History of regulation: Caveat vendor

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US business leaders fear a heavy-handed legal and regulatory response to accounting scandals. The same fear was widespread in the 1930s. But the much hated laws and regulations laid down then set the foundations for a vibrant financial sector.

There are few things that corporate America in general and Wall Street in particular loathe more than the intrusion of government into their affairs. In such invasiveness, they detect the long arm of the reddest-hued socialism. They did so in the 1930s, when one congressman described the passage of the Securities Act of 1933 and the National Securities of 1934, as legislation designed to "Russianize everything worthwhile".

Some are hinting at that again today, with Intel's chairman, Andrew Grove, telling the Washington Post in July that today's anti-business atmosphere in the US reminds him of the Hungary he left in the mid 1950s.

That may be an extreme view of the legislative reform that has been rushed through Congress in a bid to restore confidence in the US corporate sector. But judging from the snail-like speed with which US companies with a turnover of more than $1.2 billion moved to fall in line with the new guidelines, most appear to believe that the Sarbanes-Oxley Act is an outrageous imposition.

The objections are twofold. First, it is felt that the legislation will load an unnecessary administrative burden on to corporate America; second, and much more important, that it may leave innocent CEOs and CFOs vulnerable, in extremis, to 25-year jail sentences for signing off accounts that are not "truly presented".

Those who object to these new constraints might pause to think about the longer-term benefits of the reforms of the 1930s. Those were based on the simple notion that companies must tell the truth about their businesses, the securities they are selling, and the risks involved in investing. As president Franklin D Roosevelt told Congress in May 1933: "There is an obligation upon us to insist that every issue of new securities to be sold in interstate commerce shall be accompanied by full publicity and information, and that no essentially important element attending the issue shall be concealed from the buying public."

He added: "This proposal adds to the ancient rule of caveat emptor the further doctrine 'let the seller also beware'. It puts the burden of telling the whole truth on the seller. It should give impetus to honest dealing in securities and thereby bring back public confidence."

While the public may have cheered, Wall Street and the US corporate sector fought tooth and nail against legislative change which, they claimed, would be so draconian as to destroy the US capital market and, as a result, strangle economic recovery as birth.
The strongest of motives for resisting regulation
The most energetic broadsides against the Roosevelt administration came from within the financial services sector itself. Charles Collins, president of the Boston Stock Exchange, foresaw the closure of hundreds of brokers' outlets throughout New England as a direct consequence of the legislation and, with it, the wholesale withdrawal from the US stock market of the small investor.

The price of seats on the NYSE collapsed. In 1933, these had been changing hands for up to $250,000. By February 1934 the going rate was closer to $190,000, and the following month seats were being sold for not much more than $100,000. Nobody lobbied against the government's meddlesome approach to Wall Street with quite the same forcefulness as Richard Whitney, president of the NYSE.

In February 1934, he wrote to the presidents of 850 of the largest listed companies in the US warning them of the dire consequences of the "sweeping and drastic provisions" built into the proposed National Securities Act. The following month, Whitney told members of the Senate banking and currency committee that rather than regulate exchanges, the bill laid before them would put his members out of business. The proposed changes, he warned, would bring with them "the end of liquidity in our markets"; it would "hamstring and freeze the security markets of the United States", and it would probably "lead to another panic".

Whitney had plenty of strong personal reasons for objecting with such inexhaustible passion to the proposals for increased regulatory surveillance. An incurable speculator, by the mid 1930s he was attempting to cover his own losses by embezzling funds to the tune of about $1 million from, among others, the New York Yacht Club. This earned him an unenviable entry into the history books as the first former president of the exchange to serve time in prison.

After a spell in Sing Sing, Whitney became mute on market regulation. He had already said more than enough: he probably delivered more power to the Securities&Exchange Commission than its founders had ever imagined would be possible.

But furious opposition to the new laws of the 1930s was by no means the sole preserve of Wall Streeters, straight and crooked alike. Gerard Swope, president of General Electric, signed a letter submitted by the Business Advisory and Planning Council, which he chaired, apparently voicing the view of American industry that the reform amounted to "a national calamity" and "a disaster".

In the academic world, a prominent NYSE member firm polled US finance professors for their views on federal regulation early in 1934. Of these, 39 opposed the measures, arguing that they would hamper economic recovery. Only four expressed support for them.

From the specialist financial press, too, there came howls of disapproval. "The process of extending the reach and grasp of government direction is endless, or appears to be," said Barron's in September 1933, adding the following March that the efforts of the reformers amounted to "a grandiose experiment in broad social control under the guise of stock exchange regulation".

In its darkest moments of 1934, Barron's was even penning premature obituaries for scores of brokers as well as for the entire new-issue market. Its "With the Editor" column of February 10 1934 pointed to some of the more alarming likely by-products of the perceived emergence of America's new "centrally-controlled economy". "Unfortunately," it warned in one of its more apocalyptic prognostications, "the provisions of the Act make it unlikely that there will be any new securities."

Within 40 or so months the doomsayers had plenty of ammunition. By 1937, US stocks were in the clutches of their worst bear market since 1929. By October the Dow's fall for the year had reached 40%, with railway stocks off 60% and utilities down more than 80%. Wall Street had no doubt about who to blame.

With interest rates low, railway car loadings at their highest level since 1930, and electricity production at a record high, many of the Street's bankers argued that they could see no macroeconomic reason for the depression in the market. In the words of Winthrop W Aldrich, then chairman of Chase National Bank: "The break in the market may or may not have significant consequences for business, but it was not initiated by a change in business facts. Few informed investors ... are free from apprehension regarding the long-run consequences of [government] policies already inaugurated or of policies proposed." The reason for the collapse of share prices, he argued, was "clearly and definitively to be found in the cumulative effect of a variety of governmental policies, some of which are directly concerned with the activities of the Stock Exchanges themselves..."

This was selectivity with the truth par excellence - apparently an economy contracting by 8%, unemployment at 20% and a deteriorating global political backdrop did not rate a mention for their contribution to the malaise in the US market.

These were exceptionally bleak times for Wall Street, where an estimated 1.5 million shares needed to trade each day for the industry to cover its costs. With volume in 1937 seldom reaching anything like that, the impact was inevitable, and involved extensive job losses and deep salary cuts for those lucky enough to hold on to their jobs. As The Economist pointed out in September 1937: "Persons are employed in fairly responsible positions in brokerage offices at wages which compare unfavourably with those of the lift operators in their office buildings."

Democratizing stock markets
None of this was enough to persuade the government to ease up on its regulation of Wall Street, chiefly because the reforms pushed through by the Roosevelt administration were based on the unshakeable belief - revolutionary at the time - that trading on the stock exchange should not to be viewed as a dangerous sport played out among a few wealthy, consenting adults. Instead it was an activity that had an incalculably important impact on the national economy as a whole and on the well-being of every American citizen. As a result, building a new relationship between Wall Street and middle America, based above all on mutual trust, was an objective prized by the government over any other.

Nothing less is needed in 2002.

While the foundation of the SEC and the passage of the National Securities Act formed the cornerstone of that new relationship, a number of other profoundly significant initiatives emerged from the rubble of the 1929 crash, the long-term value of which were almost entirely misunderstood at the time.

Above all, the appalling mismanagement of investment trusts in the US in the 1920s gave rise to the notion that far too many investment managers simply could not be trusted to handle savers' funds responsibly. The result was the arrival of the fixed trust, the idea being that the safest way for collective investment vehicles to be administered was for their managers to establish a fixed and transparent portfolio of profitable, dividend-paying companies, and stick to them. As The Economist remarked at the time, this carried the advantage of offering investors a copper-bottomed guarantee that they could not lose their money "through speculation, directorial irregularities or management errors".

In the America of the early 1930s (and, some cynics might argue, of 2001 and 2002), that was quite a novel concept.

Like the creation of the SEC, the idea of the fixed trust was not one that went down well. Standard Statistics, the forerunner of Standard&Poor's, commented in a 1931 report that "it is indisputable that the success in the sale of fixed trusts must stand as one of the bitterest indictments ever launched against Wall Street."

On the other side of the Atlantic, commentators such as The Economist said that the idea of the fixed trust was unlikely to catch on in Britain, where - apart from anything else - investment trust managers had performed so much better than their counterparts in the US. When the first look-a-like product was launched in Britain in 1931 by the Municipal and General Securities Company the press response was lukewarm. Thus was born, on both sides of the Atlantic, the mutual fund and unit trust industries.

The rapid growth of the mutual fund industry in the US after World War II was perhaps the clearest indication of the success with which trust had been restored, nationwide, in the American securities industry following the trauma of the 1929 crash. Indeed, by the late 1950s, commentators elsewhere in the world were expressing the view that their markets would have benefited inestimably from the sort of legislation that the US had bludgeoned through two and half decades earlier.

The most intelligent observer on the subject of the UK capital market in the 1950s was Harold Wincott, whose Tuesday column in the Financial Times regularly called (among other things) for the creation of a UK version of the SEC. "If you really want to establish a property-owning democracy you've got to be very militant in selling it, and very militant in defending it," he wrote in October 1959. "With one hand, you've got to make share ownership cheap, easy and simple; in the other, you must carry a dirty great stick and crack down immediately on the knuckles of anyone who attempts to trade on the simplicity or ignorance of the investing public. [Britain has] done neither the one, nor the other. We didn't fall between two stools. We never even got the stools ready."

If the Sarbanes-Oxley Act has the effect of repositioning those stools in the US and making them sturdier and more durable, future generations may come to thank the likes of Enron and WorldCom for unwittingly helping to build a more secure environment for investing in the US securities markets.