Executives: Crying on the Inside

A banker sits on a company’s board and also has a place on the investment committee of his bank’s trust department. Almost simultaneously he learns that the company’s profits will be disappointing and that someone in his trust department wants to buy the company’s stock. Should he warn the bank not to buy?

A lawyer on the board of another company finds out that the firm will soon market a profitable new product. But one of his law partners is an adviser to several estates and intends to unload the company’s shares. Should the lawyer dissuade his partner?

A corporate executive lunches with his firm’s president and discovers that hard times are ahead. Would he be wrong to dump his own holdings in the corporation’s stock?

These are typical of the problems of capital and conscience that plague some of the nation’s businessmen. The issue of conflict of interest is as old as business, yet it has never been quite so urgent or confusing. It was brought to a boil by the still continuing Texas Gulf Sulphur case, involving stock purchases by company officers who had confidential information of a Canadian mineral strike, and by last month’s charge by the Securities and Exchange Commission that 14 executives and salesmen of Merrill Lynch had illegally fed “inside” information to mutual funds and other institutional investors. The two cases have inspired a run of stockholder suits and general jitters among corporate insiders. One measure of the concern is the rising cost of directors’ liability insurance. Since July, rates have increased by as much as 400%.

Mistake or Stupidity. The controversy centers on corporate insiders’ rights, responsibilities and restrictions-and, indeed, on just who qualifies as an insider. For years, the definition came from Section 16 of the Securities Exchange Act of 1934, which rather narrowly considers as an insider any corporate director or officer, or any stockholder with more than a 10% stock interest. Primarily, Section 16 prohibits short-swing trading—buying and selling stocks within a six-month period.

Under Manuel Cohen, the SEC’s activist chairman since 1964, the insider has become a much more visible target. The key to the SEC’s current approach is Rule 10b-5 of the 1934 act. A broadly worded regulation against fraud in trading, 10b-5 has been interpreted in the courts to mean that all investors must be guaranteed “equal access” to “material information” that might influence stock prices. In effect, it broadens the definition of insider to include anyone privy to information and requires him not to act on it before it becomes public knowledge.

There seems almost no limit to the situations that could fall under 10b-5. Speaking to security analysts in Atlanta last week, Philip A. Loomis Jr., the commission’s general counsel, warned that if a company officer “by mistake or stupidity” leaves an analyst with a choice bit of inside information, the analyst ought to make it public as soon as possible. Companies, too, might face SEC investigation and possible lawsuits if their officers remain silent about important corporate developments.

Hunting License. Suit-happy stockholders have thus been handed a hunting license. Last month, for example, a Manhattan accountant brought a conflict-of-interest suit naming, among others, Philadelphia Broker Howard Butcher III, senior partner of Butcher & Sherrod. The suit charges that, using “secret information” that he gleaned as a director of the Penn Central Co., Butcher had his brokerage firm sell off Penn Central stock last summer, just before the company announced an earnings decline. “Theoretically,” says Butcher, who denies the charges, “anyone who has any business at all is going to have conflicts of interest. The question is: How do you avoid liability?” Butcher’s answer: he quit all of his directorships in close to 70 outside firms. His five partners, who held twelve directorships among them, did the same. “The potential liability of being a director,” says Butcher, “has become too great for the active, experienced businessman to suffer.”

Since one result of the confusion over conflict of interest is the understandable reluctance of first-rate businessmen to accept seats on other companies’ boards, the interests of stockholders may ultimately suffer.

As for brokers and bankers who hold directorships, lawyers generally agree that their first legal responsibility in the handling of inside information is to the company and its stockholders—not to the clients of their banks or brokerage houses. Obviously struggling with the problem, the New York Stock Exchange, in a statement in July, found that, “carried to the extreme,” the rules seem to say that a company officer or director “should never buy or sell stock in the company he represents.” That notion is not likely to make much headway on the Street, where brokers routinely trade in stocks of companies that they serve as directors.

Clamming Up. Until the rules are refined in the courts—and that may take years—businessmen must struggle through what one lawyer calls an “agonizing reappraisal of common practice.” As a defense against possible future stockholders’ suits, a few companies have all but clammed up on information; other companies are practicing full disclosure, and then some. Texaco Chairman J. Howard Rambin Jr. last week persuaded the Boston Security Analysts Society to drop a ten-year ban on press coverage of meetings by threatening not to show up for an address if newsmen were not present. An executive of the American Cement Corp. recently refused to answer questions put by an analyst from a large Manhattan brokerage house. Result: the brokerage firm removed the company’s stock from its “buy” list.

A new Administration might try to take the heat off. Richard Nixon, in his now famous letter to Wall Streeters, promised to do something about “heavyhanded bureaucratic regulatory schemes.” But the autonomous SEC cannot be quickly recast. It is now composed of two Republicans and three Democrats, including Chairman Cohen. As President, Nixon could choose a new SEC chairman from present members, and Cohen would revert to being one of the five commissioners. In that case, he would be torn between quitting or staying on in order to prevent Dick Nixon from picking a Republican to fill his place as commissioner.