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cided in 1973 by the Second Circuit. There the court, in discussing the liability of an attorney in giving an opinion with respect to the availability of an exemption for a sale without registration under the Securities Act of 1933, said:
"We do not believe, moreover, that imposition of a negligence standard with respect to the conduct of a secondary participant is overly strict, at least in the context of this case. The legal profession plays a unique and pivotal role in the effective implementation of the securities laws.
"We do not find persuasive the argument by one recent commentator that since 'the alleged aider and abettor will merely be engaging in customary business activities, such as loaning money, managing a corporation, preparing financial statements, distributing press releases, completing brokerage transactions, or giving legal advice, [a requirement that he] investigate the ultimate activities of the party whom he is assisting (may impose) a burden ... upon business activities that is too great.' . . . In the distribution of unregistered securities, the preparation of an opinion letter is too essential and the reliance of the public too high to permit due diligence to be cast aside in the name of convenience. The public trust demands more of its legal advisers than 'customary' activities which prove to be careless."
The Spectrum case, which I think has applicability in considering the liability of directors, involved an injunctive proceeding by the Commission. I would suggest that with respect to such actions there is beginning to jell a consistent pattern, namely, that with respect to responsibility, whether the question be one of participation in wrongdoing or aiding and abetting it, the proper test is negligence. I would further suggest thatthe returns are still not in with regard to the standard of liability to be applied with respect to a suit for damages. It seems to me that the misgivings expressed by Judge Henry J. Friendly in the Texas Gulf case continue to be of concern:
“The consequences of holding that negligence in the drafting of a press release such as that of April 12, 1964, may impose civil liability on the corportation are frightening. . . . If the only choices open to a corporation are either to remain silent and let false rumors do their work, or to make a communication, not legally required, at the risk that a slip of the pen or failure properly to amass or weigh the facts—all judged in the bright gleam of hindsight-will lead to large judgments, payable in the last analysis by innocent investors, for the benefit of speculators and their lawyers, most corporations would opt for the former."
It is very easy for a trier of fact to find negligence on the part of directors. With regard to even corporations of moderate size the liability consequences of negligence for directors can be absolutely ruinous; the holding of the court in the Second Circuit in Shapiro v. Merrill Lynch, Pierce, Fenner & Smith that a defendant accused of selling stock on an exchange on the basis of an illegally communicated “tip" may be liable to everyone who purchased or sold a security in the market during the period of the offense opens the threat of even greater liability than had previously been considered. If the standard in money damage cases is to be negligence, then I would suggest that perhaps we must reconsider the exposure of directors to monetary liability. Professor Alfred Conard has discussed this in a thoughtful article entitled, A Behavioral Analysis of Directors' Liabilities for Negligence. He there suggests, among other things, that perhaps a director should have a liability limited to the after tax amount he received from the corporation during the year in which his offense occurred. I would suggest that this is much too light an exposure. Such a penalty would in most cases be small deterrent to neglect of duty on the part of directors. It may well be that a more realistic test would be that proposed in the Federal Securities Code now under consideration by the American Law Institute which, for all practical purposes, would limit directors' liability to $100,000. If there were such a limitation, obviously it would be much easier for smaller corporations to secure liability insurance for their directors, although I suppose any re-examination of the exposure of directors' liability should also include a consideration of the public policy implications of officer and director liability insurance.
As I mentioned, the limits of responsibility are obscure. Perhaps the most significant recent case with respect to directors' liability is that of Lanza v. Drexel & Co. In this case, one Coleman, an outside director of the ill-fated BarChris Construction Corporation and a partner of the company's principal financial
advisor, was charged with liability for the failure of the management of BarChris to inform a company to be acquired concerning the problems of BarChris. The Second Circuit split five to four on the question of Mr. Coleman's responsibility, with the majority holding he did not have liability.
In my estimation the majority's opinion has been interpreted in a fashion that preserves a low standard of directoral responsibility. It held that Mr. Coleman, because he had not attended critical meetings at which the acquisition was discussed, had no responsibility to inform the company to be acquired about BarChris and its troubles. The court appeared to indicate that he had no responsibility to ascertain the nature of the representations being made by BarChris management or their accuracy.
The minority opinion, on the other hand, insisted that Mr. Coleman, in view of his knowledge of the gathering clouds over BarChris, had the obligation to at least inquire concerning the information management was furnishing to the company to be acquired. The minority placed great emphasis upon Mr. Coleman's financial expertise, his presence on the board as a representative of the underwriter, his awareness of the problems of the company.
The court did not confine its discussion to the standard of conduct-negligence, scienter, recklessness, etc. The court placed considerable emphasis on the duty of an outside director in an acquisition situation involving the issuance of stock.
I am rather strongly in sympathy with the minority opinion. Mr. Coleman, prior to the completion of the acquisition, had become aware of the increasingly difficult financial plight of BarChris, the existence of bitter dissension within the executive ranks, the declining fortunes of the company. In this situation does he not have at least the responsibility to inquire whether the management of his company has been leveling with the company to be acquired? After all, the board had authorized the issuance of the securities to the shareholders of the company being acquired. Were these shares to be issued in a vacuum, were they simply pieces of paper without relationship to the totality of the issuing corporate enterprise? I shrink from admitting that the role of the director is so limited and his responsibility in such a situation so little. Rather it seems to me that, given the expertise of Mr. Coleman, the fact that shares, deriving their value only from the state of the mother enterprise, are to be issued for economic interests, there should be at least the obligation to inquire whether the whole story is being told the lambs. To the shareholders of the acquired company the transaction was perhaps the most important of their lives. Should not they expect the interested, involved, careful concern of the directors of the acquiring company in assuring that they are given the benefits of information concerning the true staet of the company whose shares they are about to receive? It is to my mind little short of shocking that Mr. Coleman apparently had not even the obligation to inquire whether, knowing the deteriorating situation in BarChris, the whole unpleasant truth had been told the trusting shareholders of the company to be acquired.
The minority opinion in the Lanza case has an interest beyond the conclusion reached by the judges. Judge Hays, writing for the minority, suggested that conventional analysis of fault was inappropriate in Rule 105-5 cases. He said :
"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."
This notion in White v. Abrams, decided in 1974 by the Ninth Circuit, became law, at least in that circuit. There, in a case involving an advisor, the court said:
“The proper analysis, as we see it, is not only to focus on the duty of the defendant, but to allow a flexible standard to meet the varied factual contexts without inhibiting the standard with traditional fault concepts which tend to cloud rather than clarify ..
I would suggest that close scrutiny of the technicalities of the degrees of fault in the context of Rule 10b-5 cases will steadily become obsolete. I doubt seriously whether juries confronting the complexities of conduct within the framework of the modern corporation pay much attention to the niceties of the degrees of scienter; rather I think they do pretty much as the court in the White case suggests; they look at the relationship of the parties, try to understand the duties attending the situation of the defendant, assess the measure of reliance of those to whom the duty is owed, define the depth of involvement of the defendant in the affairs of the corporation, understand the skills and ability the director brings to the chore at hand. Analysis involving these elements in my estimation is more meaningful than the conventional analysis of fault.
This is in some measure the process the Commission went through in determining which among the outside directors of Penn Central should be named in that action. You will recall that only three were named. It would, I think, be inappropriate for me to presume to search out the thinking of my colleagues in reaching that decision, or even to express my own. However, I think an examination of the total situation, including the history of the named directors in relation to the company, their expertise, and similar considerations, divulges many clues to our thinking.
Obviously, as greater attention than ever before is focused upon the conduct of directors, and in view of the still expanding scope of Rule 105–5, those who serve in the capacity of director and those who advise them are driven to find means of assuring avoidance of liability, not only in connection with SEC-instituted actions, but civil litigation as well.
It is perhaps idle to simply repeat the old rules with respect to “duty of loyalty” and “duty of care.” People need more specific advice than that. I have on occasions suggested various means of avoiding the perils. Without repeating unduly, I would suggest these as among the safeguards which directors should consider, though they are far from being exhaustive.
First, if I were a director, I would be most interested in whether the corporation I serve has a functioning, effective audit committee. I would be concerned with whether those serving on it understood their responsibilities and performed them diligently and regularly. Beyond that, I would want an opportunity to discuss myself with the auditors the problems they identified, the practices of management, the extent to which management appeared to be "prettying up" the financial statements. I would try to observe whether the auditors truly appeared independent, whether their personal relationships or other circumstances might impede their independence. I emphasize the role of the auditors as guardians of the directors for increasingly I feel they are critical to the integrity of the corporate process.
Secondly, I think directors should be particularly sensitive to developments and occurrences within the corporation which may give clues to problem areas or which are peculiarly suited to give trouble to directors. For instance, whenever the corporation proposes to issue securities, whether for cash or in an acquisition, directors should exercise great caution to assure that disclosures are proper and complete; certainly, if the securities are being offered through written means, they should review the disclosure documents being used. If there is any reason to fear that the full story is not being told to those who are to receive the stock, they should at least make inquiry concerning the measure of truth telling.
Further, I think directors should be peculiarly sensitive to litigation involving the corporation, especially litigation involving charges of wrongdoing against officers of the company. Often the first hints of trouble lie buried in a complaint in some courthouse file. Charges should be carefully investigated. This means inside or outside counsel should report regularly concerning new litigation and the nature of the charges, as well as developments in previously pending litigation.
Certainly an occasion demanding full analysis is a change of auditors. We all know that for practical purposes management chooses the auditors and manage. ment fires them. When they are fired or quit, the directors should investigate with great care the circumstances surrounding the change. Conversation with the re. tiring auditors would seem to be a minimum.
More generally, I think directors should have well developed antennae; they should be alert for any indications that all is not going well, that trouble is lurking down the road. When there are material developments within the company, they should inquire concerning the measures taken to assure that the information is disclosed in the marketplace. They should scrutinize the materials furnished them-and if they are not furnished sufficient information they should demand it-with a questioning eye--and if they do not understand some part of it, they should cast pride aside and find out what it means.
Having said all this, I must also add that as the reexamination of the role of directors continues there is the temptation to impose upon them excessive demands, 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
(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 responsi. bility for any private publication or speech by any of its members of 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, 108, 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 law. suits 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