SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 (202) 755-4846 ANNUAL COOPERATIVE SECURITIES REGULATION SEMINAR IHE AMBASSADOR HOTEL J Los ANGELES J CALIFORNIA OCTOBER 27J 197~ "MANAGEMENT FRAUD - WHAT ARE THE STANDARDS?" REMARKS BY: ROBERTA s. ~RMEiJ COMMISSIONER* SECURITIES ~ANGE COMMISSION *THE SECURITIES AND EXCHANGE COMMISSION J AS A MATTER OF POLICY) DISCLAIMS RESPONSIBILITY FOR SPEECHES BY ANY OF ITS COMMISSIONERS.IHE VIEWS EXPRESSED HEREIN ARE THOSE OF THE SPEAKER AND DO NOT NECESSARILY REFLECT THE VIEWS OF THE COMMISSION.
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SECURITIES ANDEXCHANGE COMMISSION
Washington, D. C. 20549(202) 755-4846
ANNUAL COOPERATIVE SECURITIES REGULATION SEMINARIHE AMBASSADOR HOTELJ Los ANGELESJ CALIFORNIA
OCTOBER 27J 197~
"MANAGEMENT FRAUD - WHAT ARE THE STANDARDS?"
REMARKS BY:ROBERTA s. ~RMEiJ COMMISSIONER*SECURITIES ~ANGE COMMISSION
*THE SECURITIES AND EXCHANGE COMMISSIONJ AS A MATTER OFPOLICY) DISCLAIMS RESPONSIBILITY FOR SPEECHES BY ANY OFITS COMMISSIONERS.IHE VIEWS EXPRESSED HEREIN ARE THOSEOF THE SPEAKER AND DO NOT NECESSARILY REFLECT THE VIEWSOF THE COMMISSION.
1.I HAVE CHOSEN TO SPEAK TO YOU THIS AFTERNOON ON A TOPIC
WHICH HAS BEEN DISCUSSED FREQUENTLY AT COMMISSION MEETINGSSINCE I BECAME A COMMISSIONER--THE MATERIALITY OF MANAGEMENTINTEGRITY TO DECISION MAKING BY INVESTORS AND STOCKHOLDERS.THIS TOPIC CAN BE DISCUSSED IN A VARIETY OF CONTEXTS. FOREXAMPLE~ MANAGEMENT INTEGRITY HAS BEEN A RELEVANT CONSIDERA-TION IN SOME RECENT ENFORCEMENT CASES AS WELL AS A TOPIC OFDISCUSSION IN THE COMMISSION'S CORPORATE GOVERNANCE HEARINGSHELD DURING THE PAST YEAR AND THE RULEMAKING PROCEEDINGSWHICH HAVE EVOLVED FROM THOSE HEARINGS.
INTEGRITY~ LIKE OTHER ETHICAL QUALITIES~ IS DIFFICULTTO DEFINE OR LEGISLATE INTO EXISTENCE. FURTHER~ THE FEDERALSECURITIES LAWS DO NOT GENERALLY REGULATE THE RELATIONSBETWEEN OFFICERS~ DIRECTORS AND STOCKHOLDERS. ACCORDINGLY~I HAVE PLACED THE TOPIC OF MANAGEMENT INTEGRITY IN ITSSECURITIES LAW OBVERSE -- NAMELY~ MANAGEMENT FRAUD.REGULATION IS OFTEN BETTER~ FROM BOTH A LEGAL AND A POLICYPERSPECTIVE~ IF STANDARDS ARE ESTABLISHED BY STATING WHATIS PROHIBITED. NEVERTHELESS~ IT IS ALWAYS DESIRABLE TOENGAGE IN SUCH STANDARD SETTING WITH REFERENCE TO BASICPRINCIPLES.
IN THE CASE OF MANAGEMENT INTEGRITY~ IT SEEMS TO METHAT THE BASIC PRINCIPLE INVOLVED IS THE PROPER RESOLUTIONOF CONFLICTS OF INTEREST BETWEEN A MANAGER OF CAPITAL ANDTHE INVESTOR WHO HAS TURNED OVER THAT CAPITAL FOR MANAGEMENT.THE ESSENTIAL LEGAL PRINCIPLES BY WHICH A MANAGER OF CAPITAL,ISJUDGED AND HELD ACCOUNTABLE PRE-DATE THE FEDERAL SECURITIESLAWS. IN THE CASE OF ~EINHARD V. SALMON, 1/ THE HIGHESTCOURT OF THE STATE OF NEW YORK WAS PRESENTED WITH THEFOLLOWING FACTS:
IN 1902~ MR. SALMON~ A REAL ESTATE OPERATOR~ AND f1R.MEINHARD~ A WOOLEN MERCHANT~ FORMED A JOINT VENTURE TO LEASE~ALTER AND OPERATE THE OLD BRISTOL HOTEL IN NEW YORK CITY.THEY AGREED THAT MR. SALMON WOULD MANAGE THE PROPERTY.TWENTY YEARS LATER~ WHEN THE LEASE WAS ABOUT TO EXPIRE~ THELANDLORD PROPOSED THAT MR. SALMON~ THE MANAGER~ RENEW THELEASE ON THE PROPERTY~ DEMOLISH THE HOTEL AND BUILD A NEW~LARGER BUILDING ON THAT LAND AND SEVERAL ADJOINING PARCELS.SHORTLY THEREAFTER~ MR. SALMON~ WHO HAD NOT TOLD MR. MEINHARDANYTHING ABOUT THE PROPOSAL~ SIGNED THE NEW LEASE ONLY ONHIS OWN BEHALF. ABOUT THREE WEEKS LATER~ MR. MEINHARDLEARNED OF THE AGREEMENT AND--AS IS THE WONT OF DISAPPOINTEDINVESTORS--TOOK THE MATTER TO COURT.
1/ 249 N.Y. 458~ 164 N.E. 545 (1923).
THE MANAGING PARTNER OWED TO H I S PARTNER,WHO WAS A PASSIVE
INVESTOR I N WORDS WHICH HAVE FREQUENTLY BEEN C I T E D I N
S E C U R I T I E S LAW CASES UNDER THE STATUTES WHICH THE SEC
ADMINISTERS:
MANY FORMS OF CONDUCT P E R M I S S I B L E I N A WORKADAY -
WORLD FOR THOSE ACTING AT ARM s LENGTH, ARE FOR-B IDDEN TO THOSE BOUND BY F I D U C I A R Y T I E S . A
,TRUSTEE I S HELD TO SOMETHING..STRICTER THAN THE MORALS OF THE MARKETPLACE, NOT HONESTY ALONE, BUT THE P U N C T I L I O OF AN HONOR THE MOST SENSIT IVE, I S THEN THE STANDARD OF BEHAVIOR* 2 / INH I S THOUGHTFUL BOOK CONSIDERING THE OVERLAP BETWEEN
LOYALTY- EVEN ON THE LEVEL OF COMMERCIAL A F F A I R S - BEARS A S P E C I A L BEAUTY OF I T S OWN TO WHICH MEN ARE IRRESISTIBLY DRAWN, FORTHE EXAMPLE OF A F A I T H F U L TRUSTEE REMINDS US THAT RAPACIOUSNESS AND I N S E N S I B I L I T Y DO NOT NECES-S A R I L Y MAKE UP THE F I N A L SUM OF HUMAN CHARACTER, 3/
THE PROBLEM OF ASSESSING LOYALTIES IS THEREFORE ONE OF THE MOST ACUTE I N MODERN ECONOMIC L I F E , AND VERY FEW POWERFUL MANAGERS SEEM TO MEET I T W I T H WISDOM, $/
4.IN THE POST-INDUSTRIAL SOCIETY IN WHICH WE LIVE
THERE IS SOME QUESTION AS TO WHETHER MANAGEMENT HIRESCAPITAL OR CAPITAL HIRES MANAGEMENT. THE CORPORATE WORLDLIKE THE REST OF SOCIETY SUFFERS FROM A DEHUMANIZATION WHICHENCOURAGES RAPACIOUSNESS AND INSENSIBILITY RATHER THANFAITHFULNESS. JUDGES AND LAWMAKERS THEREFORE FIND THESTRUGGLE TO TEST LEGAL STANDARDS BY MORAL PRINCIPLESDIFFICULT. AND) THERE IS SOME QUESTION WHETHER A REGULATORYAGENCY SHOULD ATTEMPT TO IMPOSE MORAL STANDARDS ON BUSINESSENTERPRISES.
ONE TRENCHENT CRITIC OF THE SEC HAS CRITICIZED THECOMMISSION'S EFFORTS TO PREVENT AND SUPPRESS MANAGEMENTFRAUD AS AN INVOCATION OF MORAL RATHER THAN LEGAL MATERIALITY. 5/WHILE I BELIEVE THAT MORAL STANDARDS ARE AN IMPORTANT GUIDEFOR REGULATORS) I ALSO BELIEVE THAT GOVERNMENT REGULATION OFBUSINESS CONDUCT MUST BE BASED ON OBJECTIVE LEGAL STANDARDS.ACCORDINGLY) THE COMMISSION'S POLICIES AND PROGRAMSCONCERNING MANAGEMENT INTEGRITY AND MANAGEMENT FRAUD MUST BEDEFENDED BY STANDARDS OF MATERIALITY CONTAINED IN THEFEDERAL SECURITIES LAWS--OR THEY ARE INDEFENSIBLE.
51 KRIPKE) "WHERE ARE WE ON SECURITIES DISCLOSURE AFTERTHE ADVISORY COMMITTEE REPORT?" 6 SEC. REG. L. J. 99(1978), A~so PUBLISHED AT 2 J. ACCOUNTING) AUDITING& FINANCE 4 (19/8),
5.ALTHOUGH THE MATERIALITY OF MANAGEMENT INTEGRITY UNDER
THE FEDERAL SECURITIES LAWS RECENTLY HAS BEEN THE SUBJECT OFCONTROVERSYJ THE SIGNIFICANCE OF MANAGEMENT INTEGRITY TOINVESTORS AND STOCKHOLDERS IS NOT NEW. THE COMMISSION INTHE FRANCHARD CASEJ ITS FIRST MANAGEMENT INTEGRITY CASEJ
DECIDED ALMOST FIFTEEN YEARS AGOJ DEFINED THAT CONCEPT ASMANAGEMENT'S "WILLINGNESS TO PLACE ITS DUTY TO PUBLICSHAREHOLDERS OVER PERSONAL INTEREST." Q/ THUSJ THE MORALAND LEGAL VALUE OF LOYALTY THAT WAS THE BASIS FOR THE ANALYSISOF COMMON LAW PARTNERSHIP DUTIES BY JUDGE CARDOZO IN ~EINHARDV. SALMON, ALSO HAS BEEN THE BASIS FOR MANAGEMENT INTEGRITYJ
AS A TERM OF ART UNDER THE FEDERAL SECURITIES LAWS. IN OTHERWORDSJ THE DUTY OF LOYALTY THAT CARDOZO FOUND IN THE TWO-PERSON PARTNERSHIP HAS BEEN RECOGNIZED TO APPLY TO THEMODERN CORPORATION, ALTHOUGH THE TERM "MANAGEMENT INTEGRITY"IS SOMETIMES USED MORE BROADLY OR COLLOQUIALLY) IT SEEMS TOME THAT THE FRANCHARD CASE DEFINITION IS A GOOD PREDICATEFOR ESTABLISHING A STANDARD PROHIBITING MANAGEMENT FRAUD.
ACCORDINGLY) INFORMATION RELATING TO A LACK OF INTEGRITYIN THE RESOLUTION OF CONFLICTS OF INTERESTS BY AN ISSUER'SMANAGEMENT IS AN APPROPRIATE SUBJECT FOR DISCLOSURE. IT ISTHE REASONABLE EXPECTATION OF PUBLIC INVESTORS THAT MANAGEMENTWILL BE LOYAL TO THEIR INTERESTS, OF COURSE) INVESTORSSHOULD EXPECT MANAGEMENT TO PROSPER ~ THE CORPORATION,BUT) THEY ARE ENTITLED TO EXPECT THAT MANAGEMENT WILLNOT PROSPER AI IHE EXPENSE OF THE CORPORATION, WHERE
6.MANAGEMENT HAS MATERIALLY BREACHED ITS DUTY OF LOYALTY--FORAN EXTREME EXAMPLEJ BY MISAPPROPRIATION OF CORPORATE FUNDSFOR PERSONAL USE--INVESTORS HAVE THE RIGHT TO KNOW THATTHEIR EXPECTATIONS HAVE BEEN DISAPPOINTED. THE DISAPPOINTMENTOF REASONABLE INVESTOR OR SHAREHOLDER EXPECTATIONS IS CRUCIALTO AN ANALYSIS OF MANAGEMENT INTEGRITY UNDER THE FEDERALSECURITIES LAWS BECAUSE OF THE ELEMENT OF DECEPTION REQUIREDFOR FRAUD CASES.
I RECOGNIZE THAT THE FIDUCIARY STANDARDSJ AGAINST WHICHfNVESTORS' EXPECTATIONS OF LOYALTY ARE MEASUREDJ DO NOTNECESSARILY ARISE UNDER THE FEDERAL SECURITIES LAWS. THEUNITED STATES SUPREME COURT IN SANTA FE V. GREEN} 7/ESSENTIALLY HELD THAT AT LEAST ONE CRITICAL ASPECT OF THEFIDUCIARY RELATIONSHIP BETWEEN MANAGEMENT AND SHAREHOLDERSTHE DUTY TO DEAL FAIRLY -- IS NOT FOUND IN SECTION 10(B) OFTHE SECURITIES EXCHANGE ACT OR RULE 10B-5 THEREUNDER.NEVERTHELESSJ THE LEGISLATIVE HISTORIES OF THE SECURITIESACT AND THE EXCHANGE ACT ARE REPLETE WITH REFERENCES TOTRUSTEESHIP AND FIDUCIARY OBLIGATIONS. FOR EXAMPLEJ ONEVERY SIGNIFICANT INTENT OF THESE LAWS IS "THAT ALL THOSERESPONSIBLE FOR STATEMENTS UPON THE FACE OF WHICH THEPUBLIC IS SOLICITED TO INVEST ITS MONEY SHALL BE HELD TOSTANDARDS LIKE THOSE IMPOSED BY LAW UPON A FIDUCIARY." 8/
ZI 430 U.S. 462 (1977).81 H.R. REP. 85J 73RD CONG'J 1ST SESS. 5 (1933),
-
&TA FE V, PROBABLY MANDATES THE CONCLUSION THAT
THESE STANDARDS REFER TO THE REQUIREMENTS OF F U L L
D ISCLOSUREj RATHER THAN THE OBLIGATIONS OF F A I R DEALING T H A r
ARE IMPOSED UPON THE COMMON LAW F I D U C I A R Y OR UPON MANAGEMENT
BY STATE CORPORATION LAW,
THE bDECISION DOES NOT MEAN THAT CONTROLLING
PERSONS ARE R E L I E V E D FROM D I S C L O S I N G TRANSACTIONS I N WHICH
THEY HAVE OVERREACHED THE MINORITY, FOR EXAMPLE,
THE SECOND CIRCUIT IN A CASE DECIDED AFTER GREEN, 601DBERG
v , MERIDOR 9/ HELD THAT RULE 1 0 ~ - 5COVERS A PARENT CORPORATION'S
UNDISCLOSED OR M I S L E A D I N G SALE OF I T S OVERVALUED ASSETS FOR
STOCK OF A CONTROLLED S U B S I D I A R Y WITH S E C U R I T I E S I N THE
HANDS OF THE PUBLIC. THUS, THE SECURITIES LAWS PROHIBIT
DECEPTIVE FAILURES TO DISCLOSE MATERIAL CONFLICTS OF INTEREST,
BUT, ASSUMING SUCH DISCLOSURE, QUESTIONS REGARDING THE
FAIRNESS OF TRANSACTIONS MUST B E RESOLVED BY STATE LAW,
8.
BECAUSE OF THIS INTERACTION BETWEEN THE ANTI-FRAUDPROVISIONS OF THE SECURITIES LAWS AND STATE LAW~ THECOMMISSION REALISTICALLY HAS THE POWER UNDER ITS DISCLOSUREPROVISIONS TO INDIRECTLY AFFECT CORPORATE CONDUCT. THISPOWER EXISTS BECAUSE THE COMMISSION~ BY REQUIRING DISCLOSUREOF PRACTICES THAT WOULD RESULT IN ADVERSE PUBLICITY~ CANEFFECTIVELY CAUSE THOSE PRACTICES TO BE TERMINATED. WHETHERAND TO WHAT EXTENT THE COMMISSION SHOULD USE THIS POWER ISPROBABLY MORE A QUESTION OF POLICY THAN LAW.
ALTHOUGH LEGISLATIVE HISTORY OF THE SECURITIES ACTDOES NOT REFLECT THE REGULATORY CONSEQUENCES INHERENT INREQUIRING FULL DISCLOSURE OF MANAGEMENT'S CONFLICTINGINTERESTS ViS-A-ViS THE CORPORATE ISSUER~ THESE RESULTS WEREOBVIOUSLY APPRECIATED BY THAT LAW'S SOPHISTICATED DRAFTSMEN.FELIX FRANKFURTERJ THE MOST NOTED OF THESE DRAFTSMEN~ WROTESHORTLY AFTER THE SECURITIES ACT'S ENACTMENT --
9'THE EXISTENCE OF BONUSESJ OF EXCESSIVE COMMISSIONSAND~LARIESJ OF PREFERENTIAL LISTS AND THE LIKEJMAY ALL BE OPEN SECRETS AMONG THE KNOWINGJ BUTTHE KNOWING ARE FEW. THERE IS ASHRINKING QUALITYTO SUCH TRANSACTIONS: TO FORCE KNOWLEDGE OF THEMINTO THE OPEN IS LARGELY TO RESTRAIN THEIRHAPPENING. MANY PRACTICES SAFELY PURSUED INPRIVATE LOSE THEIR JUSTIFICATION IN PUBLIC. THUSJSOCIAL STANDARDS NEWLY DEFINED GRADUA~LY ESTABLISHTHEMSELVES AS NEW BUSINESS HABITS. 10/ITIS NOT SURPRISING THAT THE FRAMERS OF THE FEDERAL
SECURITIES LAWS PLACED SUCH GREAT EMPHASIS ON THE OBLIGATIONSOF FULL DISCLOSURE. AMONG THEIR RANKS WERE ADMIRERS OFJUSTICE LOUIS BRANDEISJ WHO BELIEVED THAT INFORMED INVESTORSWOULD REVOLT AGAINST OVERREACHING PROMOTERS WITH WHAT HECALLED A "STRIKE OF CAPITAL" --THE PUBLIC'S REFUSAL TOPURCHASE THEIR SECURITIES. JUSTICE BRANDEISJ IN HIS CLASSICWORKJ OTHER PEOPLE'S ~ONEY, ARGUED THAT DISCLOSURE REQUIREMENTSCOULD HAVE REGULATORY CONSEQUENCES WHEN HE WROTE --
PUBLICITY IS JUSTLY COMMENDED AS A REMEDY FORSOCIAL AND INDUSTRIAL DISEASES. SUNLIGHT ISSAID TO BE THE BEST OF DISINFECTANTS1' ELECTRICLIGHT THE MOST EFFICIENT POLICEMAN. -1/
WHILE I BELIEVE TH~T BRANDEIS' ANALYSIS WAS CORRECTJ INIOUR MODERNJ COMPLEX POLITICAL ECONOMYJ THE PENALTIES IMPOSED
UPON THE ISSUER BECAUSE OF DiSCLOSED ,ERRANT BEHAVIORMAY EXTEND BEYOND A BRANDEISIAN "STRIKE OF CAPITAL" TOFAR-REACHING POLITICAL AND CONSUMER RESPONSES.
10.A CONCERN OVER THESE CONTINUING SIGNIFICANT REGULATORY
CONSEQUENCES OF DISCLOSURE POLICY WAS ADDRESSED BY THECOMMISSION'S DISTINGUISHED ADVISORY COMMITTEE ON CORPORATEDISCLOSURE. IT REPORTED THAT --
THE PREVENTION OF FRAUD AND THE ALTERING OFCORPORATE CONDUCT ARE NECESSARY CONSEQUENCES OF'DISCLOSURE' AS A REGULATORY TECHNIQUE. THISEFFECT OF THE DISCLOSURE CONCEPT IS ONE REASONIT WAS CHOSEN AS THE MEANS TO PROTECT INVESTORS.CERTAINLY DISCLOSURE STILL HAS THIS EFFECT ANDPURPOSE~ AND THE COMMITTEE BELIEVES IT DESIRABLE.NONETHELESS~ THE COMMITTEE DOES NOT BELIEVE THATDISCLOSURE REQUIREMENTS SHOULD BE IMPOSED~ REGARD-LESS OF THE MATERIALITY OF THE INFORMATION TO BEELICITED~ BECAUSE OF THE EFFECT THEY WILL HAVE ONCORPORATE CONDUCT. IF THE COMMISSION SEES THE NEEDTO DIRECTLY REGULATE CORPORATE CONDUCT~ IT SHOULDREQUEST CONGRESS TO AUTHORIZE IT TO DO SO AND SHOULDNOT DO SO THROUGH REQUIRING DISCLOSURE OF IMMATERIALINFORMATION. 12/THE COMMITTEE RECOMMENDED THAT THE COMMISSION CONSIDER
A STATEMENT OF OBJECTIVES WHICH~ IN PART~ WOULD PROVIDE THATTHE COMMISSION SHOULD NOT ADOPT DISCLOSURE REQUIREMENTS WHICHHAVE AS THEIR PRINCIPAL OBJECTIVE THE REGULATION OF CORPORATECONDUCT. THE COMMISSION CAREFULLY CONSIDERED THE RECOMMENDA-TION~ BUT ANNOUNCED THAT IT DOES NOT BELIEVE THAT THE BENEFITSTO BE DERIVED FROM SUCH A STATEMENT WOULD~ ON BALANCE~ OUTWEIGHTHE DIFFICULTIES WHICH IT MIGHT CREATE. THE COMMISSION WASCONCERNED THAT IT COULD BECOME INVOLVED IN UNFRUITFULARGUMENTS~ AND EVEN LITIGATION) AS TO WHETHER ITS RESPONSETO A PARTICULAR SITUATION WAS CONSISTENT WITH THE STATEMENTOF OBJECTIVES. IT NOTED THAT
12/ REPORT OF THE ADVISORY_COMMITTEE ON CORPORAIE DISC~QSURETO THE SECURITIES AND eXCHANGE COMMISSION~5 H-IY (IY//).
11.THE BASIC OBJECTIVE OF THE DISCLOSURE REQUIREMENTSIS TO INCREASE INVESTOR CONFIDENCE AND TO MAKE THESECURITIES MARKETS MORE EFFICIENT AND AS FAIR ANDHONEST AS POSSIBLE. ANY ENDEAVOR TO DEFINE THESEOBJECTIVES MORE PRECISELY WOULD NOT BE BENEFICIALSINCE THE DISCLOSURE REQUIREMENTS NECESSARILY MUSTBE DYNAMIC TO MEET THE EVER CHANGING ENVIRONMENT INWHICH THE SECURITIES MARKETS OPERATE. 12/OF COURSE~ ANY DISCUSSION OF WHETHER THE COMMISSION
SHOULD LIMIT ITS REQUIREMENTS TO THE DISCLOSURE OF MATERIALINFORMATION CANNOT BE DIVORCED FROM AN ANALYSIS OF THECONCEPT OF MATERIALITY~ ITSELF. Two DECISIONS INVOLVINGCOMMISSION ENFORCEMENT ACTIONS CHARGING THE FAILURE TODISCLOSE MATERIAL INFORMATION REGARDING MANAGEMENT'SINTEGRITY ARE INSTRUCTIVE.
THE KALVEX DECISION STEMMED FROM CROSS-MOTIONS FORSUMMARY JUDGMENT AND RESULTED IN AN INJUNCTION AGAINST ADEFENDANT~ ROBERT INGIS~ WHO HAD COMTEMPORANEOUSLY SERVED ASKALVEX'S DIRECTOR~ EXECUTIVE VICE-PRESIDENT AND CHIEFOPERATIONAL OFFICER. THE COURT FOUND THAT A PROXY STATEMENTDID NOT DISCLOSE CERTAIN FACTS WHICH~ IN THE COURT'S WORDS~"MIGHT HAVE LED A REASONABLE STOCKHOLDER TO QUESTION THEINTEGRITY OF INGIS AND HIS ABILITY TO DISCHARGE HIS FIDUCIARYOBLIGATIONS." 14/ THESE UNDISCLOSED FACTS WERE THAT INGISENGAGED IN A SCHEME TO SECRETLY FUNNEL KICKBACK MONEY TOHIM FROM A KALVEX SUPPLIER THROUGH A DUMMY CORPORATION; ANDTHAT HE SIPHONED OFF CORPORATE FUNDS TO HIS PERSONAL USE BYSUBMITTING EXPENSE VOUCHERS UNRELATED TO ANY CORPORATE PURPOSE.
12.THE COURT FOUND THIS OMITTED INFORMATION MATERIAL} NOTINGTHAT "lOlNE DOES NOT ELECT AS A DIRECTOR AN INDIVIDUAL WHOIS USING THE CORPORATION HE REPRESENTS FOR PERSONAL GAIN." 151
IN THE SCHLITZ CASE} 1~1DEFENDANT'S MOTION TO DISMISSTHE COMMISSION'S ACTION} WHICH ALLEGED NON-DISCLOSURE OFPOTENTIALLY CRIMINAL MARKETING PRACTICES} WAS DENIED. INPART} THE COMMISSION'S CASE WAS BASED ON A MANAGEMENTINTEGRITY THEORY} ALTHOUGH THE COMPLAINT MADE NO REFERENCETO INDIVIDUAL DIRECTORS. THE COURT AGREED WITH THE COMMISSIONTHAT "THE QUESTION OF THE INTEGRITY OF MANAGEMENT GIVESMATERIALITY TO THE MATTERS THE COMMISSION CLAIMS SHOULD HAVEBEEN DISCLOSED." 171
IN NEITHER OF THESE DECISIONS WAS ANY TEST MADE OF THEECONOMIC CONSEQUENCES OF THE ILLEGAL TRANSACTIONS RELATED TOTHE MANAGEMENT INTEGRITY ISSUE} EVEN THOUGH IN SCHLITZ THESECONSEQUENCES WERE DISCUSSED IN CONNECTION WITH OTHER DISCLOSURETHEORIES.
As YOU PROBABLY KNOW} IN THE TEXAS GULF SULPHUR CASE} 181WHICH INVOLVED THE SECURITIES MARKETPLACE} THE SECOND CIRCUITHELD THAT A MATERIAL FACT IS ONE WHICH IS LIKELY TO AFFECT
tlg69~,CERT. DENIED SUB NOM. COATES v. SEC, 394 U.S. 976
13.THE MARKET PRICE OF ANY OF THE COMPANY'S SECURITIES OR ISLIKELY TO BE CONSIDERED IMPORTANT BY REASONABLE INVESTORS~INCLUDING. SPECULATIVE INVESTORS~ IN-DETERMINING WHETHER TOTRADE IN SUCH SECURITIES. ON THE OTHER HANDJ IN I£C]NDUSTRIES, 191 WHICH INVOLVED THE SOLICITATION OF PROXIESJ
THE SUPREME COURT HELD A FACT TO BE MATERIAL IF THERE IS ASUBSTANTIAL LIKELIHOOD THAT A REASONABLE SHAREHOLDER WOULDCONSIDER IT IMPORTANT IN DECIDING HOW TO VOTE. THE RELATIONOF THESE TWO CASES IS UNCLEAR. THE COMMISSION'S ADVISORYCOMMITTEE ON CORPROATE DISCLOSURE COULD NOT AGREE WHETHERTHE MATERIALITY STANDARD IS NOW THE SAME UNDER THE ANTIFRAUDAND THE PROXY PROVISIONS. INTERESTINGLYJ THE COURT IN THESCHLITZ CASE CITED ~ ISC AND TEXAS GULF SULPHUR INDETERMINING THAT A REASONABLE PERSON WOULD ATTACH IMPORTANCETO THE QUESTIONABLE TRANSACTIONS IN MAKING INVESTMENTDECISIONS REGARDING SCHLITZ SECURITIES.
Now I WISH TO EXTEND THIS SOMEWHAT ABSTRACT DISCUSSIONON MANAGEMENT INTEGRITY AND ITS MATERIALITY TO INVESTORSAND SHAREHOLDERS TO THE COMMISSION'S CURRENT WORK. INPARTICULARJ I WILL REFER TO THREE OF THE MOST SIGNIFICANT--AND CONTROVERSIAL--OF THE COMMISSION'S ONGOING PROGRAMS:CORPORATE GOVERNANCEJ MANAGEMENT REMUNERATIONJ AND QUESTION-ABLE PAYMENTS. I BELIEVE IT IS IMPORTANT FOR THE COMMISSIONAND PERSONS REGULATED BY THE COMMISSION TO AGREE ON HOW AND
191 ~NDUSTRIES V. NORTHWAY, INC., 426 U.S. 438 (1976).
14.UNDER WHAT CIRCUMSTANCES MANAGEMENT INTEGRITY IS MATERIALUNDER THE SECURITIES LAWS BECAUSE INTEGRITY CAN BE ANAMORPHOUS AND MORALISTIC CONCEPT. FEDERAL REGULATION~HOWEVER~ UNDER OUR CONSTITUTIONAL SYSTEM~ MUST MEETOBJECTIVE LEGAL STANDARDS TO BE VALID AND ENFORCEABLE.
THE COMMISSION HAS UNDERTAKEN A COMPREHENSIVE EXAMINATIONOF THE ISSUES PERTAINING TO HOW CORPORATE AMERICA IS GOVERNED.IN SEVERAL AREAS~ THE COMMISSION PROPOSED DISCLOSURES REGARDING~AMONG OTHER THINGS~ MANAGEMENT INTEGRITY -- THAT IS~ AS IDISCUSSED EARLIER~ MANAGEMENT'S WILLINGNESS TO PLACE ITSDUTY TO PUBLIC SHAREHOLDERS OVER PERSONAL INTEREST. THESEAREAS INCLUDE THE CORPORATE BOARD'S COMPOSITION AND INDE-PENDENCE FROM MANAGEMENT~ THE EXISTENCE OF CERTAIN KEYCOMMITTEES} BOARD AND COMMITTEE ATTENDANCE~ AND INFORMATIONTHAT WOULD BE REQUIRED WHEN A DIRECTOR RESIGNS OR DECLINESTO STAND FOR RE-ELECTION BECAUSE OF A DISAGREEMENT CONCERNINGTHE ISSUER'S OPERATIONS~ POLICIES OR PRACTICES. WHILE THESEDISCLOSURES WOULD NOT DIRECTLY SHOW WHETHER MANAGEMENT ISSATISFYING ITS OBLIGATIONS OF LOYALTY~ THEY COULD PROVIDESTRUCTURAL INFORMATION UPON WHICH INVESTORS AND SHAREHOLDERSCOULD DETERMINE THE INSTITUTIONAL CHECKS AND BALANCESAVAILABLE TO MONITOR MANAGEMENT'S FIDELITY TO SHAREHOLDERS.
SINCE THESE RULE PROPOSALS ARE PART OF AN ONGOINGRULEMAKING PROCEEDING~ IT WOULD BE INAPPROPRIATE FOR ME TODISCUSS IN ANY DETAIL THEIR MERITS TODAY.
15.HOWEVER~ I WOULD LIKE TO DRAW A DISTINCTION BETWEEN THECOMMISSION'S AUTHORITY TO REQUIRE DISCLOSURES WHICH RELATE TOMANAGEMENT INTEGRITY AND THE EFFICIENT FUNCTIONING OF ACORPORATION IN THE BEST INTERESTS OF SHARHOLDERS AND ANYEFFORT BY THE COMMISSION TO CHANGE OR MANDATE CORPORATEBOARD OR COMMITTEE STRUCTURE. IN MY OPINION~ COMPELLING APARTICULAR COMPOSITION FOR DIRECTORS' COMMITTEES GOESBEYOND DISCLOSURE REQUIREMENTS OR EVEN THE REGULATORYCONSEQUENCES OF DISCLOSURE. RATHER~ I BELIEVE THAT POSITIONWOULD REPRESENT A DIRECT REGULATION OF THE CORPORATE SECTORWHICH WOULD REQUIRE A SPECIFIC LEGISLATIVE AUTHORIZATION.
ON THE OTHER HAND~ THE COMMISSION'S PRONOUNCEMENTSON MANAGEMENT REMUNERATION~ INCLUDING UNDISCLOSED MANAGEMENTPERQUISITES~ REPRESENT AN AREA SQUARELY WITHIN THE COMMISSION'SJURISDICTION. I BELIEVE THAT SHAREHOLDERS REASONABLY HAVEAN EXPECTATION THAT MANAGEMENT WILL DEAL OPENLY WITH THECORPORATION. INHERENT IN THIS CONCEPT IS THE IDEA THATMANAGEMENT WILL NOT ACT TO THE DISADVANTAGE OF PUBLICINVESTORS BY DECEITFULLY EXTRACTING PERSONAL GAINS FROMCORPORATE ASSETS. By DECEITFULLY~ I MEAN WITHOUT PROPERDISCLOSURE TO THE PERSONS TO WHOM MANAGEMENT HAS A DUTYOF LOYALTY.
i1
I;,,,
In.
THE RELATION OF QUESTIONABLE CORPORATE PAYMENTS TOMANAGEMENT'S INTEGRITY IS A SOMEWHAT DIFFERENT" MATTER. THETHRESHOLD QUESTION~ IN DECIDING WHETHER MANAGEMENT'S INTEGRITYHAS BEEN COMPROMISED~ IS DETERMINING WHETHER MANAGEMENTTHEREBY PLACED ITS OWN INTEREST ABOVE ITS DUTY TO PUBLICSHAREHOLDERS IN MAKING THE PAYMENTS. To CITE PROFESSORWALTER WERNER'S EXAMPLE~ 20/ WHEN GULF OIL CORPORAT.ION MADEPAYMENT TO REPRESENTATIVES OF FOREIGN GOVERNMENTS~ ITS CHIEFEXECUTIVE OFFICER~ WHO MADE THOSE PAYMENTS~ RECEIVED NOPERSONAL BENEFIT THEREFROM, RATHER~ HE ACTED IN WHAT HETHOUGHT TO BE THE BEST INTERESTS OF THE COMPANY AND ITSSTOCKHOLDERS. AND HE PERSONALLY ASSUMED THE RISKS FOR THOSEPAYMENTS. WAS HE ACTING DISLOYALLY TO HIS SHAREHOLDERS?
IN 1974 THE COMMISSION'S DIVISION OF CORPORATION FINANCESTATED ITS VIEW 21/ THAT THE CONVICTION OF A CORPORATIONAND/OR ITS OFFICERS OR DIRECTORS FOR HAVING MADE CERTAINILLEGAL CAMPAIGN CONTRIBUTIONS IS A MATERIAL FACT THATSHOULD BE DISCLOSED TO THE PUBLIC AND SPECIFICALLY TOSHAREHOLDERS~ PARTICULARLY IN THE CONTEXT OF A PROXYSTATEMENT WHERE SHAREHOLDERS ARE BEING ASKED TO VOTE FORMANAGEMENT. THE DIVISION BELIEVED THAT --
ZQ/ W~RNER~ MANAGEMENT~ STOCK MARKET AND CORPORATE REFQBM:BERLE AND MEANS RECONSIDERED~ 77 COL. L.R. 388 (19//).
2lJ SECURITIES ACT RELEASE No, 5466 (1974).
17.SUCH A CONVICTION IS MATERIAL TO AN EVALUATIONOF THE INTEGRITY OF THE MANAGEMENT OF THECORPORATION AS IT RELATES TO THE OPERATION OFTHE CORPORATION AND THE USE OF CORPORATE FUNDS.IT IS HARD TO ARGUE AGAINST A DUTY TO DISCLOSE A
CRIMINAL CONVICTION FOR A CRIME COMMITTED BY AN OFFICER ORDIRECTOR IN THE COURSE OF A COMPANY'S BUSINESS. NEVERTHELESSJ
I AM TROUBLED BY THE SOMETIMES ARTICULATED THEORY THAT ANYILLEGAL ACT BY MANAGEMENT IS NECESSARILY MATERIAL TO ANEVALUATION OF THAT MANAGEMENT'S INTEGRITYJ AND THEREFORE THEFAILURE TO DISCLOSE SUCH INFORMATION VIOLATES THE ANTI-FRAUDPROVISIONS. IN PARTICULARJ I AM TROUBLED BY THE NOTION THATTHE SEC SHOULD BE GENERALLY INVESTIGATING SUSPECTED VIOLATIONSOF FEDERAL OR STATE LAWS OTHER THAN THE SECURITIES LAWS INORDER TO COMPEL DISCLOSURE BY MANAGEMENT OF SUCH OTHERVIOLATIONS. Now THATJ OF COURSEJ DOES NOT CONSTITUTE ANACCEPTANCE OF CORPORATE CRIME AS A WAY OF BUSINESS. BUTCORPORATIONS ARE SUBJECT TO A MYRIAD OF FEDERAL ANDSTATE LAWSJ MANY OF WHICH ARE KNOWN TO BE HONORED IN THEIRBREACH. IF THE SEC COULD INVESTIGATE AND COMPEL DISCLOSUREOF ANY BUSINESS CRIME UNDER A MANAGEMENT INTEGRITY THEORYJ
THE COMMISSION COULD WELL HAVE LICENSE TO PROSECUTE ANY PUBLICCORPORATION IN AMERICA. I BELIEVE THAT KIND OF LAXITY IN THELEGAL STANDARDS BY WHICH CORPORATE CONDUCT IS MEASUREDWOULD BE VERY BAD GOVERNMENT.
I SHOULD STRESSJ HOWEVERJ THAT MY RESERVATIONS ABOUTTHE MATERIALITY UNDER THE ANTI-FRAUD PROVISIONS OF CONDUCTINDICATING A LACK OF MANAGEMENT INTEGRITYJ DOES NOT MEAN THATI QUESTION WHETHER CERTAIN FORMS OF ILLEGAL BEHAVIOR SHOULDBE DISCLOSED UNDER OTHER THEORIES.
18.FOR EXAMPLE) A CORPORATION WHOSE VITALITY IS BASED ONSURREPTITOUS PAYMENTS TO PARTICULAR INDIVIDUALS MAY BEEXPERIENCING COMMENSURATE BUSINESS RISKS THAT MUST BEDISCLOSED. OR) A CORPORATION MAINTAINING SUBSTANTIALUNDISCLOSED OFF-BOOK ACCOUNTS OR SUBSIDIARIES TO FUND THESEPAYMENTS MAY NOT BE PRESENTING ITS INVESTORS WITH ACCURATEFINANCIALS. FURTHER) THE ENACTMENT OF THE FOREIGN CORRUPTPRACTICES ACT HAS MADE MORE COMPLEX THE QUESTION OF WHETHERQUESTIONABLE PAYMENTS REFLECT ON MANAGEMENT'S INTEGRITY SOTHAT FAILURE TO DISCLOSE SUCH PAYMENTS IS A MATERIALOMISSION UNDER THE ANTI-FRAUD PROVISIONS OF THE SECURITIESACT.
MOREOVER) QUESTIONS ABOUT THE MATERIALITY UNDER THESECURITIES LAWS OF ILLEGAL MANAGEMENT CONDUCT ARENOT EASILY ANSWERED. WHILE I BELIEVE THAT THE FEDERALSECURITIES LAWS ARE INTENDED TO PROTECT INVESTORSAGAINST NONDISCLOSED OVERREACHING BY CORPORATE MANAGEMENT)I AM NOT CERTAIN THAT THOSE LAWS -- OR THE COMMISSION THATADMINISTERS THEM -- SHOULD BE USED TO PROTECT SOCIETY AGAINSTGENERAL MISCONDUCT BY CORPORATE MANAGEMENT. CONSEQUENTLY)I WOULD DISCARD THE SIMPLEST POSSIBLE MANAGEMENT FRAUDSTANDARD: THE THEORY THAT ANY KNOWING ILLEGAL ACTION BYMANAGEMENT CONSTITUTES MANAGEMENT FRAUD. IN CONTRAST) IBELIEVE THAT DEFINING MANAGEMENT INTEGRITY IN TERMS OF ITS)LOYALTY TO PUBLIC INVESTORS IS JUDICIALLY ADMINISTERABLE)
19.EFFECTIVELY PROTECTS THE INTERESTS OF THOSE INVESTORS}AND IS SQUARELY WITHIN THE COMMISSION'S STATUTORY MANDATE.ALTHOUGH THIS STANDARD MAY NOT BE SUFFICIENT AS ANEXCLUSIVE STANDARD FOR MANAGEMENT FRAUD} I BELIEVE THATTHIS STANDARD WOULD ENCOURAGE THE PUBLIC CONFIDENCE NEEDEDTO MAINTAIN THE VITALITY OF THE CAPITAL MARKETS.
WHEN THE PUBLIC INVESTOR THINKS IN TERMS OF MANAGEMENTINTEGRITY HE THINKS IN TERMS OF MANAGEMENT LOYALTY. HEWANTS AND EXPECTS HIS HARD-EARNED CAPITAL TO INCREASE} NOTTO BE SIPHONED OFF BY DISLOYAL MANAGERS INTO A SWISS BANKACCOUNT. HE DOES NOT WANT TO FEEL "TAKEN}" WHICH IS PERHAPSA COLLOQUIAL WAY OF EXPRESSING THE PROHIBITIONS OF THE ANTI-FRAUD PROVISIONS OF THE SECURITIES LAWS. THIS PRIMARYCONCERN OF INVESTORS AND SHAREHOLDERS SHOULD ALSO BE THECOMMISSION'S PRIMARY CONCERN.
MANAGEMENT INTEGRITY IS ALSO A NATIONAL CONCERN.ABSENT CONFIDENCE THAT BUSINESS MANAGEMENT WILL BE LOYAL TOTHE INTERESTS OF INVESTORS} THE CAPITAL INVESTMENT THAT ISNEEDED TO KEEP AMERICA COMPETITIVE IN THE WORLD MARKETPLACEWILL NOT BE FORTHCOMING. THIS BOTTOM LINE REACTION --THE"STRIKE OF CAPITAL" WHICH MEANS LOSS OF PUBLIC CONFIDENCEIS THE INVESTING PUBLIC'S COMMON SENSE RECOGNITION OFFRANKFURTER'S PRINCIPLE THAT --
IN THE LAST ANALY~l& BUSINESS} LIKE GOVERNMENT}DEPENDS ON MEN. ~
