Economics and The Public Welfare

Chapter 69

A Verdict on the S.E.C.

S.E.C. versus Congress on Marketability. The concept of the stock market as a broad and active market in which men who need to sell can find buyers and men who wish to buy can find sellers, in which the spread between the bid price and asked price is narrow, a market in which securities can be marketable, encountered definite hostility upon the part of the Securities and Exchange Commission. The Commission questions the value and importance of liquidity in the securities market in pages 98 to 102 of its Report on Segregation, of June 20, 1936. In this the Commission runs definitely counter to the intention of Congress, which in the Banking Act of 1935 (legislation more recent than the Securities and Exchange legislation of 1934) reasserts its long-standing emphasis on marketability as an essential attribute of investment securities. Section 308 of the Banking Act of 1935 says, “As used in this section, the term ‘investment securities’ shall mean marketable obligations.” This is in harmony with long-established banking law, and long-established practice of the Comptroller of the Currency in dealing with National Banks. The bank examiners, in examining a bank’s bond portfolio, have been constantly concerned with marketability as measured by frequency of quotations and by number of transactions, and they have always been concerned with marketability in examining the Stock Exchange collateral behind bank loans. The Securities and Exchange Commission allowed its own theories, rather than the law of Congress, to guide its policy in dealing with the stock market.

S.E.C. Does Much More Harm Than Good. The Securities and Exchange Commission has done very much more harm than good. The Securities Act of 1933 was itself incredibly drastic and imposed such limitations on the issue of new securities as virtually to stop them. It is to the credit of the Securities and Exchange Commission, as constituted at that date, that it aided investment bankers in getting from the Congress certain modifications of the extreme restrictions of the original Act. But the legislation, as administered by the Securities and Exchange Commission, has radically limited the issue of new securities as well as contributed to the stock market situation just reviewed.

“Truth in Securities” Legislation Needed. The Securities Act of 1933, designed by the Congress to compel “truth in securities” and full disclosure of all material facts in connection with new security issues, had a very laudable purpose. We had had an orgy of new security issues between 1925 and the latter part of 1929, many of which ought not to have been issued, and many of which could not have been sold if full disclosure had been made regarding them.

Prior to the middle of 1924 our investment bankers on the whole had shown a great deal of concern for their reputations and a real sense of responsibility toward investors. There were occasional lapses, notably in the period 1897 to 1903, which was like the 1924-1929 period in that there was a great excess of money and credit available, and a very eager public with too much cash in its hands and anxious to speculate in stocks. But with the appalling excess of money and credit created by the cheap money policies of the Federal Reserve banks, particularly after the renewal of cheap money in the autumn of 1927, credit standards broke badly, financial judgment went haywire, and great abuses came.

The impressive fact is that so many men kept sane and remained responsible, rather than the fact that a good many failed to keep sane and failed to meet responsibilities. There is no worse intoxicant than prolonged cheap money and excess credit. But control of this lay with a Governmental institution, the Federal Reserve System, rather than with private finance.

But Actual Legislation and Administration Paralysing. None the less, the legislation compelling “truth in securities” was called for, and there was sympathy (which the present writer shared) among men informed regarding financial matters, with the purposes of the Securities Act of 1933. On the other hand, as such men read the bill, there was general recognition that it was so drastic that it would stop normal functioning as well as prevent abuses. The business of issuing new securities became very pure but very sterile.

Taking the year 1923 as a standard—one should not make the comparison with the wild years 1925-1929—we find no year in the period, 1933-1945, in which new corporate security issues amounted to as much as 50% of the issues of 1923. In 1934 new security issues were less than 7% of the 1923 levels, while in 1935 they were 15%. In the more prosperous years of 1936 and 1937 new corporate issues were higher, and even then they were only 46% of those in 1923, while in 1938 and 1939 they fell to 33% and 14%, respectively, of the 1923 levels.

Hampering and Expensive Legal Details—Not Needed for “Truth in Securities.” The British Law requiring “truth in securities” is ordinarily satisfied by a prospectus of four pages or less. The prospectuses issued under the British law are brief, clear, readable documents. A whole year’s series, as reproduced in an annual publication in the London Times, shows none more than six pages in length, and most four pages or under. But these are adequate. The failure to include a material fact in one of them sent Lord Kylsant to prison.

In contrast, the prospectuses issued under our Securities and Exchange Commission, are impossibly long things. Fifty, sixty, and seventy pages are very common. The shortest found was twenty-three pages, in a large collection in a substantial financial house.

It is widely believed that nobody reads the prospectuses except the people who prepare them, but one house at least has a man whose main job it is to read the prospectuses, and to initial them as legal proof that he has read them. The purpose of this, however, is apparently to make a legal record. The other members of the firm do not use the prospectuses when they are discussing securities with customers, but instead use the workable documents prepared by security analysts. No one seems to know an investor who has read a prospectus through before buying a security. Perhaps the case exists, but it is very rare.

The legal requirement that a prospectus must accompany every sale of a given security during the first year of the life of the security is an absurd and utterly useless requirement. Its effect is to make work and expense, and that is all. A financial house selling securities makes a careful record that it has sent the prospectus with the securities, and it makes a request of the customer that he acknowledge receipt of the prospectus. In the course of the next few weeks a check is made to see if he has replied, acknowledging receipt of the prospectus. If not, he is again requested to do so. If no receipt then comes, the house, wishing to be absolutely safe on the legal side, will send him a registered letter, marked “Addressee only,” in which it is stated that a copy of the prospectus has been sent to the customer, and that if no reply has been received from him within ten days, it is assumed that he has received the prospectus. This involves a great deal of work and cost which has absolutely no economic justification, but which the house regards as necessary for its legal protection.

Long and uninteresting as are the prospectuses, the registration documents are, of course, very much longer and more voluminous. The really worthwhile information contained in registration documents and prospectuses could be condensed into a very much smaller space and a very much smaller number of documents. The cost of registration could be greatly reduced without sacrificing anything of the reasonable objective that full disclosure of all relevant facts be made.

“Arms’ Length Bargaining.” There is full justification for the protests of the investment bankers against the efforts of the Securities and Exchange Commission to require competitive bidding through sealed bids or in other ways, on new public utilities security issues. It is apparently only in this field that the Securities and Exchange Commission has a semblance of legal authority to suggest such a requirement, as it bases its claim to this authority on an “arms’ length bargaining” provision of the Public Utilities Holding Company Act of 1935, rather than on the Securities Act of 1933 or the Securities Exchange Act of 1934.

There should be arms’ length bargaining between borrower and lender and between issuer and underwriter, but there is no reason at all why this should preclude enduring relations between banker and customer, whether in the commercial banking field or in the investment banking field. You have arms’ length bargaining so long as the parties to the bargain are each considering primarily the interests that they represent, whether they are doing business with one another for the first time or whether they have been enjoying mutually satisfactory business relations for forty years. Business houses do not change their commercial bank relationships lightly, though constantly solicited to do so in the highly competitive commercial banking field. Each prefers to deal with the institution that knows its business, knows its needs, and feels responsibility for it in times of pressure and crisis. Similarly, in the underwriting field the investment banker who knows his customer’s business and who feels responsibility for him when maturities come in bad money markets, gives him a far more useful service than he could get if he were shopping around all the time.

There should be a competitive investment market in which corporations are free to shift their investment bankers if dissatisfied with their services or with their charges. The strong corporate issuer with its financial affairs in good order and with prestige such that the public is readily interested in its securities, ought to find a market situation highly competitive, in the sense that there are a number of strong banking groups ready to do the business, if it wishes to turn from the institution with which it has been accustomed to doing business.

On the other hand, the weak borrower or the weak issuer, or the issuer or borrower who has been engaging in venturesome financial practices, does well not to find a highly competitive situation. Both investment banks and commercial banks do well, in the interests of the credit situation, to hold to financial standards; and when a weak borrower seeks to escape the financial discipline of its existing financial connections, it is well if it finds that other banks, informed of the credit issues involved, suggest that it stay with its existing banking connections and conform to the requirements of sound practice laid down. Competition there ought to be among both commercial banks and investment banks, but the competition ought not to be in credit standards.

Further, a requirement which would rest the whole basis of investment bank competition on the question of the price and yield of a particular new security misses some of the greatest essentials of investment banking service. A second-rate group with limited financial power and limited distributing power might outbid a strong investment group with greater prestige, greater financial power, and greater distributing power. A corporation accepting this higher bid might well find at a later time that its securities had been badly placed, were selling at unreasonably low prices, and that its ability to put out further securities had been seriously prejudiced.

Distrust of S.E.C. There is pretty general confidence in the financial community in the traditions and purposes of not a few of the Governmental regulatory bodies. It is particularly true that the National Banks trust the good judgment and sense of fair play of the Office of the Comptroller of the Currency, which has been examining National Banks and giving advice regarding National Bank policy since the Civil War. Individual banks at different times have their issues with the Comptroller of the Currency, and there was a period around 1916 when the banking community felt that the Comptroller was arbitrary and unfair. But by and large, the Comptroller’s office knows what normal functioning is, and it is disposed to encourage it; and the Comptroller’s office and the National Banks have gone through a good many crises together with helpful coöperation.

There is a good deal of feeling of confidence between the Federal Reserve banks and the member banks, and the regulatory activities of the Federal Reserve banks are felt by the banking community to be fair. While many have been troubled regarding the money market policies both of the Federal Reserve banks and of the Board of Governors of the Federal Reserve System, there is a strong feeling that the individual bank can get a square deal both from the Federal Reserve banks and from the Board of Governors.

One does not find this confidence with respect to the purposes and policies of the Securities and Exchange Commission. We have here an institution which is not sympathetic with the normal functioning of the securities market, which does not believe in the desirability of, or the need for, liquidity and marketability and active functioning, which doubts the desirability of a great deal of private financing, which inclines to the view that the Government should in greater or less degree take over financial functions, and which is itself greedy for power to interfere in minute details of financial transactions. It seems to delight in multiplying technicalities which cost money and make work both for itself and for the financial institutions of the country. It has been utterly indefensible in dealing with the matter of proxies, and it has imposed inexcusable trouble and expense upon many corporations in connection with this matter. It has gone far out of its way in interfering in the relations and terms of contracts between investment bankers and issuers.

The Securities and Exchange Commission aroused a great deal of apprehension by its part in the so-called monopoly investigation of the “Temporary National Economic Committee,” the so-called T.N.E.C., where it developed a one-sided presentation designed to show that there is little need for private investment, with the conclusion that a great deal of Government investment is called for. They carefully excluded witnesses whose testimony would not have been agreeable to them, and picked witnesses whose testimony would contribute to their one-sided case. This is particularly true of the testimony on the theory of capital, which is not representative of prevailing views among authoritative economists. The T.N.E.C. was largely dominated by the representatives of the Securities and Exchange Commission. There were able Congressional members of the Commission, including the Chairman, who tried hard to have fair hearings, but the hearings were not fair.

S.E.C. Greedy for Power. The Securities and Exchange Commission has seemed greedy for more power. The bringing of the life insurance companies into the T.N.E.C. investigation aroused fear in many minds that the Securities and Exchange Commission was looking for another field to regulate.

The Securities and Exchange Commission prepared a bill which was introduced in 1940 into the Senate and House of Representatives, designed for the regulation of investment trusts, which involved a sweeping delegation of ill-defined powers to the Securities and Exchange Commission, even giving them authority over the Courts of the United States in certain connections, and giving them authority to substitute their regulations for existing laws of Congress, subject only to vague limitations. This bill aroused the resentment of the Senate Committee on Banking and Currency, and the Securities and Exchange Commission met its first Congressional rebuff at this point. Able men in the investment trust field went before the Senate Committee and presented with great clarity and frankness the facts regarding their business, and protested with great effectiveness against the bill sponsored by the Securities and Exchange Commission. The upshot was that the Senate Committee invited the representatives of the investment trusts to suggest legislation, and that the Securities and Exchange Commission rather meekly requested that it be allowed to participate in the preparation of these legislative suggestions. The investment trust law as finally passed by the Congress was a very different bill indeed from that which the S.E.C. had originally proposed.

A striking instance, attracting wide public attention, of greed for power on the part of the Securities and Exchange Commission came in 1943. The thinness of transactions on the floor of the Stock Exchange itself had led to the development of a new practice, that of offering through brokerage or investment houses, off the Stock Exchange, at the closing price, large blocks of stocks which security houses over the country could offer to their customers. The practice has become well established and has doubtless alleviated in some measure the thinness of the market in good times, though how efficacious it would be in a rapidly declining market has not been adequately tested. Under this established practice, in 1943 a wealthy individual, through his investment banker, publicly announced that he was offering off the Stock Exchange 25 million dollars’ worth of stocks. At the same time it was announced that his purpose in making the sale was to get cash with which to buy Government war bonds. The offering was suddenly withdrawn. The Securities and Exchange Commission, however, denied that it had interfered. It had merely had inquiry made of the attorneys of the wealthy individual as to whether they had considered “the possibility of registering the proposed distribution with the Commission.” 1

Radical Changes in Method Called For—Settled Law vs. Bureaucratic Regulation. The Congress was right in demanding truth in securities, and in forbidding stock market manipulation. But a radical change in the whole approach to this problem is called for. There is no more reason in the security and security exchange field than in any other field of private enterprise for constant Government interference in the details of transactions. The security business is in general a clean and sound business. The men in the field are in general high-minded, upright, and able men. The normal functioning of the security business, including the stock market, is clean and sound. Indeed, the standard of integrity in this field is among the highest in all fields. Every day transactions involving many tens of millions of dollars, and often hundreds of millions of dollars, are made by word of mouth over the telephone. Transactions between the brokers on the floor of the exchanges are made by a word or even a nod of the head, each man making a memorandum of his own part in the transaction, but neither man giving the other a written document. Disputes regarding these transactions are very rare, and when they occur the assumption is that they are due to an honest misunderstanding and they are quickly adjusted. A very high order of integrity is necessary to make such a system work.

Occasionally, however, criminal acts occur, as in every field where human beings deal with one another. For these occasional criminal acts, there is need for criminal law and punishment. But there is no more need for the kind of supervision of multitudinous details in which the Securities and Exchange Commission engages here than in any other field. What we should do, in the interest of normal functioning, is to set the business free in a framework of definite law, and do away with the detailed regulation.

This should involve the following: (1) The Securities and Exchange Commission should be abolished. (2) The function of the Securities and Exchange Commission, of receiving and filing sworn registration statements and prospectuses, should be put in the hands of a purely ministerial body in some such place as the Department of Commerce. You want a legal record of the statements of fact made by men who are putting out new securities, so that they may be punished if they make false statements or if they omit essential information regarding the issues they put out. (3) There should be created in the Department of Justice a security and exchange division, whose business it should be to prosecute by criminal law in the courts of the United States men who make false registration statements or who put out false prospectuses, and men who otherwise violate the Federal laws governing securities and security exchanges. One may oppose a Governmental agency interfering with the details of the transactions in securities, but still strongly favor criminal laws that will prevent abuses and want them enforced. (4) The existing rules and regulations of the Securities and Exchange Commission, together with the security and exchange legislation, should be thoroughly reviewed, with a view to eliminating most of the detail, and with a view to saving that part which is needed and valuable for the protection of investors and for the prevention of fraud and misrepresentation. In this connection, the Congressional Committees should call before them the able men in investment banks and brokerage houses, who watch the Securities and Exchange Commission and who know the details, and get from them recommendations as to what parts of the law and the rulings should be preserved in the form of statute law. The Congressional Committees will find reluctance on the part of many of these men to testify, because of fear of reprisal by the S.E.C.

Finally, (5) the law itself with respect to prospectuses and registration statements should be greatly simplified. Altogether too much detail is called for. The procedure is altogether too expensive. There is no reason for a registration statement. A prospectus should suffice, and the prospectus should be short enough so that men will read it. But it is important that the prospectus should be a responsible document on the basis of which men may be put in prison if they falsify, and on the basis of which the purchasers of securities will have legal evidence for bringing suit in the event that they have been tricked or cheated.

• 1This point will be discussed at length in Chap. 34.