mix the functions of government and the functions of corporations together in a manner which I would regard as most unfortunate. Such would be a step toward a more direct regulation of corporate affairs by government than I think desirable, and a step which it would be easy to follow with other steps that would make corporations in this country into a simple economic arm of a central government. This seems to me to be peculiarly inconsistent with what seem to be the dominant trends of American thinking-limitations upon government and reduction of its role in the economic life of the country. The same might be said with respect to a proposal by Senator Church that there be a specified number of outside directors who would have a responsibility of reporting to the Securities and Exchange Commission. This proposal would even more forcibly intrude government into the affairs of corporations; beyond that, it suffers from a more basic fault, namely, it exalts the function of directors as monitors of legality of conduct to a preeminent position, ignoring the responsibility of directors with regard to the economic functioning of the corporation.
Proposals have been made, notably by Justice Arthur Goldberg, when he was a member of the board of TWA, that outside directors should have a staff separate and apart from the corporation and totally committed to the outside directors. While I think it is important that outside directors have the right to call upon and use the services of corporate staff members—and there may be merit in, for instance, giving an assistant general counsel a special responsibility of assisting the board-nonetheless I think a separate staff would be unduly divisive and would create antagonism, tensions and stresses which would not be consistent with the most effective functioning of the corporation. A separate staff beholden only to the outside directors could easily become a quasi-inspector general, regarded with hostility by regular staff people and dedicated to fault-finding the activities of the regular management. Bearing in mind again the primary function of the corporation it seems to me that the establishment of a separate staff answerable only to the outside directors would elevate to inappropriate importance the subsidiary function of directors as monitors of the propriety of the conduct of management.
As has been repeatedly pointed out, the idea of federal incorporation is not a new one; its origins go back to the earliest days of our nation. Perhaps this is not as surprising as the fact that during all these years when strong forces were welding the nation into a powerful economic unity, a federal incorporation law has never been adopted. One would have thought that as we broke the economic barriers down between the states and made them into a genuinely single economic unit the forces tending towards a federal incorporation law, at least one applicable to the larger nationwide companies, would have become irresistible.
Why that has not happened is difficult to say. In more recent times, it seems to me that the realization of such a statute has been thwarted by the insistence of those who advocate that it take on a strong regulatory bias—that is, that it not be simply an "enabling" statute, one that delineates the allocation of powers between shareholders, directors and management, establishes procedures for the holding of shareholders' and directors' meetings, and so on, but that it also be the main instrumentality for protecting consumers, breaking up large industrial concentrations, protecting the environment, and implementing antitrust concepts. The proposal made by Mr. Nader and his group, like many proposals before, is designed to do many things; it is rather like the nostrums that were touted in earlier days in our country as the cures for everything from gout to cancer.
I am deeply troubled by this approach. For one thing, since this proposed statute would be applicable only to companies with certain characteristics and size, it would introduce into many areas where now the law is universally applicable a distinction: some companies—the larger ones—would have special responsibilities with regard to environment, consumers, compliance with antitrust regulations and so on. This would tend to blur the fact that all of us, and all businesses, have responsibilities in those areas and that the public can be harmed significantly by companies that would be subject to lesser regulation than the large companies.
Beyond that, it seems to me the manner in which these problems have been dealt in our country until now is an appropriate one and that tangling all of these public policy considerations into the structure of a federal incorporation law is not a good approach.
However, I do feel that a federal incorporation law which would incorporate the best current characteristics of state corporation laws and which would include perhaps the sort of fiduciary responsibility provisions advocated by Professor William L. Cary would be a desirable advance. The deficiencies of state law, the "race for the bottom", the apparent unwillingness of many state legislatures to impose strict enough standards upon fiduciaries within the corporate system have all been catalogued and detailed and I am sure that other testimony before this Committee will discuss, has discussed, these matters explicitly. These in my estimation are real problems, although I believe there are some evidences that states, through both their legislatures and their courts, are becoming more cognizant of the need for higher corporate standards of conduct. As an example, the recently enacted California corporation law contains a number of innovations which are intended to protect investors to a greater extent than they have been protected before under California law. Furthermore. such decisions as that of Diamond v. Oreamuno by the New York Court of Appeals tells a willingness to impose upon corporate officers significant responsibilities. Likewise a number of state courts, long before the United States Court of Appeals for the Second Circuit rendered its decisions in Green v. Santa Fe Industries and Marshel v. AFW Fabric Corp., found in their statutes the bases