The Fight on the Securities Act
"Last June, the Securities Act passed both houses of Congress without a dissenting vote.... Then began a well-subsidized campaign of propaganda against the Act to force its abolition under guise of amendment."
by Bernard Flexner
.....
personal word by way of preface to forestall the criticism
that what I shall say is more of the stuff that has been said or written by men
who know little or nothing of the securities business. I am not an amateur. I
am a lawyer familiar with shares of stock, bonds, debentures, warrants,
options, and the innumerable other pieces of paper. During twenty-five
years I have supervised issues of securities by 'the company,' have passed on
the legal details, for investment bankers, of the issues of millions of 'senior
securities' of public utility operating companies, and also, alas, I have been
an investor. "Last June, the Securities Act passed both houses of Congress without a dissenting vote.... Then began a well-subsidized campaign of propaganda against the Act to force its abolition under guise of amendment."
by Bernard Flexner
.....
From the archives:
"Amend the Securities Act" (March 1934)
"In the February number of The Atlantic Monthly appeared an article by Mr. Bernard Flexner opposing any amendments to the Securities Act. This article will present facts indicating the necessity for amendment." By Eustace Seligman The views I express here I know from personal conversations to be the views of many lawyers and bankers in New York's Wall Street who are as disgusted as any farmer or small business man in the far 'interior' with the revelations before the Senate Investigating Committee, But these men feel that the Street has much to offer in honest financial guidance to the industrial and commercial community. They see that the methods of distributing securities as heretofore carried on must be reformed; that the conditions which have already ruined half of the investment banking houses will ruin the rest if they continue; and that the investment banker has got to be satisfied with smaller profits than he has made heretofore. They are aware that the country at large is now thoroughly suspicious of and effectively angry with the Street to a degree never before known—and that, for the first time in all its history of conflict with the country as a whole, the Street has not produced leaders astute enough to defend it intelligently. With enlightened self-interest, therefore, they realize that Wall Street cannot expect to continue as a stable institution in which they can make even a modestly comfortable livelihood at the work that interests them except by assuring the rest of the country of the kind of honesty in securities flotation and financial management which the Securities Act enjoins.
Because of jobs, 'connections,' the friendships that men curiously acquire with others of different ethical standards, or hopeless cynicism, these individuals do not dare or choose to be publicly critical. This article calls the bluff on an ugly campaign of propaganda, and very regretfully has to be equally ugly in calling a spade a spade. But when I speak of the Street—meaning not only Wall Street, but State, La Salle, Montgomery, South Broad, and Carondelet—I refer only to the dominant class in the Street. In no way do I impugn the intelligence or motives of the multitude of silent nonconformists, many of whom, I know, would like to sign this article with me.
Last June, the Securities Act passed both houses of Congress without a dissenting vote. A few months later the cocksure lawyers of the Street's banking houses, who never before had had difficulty in 'finding a way around' legislation regulating 'business,' discovered that the Act was substantially lawyer-proof. Then began a well-subsidized campaign of propaganda against the Act to force its abolition under guise of amendment. This campaign, led by members of certain well-known New York law firms, has been based on the wildest exaggeration. For the first time since the stupid fight the Street made in 1913 against the adoption of its now beloved Federal Reserve System, the acumen of its legal henchmen in demonstrating to courts how little a statute should mean has been put into reverse to demonstrate to Congress how awfully too much a statute could mean.
The campaign has now reached a point of pressure where there are intimations that it may succeed in opening up the Act for amendment at this session of Congress.
One fact should be bluntly understood at the outset of any discussion of this subject. The Street's sugar-coated purpose, as the public has been given to understand it, is to persuade Congress to pass 'just a few comparatively minor amendments' to the Act to 'make it workable' and to 'remove unnecessary interferences with business.' As to the broad objectives of the Act, all its opponents say that they 'agree in principle.' But every realistic believer in these objectives knows that the real hope and purpose of these helpful friends in wanting to open up the Act for amendment is to take full advantage of any opportunity that may present itself in the accidents of the legislative process to destroy its effectiveness completely. Too much money and effort has gone into this campaign of propaganda to justify a purpose of mere 'clarifying' amendments. Amendments which appear innocent enough will be artfully loaded with ingenious weasel words; seemingly casual changes from section to section will attempt to confuse the careful interrelations which give the Act its lawyer-proof quality.
II
he steady stream of propaganda takes two main lines of
attack. One is a general technical raking over of the Act to suggest the
uncertainties or injustices of its application to extreme 'supposititious'
cases. This approach helps to divert attention from the fundamental social
issues at stake, on which the public can see eye to eye with the defenders of the
Act, to innumerable squabbles over technical detail in which the public won't
know where to side. Eminent financial law firms in New York and elsewhere,
whose members feel no particular necessity to make their legal opinions fit a
purpose of attack upon the Act, consider such technical objections laughably
ridiculous. Quietly and privately they have advised their banking clients to
operate under the Act with the assurance that, as a practical matter, it exacts
no more of the directors and bankers of an issuer than can fairly be expected
under a combination of common law and a decent standard of securities ethics. The second method of attack, really insidious, appears as a 'practical' argument for economic revival in this period of emergency. Whether or not the Act, in vacuo, is fair or unfair, whether or not it is socially expedient from the long-term point of view, the Act must be abolished, at least temporarily, because otherwise the bankers and company directors simply will not give necessary cooperation to the President's plans for recovery. The argument amplifies thus:—
Admitting that the methods of marketing securities used prior to the passage of the Act have mulcted the public of an amazing proportion of the sum 'invested';
Admitting that leopards do not change their spots and that, if left unregulated, the securities business will mulct the public again in precisely the same way;
Nevertheless,
(a) There can be no fundamental recovery until there is substantial reemployment in the so-called capital-goods industries;But even a member of counsel for J. P. Morgan and Company, one of the severest critics of the Act, says frankly in Barren's Weekly for November 6, 'It is still too early to prove conclusively with figures either that it is or is not the fault of the Act that no American companies of any size are doing any capital financing.'
(b) There is no way to revive such employment without supplying the purchasers from the capital-goods industries with new funds through the flotation of securities in the ancient public-mulcting manner;
(c) Whether or not justified, directors and underwriters are, as a pragmatic fact, on strike against risking the liabilities imposed by the Act;
(d) That strike is preventing new securities;
(e) If the Act and the strike against it disappear, new flotations of securities will—within a period that will mark the difference between continued depression and immediate recovery—supply those who want to buy new capital goods with funds sufficient to give enough orders to the capital-goods industries to absorb their unemployed;
(f) The loss by investors and the loss of all the social purposes of the Act are a necessary—and cheap—price to pay for the certain recovery which will follow.
There is a famine of new securities. But the truth about that is:—
(1) For a variety of fundamental economic reasons, which the Securities Act in no way caused and a recurrence of which it is designed ultimately to prevent, there was not before the adoption of the Act, there is not now, and there may not be for some time, any investment demand for long-term industrial obligations of the ordinary type at a bearable rate of interest to the issuer.As reasonable corollaries, it seems fairly certain that, however regretfully, the risks of the Act will be taken (1) by the bankers, when long-term industrial bonds for purchases of new capital goods or refundings can be floated by them at a profit, and (2) by those directors of companies who, as stockholders or otherwise, feel a genuine interest in their companies when, with the hope of repeal of the Act gone, they face the alternative of taking the risks of refunding or of defaulting their companies' maturities. To be sure, there is the type of director who will not undertake the burden of mere due care and competence required of him under the Act—the inevitable lawyers who should be professional advisers and not directors, the scenic directors who 'dress' the annual report to the stockholders, the observers representing short interests who are only on the board to get inside information. These, just as they threaten to do, will not take the risks and will get out, and the companies and an honest business society will be the better for their going.
(2) Whenever there has been a market as there has been, for instance, in the distillery and mining shares which at the present moment are popularly considered to hold great speculative possibilities—issues have been offered and directors and banking houses have taken the risks of the Securities Act in spite of all its supposed terrors.
(3) Refunding operations are being deliberately and uneconomically delayed with the help of short-time bank loan, not only because of the unsatisfactory condition of the long-time money market, but also because of the illusory hope, deliberately fostered by Wall Street to create a lack of refunding operations as an argument against the Act, that the Act will be repealed by amendment shortly after the first of January.
Fundamental economic factors against an immediate, long-term, non-speculative capital market certainly include, from the borrower's side:—
(1) The shrinkage of the credit-worthiness of many companies according to normal investment standards;From the lender's side:—
(2) Unwillingness, after the harrowing experience with debt in the last five years, to finance with new debt at exorbitant rates;
(3) Sheer lack of national need for general industrial plant expansion at anywhere near the rate of the last decade; on the whole, as the President has pointed out, the nation's capital equipment is already built.
(1) Fear, however little justified, as to the long-term value of the dollar;These factors—and not a legal confirmation of an ethical standard that men who use other people's money must be honest and competent—have dried up the securities market. No Securities Act interferes with short-term customers' loans by banks. Yet, even under government urging, there has been no substantial credit expansion in this field. When lenders will not lend, nor borrowers borrow, for a period of more than a few months or weeks, what reason is there to expect that long-term open-market lending will immediately boom after the repeal of the Act?
(2) The drying up of institutional investment because of the troubles of insurance companies, banks, building and loan associations, and so forth—possibly the permanent loss of the market once provided by the 'secondary-reserve bond account of commercial and savings banks;
(3) The drying up of private savings out of which came the great aggregate of investment by small investors;
(4) The gun-shy attitude of investors with funds, who are themselves on strike against the bankers, and who want at any price the safety that can be found only in government obligations.
Even counting the rush to get issues under the wire before the Act became effective on July 27, there was little more financing in March, April, May, June, and July than in August, September, October, and November.
Railroad and municipal securities are exempt from registration under the Act. (They are within its scope only to give a buyer relief against his immediate seller who misrepresents securities.) But there have been no issues of railroad securities offered to the public since the operation of the Act, and only a few municipal issues even by municipalities of the very highest credit rating. Railroads and municipalities alike are financing themselves as best they can through the Federal Government. Where refinancing is not possible through the government, they simply default.
However much economists may decry an overbuilt industrial plant as a whole, it is in these very fields of railway and municipal finance that the need of new capital investment is really pressing. Competent observers estimate that the railroads could profitably expend well over one billion dollars for new equipment and deferred maintenance. Despite all the political inadvisabiities of becoming further involved in the railroads, however, the government is being driven by the force of circumstances to offer them funds in generous amounts for capital expenditures through the Public Works Administration and the Reconstruction Finance Corporation—and even for refinancings, where the government has no incentive to lend to create work. All this simply because the bankers cannot raise the money. And it is not only the perennially bankrupt roads that are coming to the government. The Pennsylvania—a credit risk comparable to that of any industrial company which might presently contemplate new capital issues—has applied to the government for equipment and construction loans aggregating approximately $85,000,000 to carry out its electrification programme. Certainly this would be a juicy issue for private distribution if it could be distributed. In view of the ingrained prejudices of the great banking houses against government 'interference' in any kind of business, this financing of the railroads by the government has enormous significance.
Again, the inability to float municipal bonds is not confined to bankrupt municipalities. Few public bonds stand on a better basis than those of the Port of New York Authority, operator of great bridges and of the famous Holland Tunnels. It serves the busiest harbor in the world and is backed by the moral obligation of the two rich states of New York and New Jersey. The Authority has already floated $140,000,000 of bonds. But it, too, after months of argument as to terms, during which there was plenty of time and incentive for private financing if it could be had, has come to the government for a loan of approximately $40,000,000 to build a new tunnel under the Hudson River.
The City of San Francisco, with its excellent credit standing and with tax delinquencies among the lowest in the country, recently attempted to sell $13,500,000 of bonds for public improvement. The only private banking syndicate which was interested bid on a 6 per cent basis. This bid was denounced as 'unconscionable' and, 'to say the least, one of non-cooperation in the recovery programme by Secretary Ickes, who had offered the city on behalf of the Public Works Administration a 30 per cent grant of the cost of the improvement.
If the bankers, unhampered by the Securities Act, are unable to take care of the needs of public bodies and railways, their wail about issues stopped by the Act cannot be taken seriously. The Street has never met the challenge that it refer by chapter and verse to expenditures for new capital goods that have been stopped by the Act. Here and there, perhaps, the refunding of an industrial maturity that was not immediately due, or that could for a short time be carried on a bank loan, may possibly have been rendered temporarily impracticable because the bankers or the company's directors were frightened, not by the Act but by the absurd gloss that Wall Street lawyers have put upon the Act. But—and this is a big but—the squawking over refundings is a patent bluff. Despite all the ominous predictions that defaults would occur, no default actually has occurred! As for the list of imminent refundings totaling $1,500,000,000 which the Act is charged with preventing, even a superficial examination of the securities and of their low quotations will convince one that many of these companies will not be able to refund in any event; unless they have a miraculous improvement in earnings, they will have to reorganize.
There is, therefore, no proved causal relation between the Securities Act and the lack of capital issues in the last six months. All the hair-tearing over the Act is based upon a guess as to what bankers and directors would do if conditions were satisfactory from their point of view except for the Act. But a guess that bankers will not spurn their profits, and that directors will not default their maturities when the capital market will take their issues, is a lot closer to the hard-boiled common sense of the Street than a guess that all bankers will sulk forever poor, and that all directors will abandon the many things they get out of a corporation besides their fees and go home.
III
he real issue is not whether the Act could be made to look
prettier on paper but whether, within only eight months of its passage and in
the midst of a general Wall Street attack upon the New Deal, the Act should be
opened up for amendment by this Congress. That entails grave questions of
legislative policy, and particularly of New Deal policy. The Act stands as a
symbol, promising a better and freer economic world. Before the sheer power of
a well-financed campaign of sabotage is permitted to slash into it, the burden
of proof is on the opposition to show not merely that it is uncomfortable for
them and their kind, for it was intended to be that, but that it
constitutes an immediate, unbearable burden upon desirable elements in the
country. The Securities Act was perhaps more carefully worked over than any other product of the first New Deal Congress. It is not a doctrinaire brainstorm. It is carefully based upon the solid foundation of British experience with the English Companies Act, which in turn is the evolution of years. In substance, the Securities Act is the English Companies Act, modified to come within the constitutional power of the federal legislature to regulate interstate commerce, and to recognize the fact that in England, except for a very unusual Hatry or Kylsant, the distribution of securities is a decorous, traditional business, offering its wares only to institutions and wary family solicitors, while in the United States it has been a high-pressure racket that jangled every housewife's doorbell.
The Act itself was under consideration in Congress for more than two months. The extraordinarily able House Committee on Interstate and Foreign Commerce and the chief of the Legislative Drafting Bureau in the House studied it phrase by phrase, section by section, for nearly a full month. Every objection now made to it was, at some time in this long process, raised, considered, and deliberately rejected.
Any statute adopted after such careful consideration—unless it really seriously and provably throws things out of joint should be given a fair trial period of at least a couple of years. It needs to be shaped by administrative rulings and court decisions into a practical instrument before being generally revised by the legislature. This caution is particularly applicable to a statute which deals with such a bewilderingly multiplicious and technical field as the Securities Act, where application to the specific situations which touch the public depend almost more on administrative rulings than on the words of the statute itself.
The unavoidably necessary complications of the Act and its subject matter are, in themselves, very important reasons for not permitting the Street to scramble it by amendment at this session of Congress. Those who have not worked with the machinery for distributing securities cannot be expected to understand its many intricacies and devices. The average citizen does not comprehend how thorough and ingenious is the protective technique in the creation of new evasions which constant experience with emasculation of state and federal statutes has developed in the Wall Street lawyer. Indeed, the whole technique, training, and tradition of the Wall Street lawyer is centred, not upon conformity with the law, but upon finding a way to get around it—a technique which, until the adoption of the Securities Act, was as a practical matter undefeatable. The necessity of caulking all the chinks to balk this expert mechanism of evasion made the problem of drafting the Act extremely difficult. To avoid those opportunities for evasion which always climb out of the scope of the law up ladders of too-specific technicalities, the Act had in many places to be couched in broad language which the draftsmen clearly recognized might give rise to difficult border-line cases. Because the adaptability of the securities business to changes in form made it certain that a hole in one section or between sections would be immediately and exclusively utilized to render the rest of the Act worthless, it was necessary to exercise especial care in articulating the several parts of the Act into a unified whole.
In a statute which has to be so carefully articulated because it is so certain to become the target of legal sharpshooting, the subtle, casual change of a significant word, phrase, or single short section may open up infinite possibilities of trouble in all the rest of the Act.
Every generous 'dollar-a-year' suggestion made by the lobbyists of the Street has upon examination proved to open up sometimes subtly, sometimes crudely, but always under the guise of improved 'workability' in some important feature of the Act—a hole through which a coach and four could be driven. And once a hole is made almost anywhere in the Act, through which financing can be carried on free of its liabilities, the entire purpose of the Act is lost, since the legal ingenuity of the Street may confidently be relied upon to find a way to put all financing of any kind through this one hole.
Consider, for example, the innocent-looking suggestion to eliminate Section 15—the very heart of the Act—which holds liable any person controlling any other person who is liable under the Act. The reason advanced for this proposed change is that it is always difficult to resolve borderline cases of what constitutes 'control.' But such an elimination would practically repeal the Act: by the simple device of organizing judgment-proof subsidiaries, all flotations could be effected by the real parties in interest with complete escape from the liabilities of the Act. And let no one suppose that none but the 'fly-by-nights' would take advantage of such an opportunity! When the device of the holding company was discovered to avoid the jurisdiction of the Interstate Commerce Commission to pass upon railroad consolidations under the Transportation Act of 1920, even J. P. Morgan and Company and Kuhn, Loeb and Company and their ultradistinguished counsel pushed through that hole with Ahleghany and Pennroad Corporation, respectively.
It becomes clear, then, that no matter how carefully the defenders of the Securities Act may study the formal proposals for amendment offered in Congressional Committee by the banking lawyers, a change of a phrase or of a word or two—well prepared and deceptively simplified with the art that conceals art—may seriously injure the fundamental purposes of the law. And if such proposals should be thrown into the hurried last moments of a committee hearing with the help of a sympathetic member of the committee, or offered as an amendment from the floor in the burlyburly of debate, the surprised defenders of the Act would not have time enough to guard against ulterior subtleties. The mere opening up of the Act for 'minor' amendments, therefore, will in itself be a great victory for those who want to reestablish the good old days of Wall Street's 'gold-plated anarchy.'
Under such circumstances, it is beside the point to charge Congressional leaders with pig-headed stubbornness in maintaining that this legislation should not, at the present moment, be subjected to even minor amendments. Theirs is the grim and realistic understanding that the opposition may—and if the chance offered, undoubtedly would—go dangerously far in following through the most innocent beginnings of an opening-up process. If this be challenged as an unfair attitude to take, one can only reply that Wall Street has brought this distrust upon its own head. The outside observer who has followed the disclosures from the witness stand of the Senate Investigating Committee, and who realizes the stakes now at issue and the impossibility of changing ingrained habits of mind, has no choice but to regard the Street's 'constructive criticism' of reform legislation with prima facie malevolence.
Another strong reason for keeping the Act inviolate from Wall Street at this session of Congress is the extreme political unwisdom of permitting a powerful class against whom a reform statute has been directed to weaken it before it has had even a chance to operate. Such an event would serve to convince the public that Wall Street had the future of the law so completely within control that it might safely be treated as a dead letter. Before a reform statute can become really effective its legal rules have to soak into a business community for a long time until practical methods of operation within the rules become business habits. As another writer has put it: 'If the Act ultimately succeeds, it will not be through any mere compliance with its lettered provisions. Its effects must go deeper. It must reach men's attitudes as to the ends and methods of economic enterprise. The Act will never protect the gullible unless it alters the premises of the sophisticated.' No reform statute can be expected to have this effect if there hangs over it a constant threat that powerful interests can force changes in it whenever they discover new ways in which it pinches them.
A Congress dealing with reform legislation and opposed by the biggest of big interests, which have always managed to beat their way through reform after reform until that ability has become common knowledge, must remember that once it yields under fire, even on minor matters, the small-business community will never believe that the reform has any fundamental stability. There will be no assurance that even its broadest purposes may not be amended from year to year as 'Wall Street dictates, with the consequence that the Securities Act and the principles of honesty which it embodies will never become part of the accepted business habits of the community.
Indeed, the vehement opposition which the Securities Act has aroused is in itself a completely adequate reason why a New Deal Congress should dig in and hold! This Act is the very keystone of the New Deal. Together with the Glass-Steagall Bill, it was the only permanent reform made in all the amazing last session of Congress. In a peculiar degree it symbolizes the spirit of the New Order in its challenge to the Old. Almost as important as its actual details will be the demonstration to Wall Street that these details, dictated as they were by the broad general interest of the nation, cannot be sabotaged by any combination of private interests, however powerful. At this impertinent organized challenge within the first year of the statute, Congress must teach the Street that the New Deal can beat its lawyers and its money. Else we have only 'scotched the snake, not killed it.'
IV
he real point of attack upon the Act is its civil-liability provisions. Under these
provisions, bankers, company directors and officers, accountants and other
experts employed in the distribution of securities, are liable to the purchaser
if, through willfulness, carelessness, or incompetence, a material misstatement
has been made in their published selling story about a security, and the
security drops below its original offering price with loss to the purchaser.
The details of registering the security with the Federal Trade Commission, the
waiting period before the public offering which deflates high-pressure
salesmanship, the risks of a stop-order by the Commission after sale
begins, are unfortunate and irksome, but tolerable. The criminal provisions do
not matter. But the idea that the purchaser of a security gone bad can sue the
seller to take it back and return the money violates every rule of 'business'
that the Street ever heard of. This 'outrageous' liability is the real nub of the objections to the Act under the smoke screen of all the other objections; this touches the pocket nerve! But it also happens to represent the principle of 'seller beware' which the President particularly wanted the Act to add to the crude old common-law maxim of 'buyer beware.' A banker or corporation director expects his Rolls-Royce dealer to take back from him a limousine not of the kind or quality it was represented to be; but for his own customer to ask him to take back sour securities is sheer cheek! Is there, then, something akin to Sovereign Immunity in the securities game?
Now what are the liabilities imposed on the seller of securities by the Securities Act and by the British Companies Act with which it is so often compared?
Both Acts demand a statement describing the securities to be sold, and in the statement certain specified information is required. Under the American Act this is called the registration statement, and has to be filed with the Federal Trade Commission twenty days before the security can be offered for sale to the public. Under the British Act this basic statement is called the prospectus. Wall Street claims that the American registration statement requires too much. It wants to know about a lot of 'trivial, gossipy details,' such as bonuses, preferred lists, secret commissions, the interests of bankers, directors, and large stockholders in inside deals with their companies; it also insists on going into the accounts of plant and property depreciation back to 1922 in order to reconcile the ingenious figures offered the Bureau of Internal Revenue since that time.
It cannot be too often repeated that after the registration statement is filed no liability of anyone to a purchaser of a security arises under the American Act unless that registration statement 'contained an untrue statement of a material fact or omitted to state a material fact required to be stated or necessary to make the statements therein not misleading.' Not until a defendant is prima facie guilty, therefore, does he come within the possibility of being liable. The words 'material fact' are taken verbatim from the English Act. The language concerning omission to state a material fact is a spelling out in the American Act of the interpretation of the scope of 'untrue statement of material fact' which British courts construing the British Act have made in the celebrated Lord Kylsant case and others.
What is a 'material fact'? The interpretation of this language in the American Act will of course follow that of the English Act from which it was copied. The English courts have interpreted 'material fact' following the recommendation of Lord Davey's Committee in the report to Parliament which laid the basis for the British Act of 1900—as a fact 'which could reasonably influence the mind of an investor of average prudence'; that is, something really important.
The objection is sometimes made that such a definition is not sufficiently concrete—that corporation directors and bankers cannot feel comfortable until the Act is amended to say 'only this and this and this are the material facts which you have to tell the investor.' The Act does try, so far as is humanly possible, to meet this selfdistrust of judgment and disinclination to make a frank disclosure of essential facts. It painstakingly enumerates in detail in Schedules A and B the kinds of facts which the registration statement is required to cover. And no other facts, even if they might otherwise be considered 'material,' are required to be given in the registration statement, or can lay the basis for any liability, unless their omission makes misleading other facts included in the registration statement pursuant to the requirements of these schedules or otherwise. Even facts required by the schedules are only prima facie 'material'; they will not ultimately be considered 'material' unless they meet the test above stated that they 'could reasonably influence the mind of an investor of average prudence.'
The amount and nature of detail required to cover each fact of this kind will only be such as are called for to provide a substantially truthful disclosure, not a meticulously accurate one. Considering the multifarious differences between issues of securities, and the different things an investor needs to know about each, no Act can do more than enumerate the kinds of facts required. Nor can it prescribe just how much substantiating data has to be submitted to make the presentation the whole truth and not merely, through omissions, a half-truth. In the last analysis, human conduct can be judged only by standards, and not by exact rules. The English have applied this same standard of 'material fact' for over thirty years. Perhaps the best example of the kind of half-truth against which the Act tries to protect the investor is that for which the English sent Kylsant to jail. The prospectus of the Royal Mail represented that its income over a number of years averaged a certain sum: it did not disclose that the greater part of that income was derived from non-recurring reserves.
The charge that juries will judge with hindsight, reasoning that to avoid a half-truth more data should have been included in the registration statement than a completely honest issuer would have recognized as necessary at the time, sounds well on paper, but is not a practical objection. Note that the Act itself does all that language can do to avoid the risks of hindsight; it already expressly provides that the reasonable care which will absolve a defendant from liability shall be determined as that which was incumbent 'at the time' of filing the registration statement (Section 11). As a practical matter, rich men have a habit and a technique of obtaining justice in this country. Moreover, the English, with the same kind of legal system as ours, have since 1900 operated under their Companies Act without complaint on this score. Indeed the British courts, which have an admitted sense of the practical limitations of juries and other legal machinery, not only have not been afraid of injustice to the rich on this point of omissions, but have deliberately created, without the basis of the clear language to that effect incorporated in the American Act, their interpretation imposing liability for omissions which give a false impression. The English Act provides the same kind of civil liability for misleading omissions in a prospectus which give a false impression as for positive misstatements; its additional provision for criminal fines is not for misleading omissions in a prospectus or other selling literature, but for selling in violation of the Act.
V
hat those who
criticize the provisions of the American law about statements of 'material'
fact really object to is that the basis of liability is not that of the old
common-law liability in fraud. That is to say, affirmative proof of 'intentional' misstatement is not
required by the Act. But nobody thinks that a liability based upon intentional
fraud is any adequate protection to the American investor. We have this
practically useless liability at common law already. Lee Higginson's failure to
require, or to disclose that they had not required, a proper audit in Kreuger
and Toll was not intentional fraud. In such cases, however, the disaster to
investors may be no less grave than if intentional fraud had been practised,
and the responsibility is clear. Certainly the Kreuger and Toll issue would not
have been floated in the way it was if the Securities Act had been in effect. Under the American Act, therefore, civil liability to the purchaser of a security does not begin to operate unless and until those who offer the security include, in their formal description of it filed with the Federal Trade Commission, a misrepresentation or a half-truth serious enough to affect the judgment of the average buyer in his decision to purchase the security. In short, the misstatement or omission must be something pretty bad. Before suit can even begin, the defendants are prima facie not innocent, but guilty. There is nothing, therefore, in the contention that some innocent banker or director may be held cruelly liable because of some wholly unimportant misrepresentation or half-truth which he carelessly permitted to creep into a registration statement.
This should be repeated over and over: No one can incur civil liability under the Securities Act unless and until he has participated in, or can fairly be considered prima facie responsible for, a really serious omission or false statement concerning the security in the formal registration statement filed with the Federal Trade Commission at Washington.
The persons potentially liable to a purchaser of any given security are, in addition to the issuing company:—
(1) Every person who signed the registration statement;If there has been a misrepresentation in the registration statement sufficiently serious to start the machinery of civil liability, the issuing company which got the money from the sale of the security must, if it loses the suit, take back the security from any purchaser at the price the purchaser paid for it, not exceeding the original offering price to the public—no excuses accepted.
(2) Every person who was a director of (or person performing similar functions), or partner in, the issuer at the time of the filing of the part of the registration statement with respect to which his liability is asserted;
(3) Every person who, with his consent, is named in the registration statement as being or about to become a director, person performing similar functions, or partner;
(4) Every accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, who has with his consent been named as having prepared or certified any part of the registration statement, or as having prepared or certified any report or valuation which is used in connection with the registration statement;
(5) Every underwriter with respect to such security.
For others than the issuers, who did not directly get the money, there may be an excuse. Even if there was some serious misrepresentation upon which potential liability might be based, it may have been an accident, or an excusable faulty emphasis not appreciated at the time the registration statement was filed, or the result of concealed misconduct of an employee, codirector, or other like person. The Act provides, therefore, that each of those potentially liable, except the issuer who got the purchase price, may escape liability if he can prove upon being sued that, 'as regards any part of the registration statement not purporting to be made on the authority of an expert, and not purporting to be a copy of or extract from a report or valuation of an expert, and not purporting to be made upon the authority of a public official document or statement, he had, after reasonable investigation, reasonable ground to believe and did believe, that the statements therein were true and that there were no omissions to state a material fact required to be stated therein or necessary to make the statements therein not misleading.'
In other words, even if the registration statement told the worst kind of lie, any banker or director would not be held liable to the injured investor if he could show that individually he exercised, under all the circumstances of his personal relation to the issue, reasonable care and competence to see that no lies should be told. That standard of reasonable care is the very backbone of the Anglo-American law of negligence, and for generations English and American courts have successfully applied it to business problems fully as complicated in their facts as any that can arise under the Securities Act.
The provision of the American Act that the standard of care and competence required under it shall be that of a 'fiduciary' obeys the strict command of the President's message: 'What we seek is a return to a clearer understanding of the ancient truth that those who manage banks, corporations, and other agencies handling or using other people's money are trustees acting for others.'
The charge that this standard of a 'fiduciary' is a confused standard differently interpreted under the laws of different states appeals only to the lawyer who wants a definition so sharp that he can calculate to the inch how closely he can slip by. Everywhere the care of a fiduciary is construed to mean substantially the care which a reasonable and prudent man would use in the conduct of his own affairs. All questions of interpretation of the Act are federal questions. The Supreme Court of the United States will therefore have jurisdiction to review and reconcile any out-of-line interpretations of the standard of fiduciary care which the state courts may adopt. Wall Street lawyers who have long tried to believe in the efficacy of so-called 'whitewash clauses' exempting their clients from responsibility for anything possibly contemplate with fear having to advise clients under such a standard of honesty where whitewash avails not. But the rest of the country, which has for a long time carried on business under the assumption that responsibilities cannot be evaded by words, does not share the apprehension.
The amount of care and competence required of each person potentially liable under the Act will, of course, vary with his relation to the issue and to the registration statement. The care expected of ordinary corporation directors would be substantially what they would be called upon to give the business if collectively they were the sole stockholders. The demands upon a 'managing director' or upon the corporation's president and treasurer would be much greater. A small country participant in a syndicate distributing securities will not have to make the original investigation of an issue that is required of the originating underwriter. He will have to make some investigation—at least of the reports made by the originating house—such as any purchaser of the security can fairly expect of a partner participating in a syndicate account no matter how small his share. The ordinary dealer who has no share in the profits of syndicate operations, but receives only the usual dealers' commission given by way of discount or otherwise, is not an 'underwriter' by the express terms of the Act. The familiar argument that juries will judge with hindsight has already been considered.
If the defendant cannot bear this burden of proof in respect of his duty of reasonable care and competence, the Act provides that he must take the security off the purchaser's hands at the price the purchaser paid for it, but not at a price exceeding that at which it was originally offered to the public. No arguments are permitted as to how much the condition misrepresented in the registration statement actually damaged the value of the security, or how much the purchaser 'relied' on the misrepresentation. If the purchaser has sold the security before suit, the defendant has to do the next best thing—that is, he must pay the purchaser the difference between the price the purchaser paid for the security (not exceeding the original offering price to the public) and the price he sold it for. The original offering price to the public must be given in the registration statement.
Note particularly two things:
(1) The only purchasers who can sue are those who did not know of the misrepresentation and the taint in the security when they bought—a factor which largely eliminates all the bugaboo of strike suits of which the opponents of the Act have been complaining. The plaintiff has to show clean hands.The original offering price of the security as given in the registration statement is definitely established as the ceiling of liability by an official administrative interpretation of the Act. This ruling completely refutes the lurid argument which has been advanced to the effect that if, after an issue of stock is offered to the public at $10 a share, it is manipulated to $1000 a share, and A buys at $1000 and sells to B at $500, B to C at $100, C to D at $10, and D keeps the stock until it reaches zero, the issuing company, the directors, and all others held under the Act are liable to A for $500, to B for $400 more, to C for $90 more, to D for $10 more—a total of $1000, all on a stock originally marketed at $10. Computing astronomical liabilities on this basis, with the thrill of assuming an indefinite number of ups and downs in the market during a stock's tumble to destruction, has been a favorite sport of the Act's opponents for weeks.
(2) No purchaser, no matter at what price he bought, can recover from the defendant more than:—(a) The original offering price of the security to the public as given in the registration statement—if the purchaser still has the security and can return it; or
(b) The difference between the original offering price and the price at which the purchaser sold the security—if the purchaser has sold it.
The administrative interpretation limiting damages to the original offering price of the security is indisputably correct. The Act offers damages only as a necessary alternative when rescission is impossible. The registration statement out of which liabilities for misrepresentation grow is filed to permit the original public offering. Clearly, the right of rescission, with its alternative of damages, is based upon the original public offering and the price at which this offering was made. One of the clearest evidences of the fundamental bad faith of Wall Street's propagandists is that when the Federal Trade Commission so interpreted the Act, within its clear intent, as already meaning what its critics urged it should be amended to mean, the propagandists charged that the Commission had no power so to interpret and cheat them of an argument to open up the Act for other amendments.
VI
ow that we have defined the civil liability under the
American Act, what are the arguments against it? Overstated for the sake of
fairness, they are:—
(1) The purchaser of a security is allowed to recover even though he cannot affirmatively prove that he actually relied in buying the security upon the misrepresentation in the registration statement. The English Act requires this proof.Objections one and two can be considered together. The difference between the American and English methods of protecting the investor rests upon a practical recognition of two facts:
(2) The recovery which the purchaser is permitted is not restricted to damages which he can affirmatively prove were caused to the value of the security by the conditions misrepresented in the registration statement. In substance, the purchaser may require the seller to take back the goods that is, as the law says, to 'rescind the transaction.' The English Act gives the purchaser only damages related to the misrepresentation.
(3) Too many persons are held liable to the purchaser in the formal registration statement—particularly accountants and a large variety of intermediate sellers included under the term 'underwriter'—and a purchaser can recover from an 'underwriter' from whom he did not actually purchase the security. The English Act holds liable only underwriters who actually signed the filed prospectus (which is the English counterpart of the American registration statement). The English Act, like the American, does hold liable the company directors.
(1) The American and English methods of distributing securities are different in their approach to the investor.As has been pointed out earlier, the great bulk of securities are purchased in England, not by inexperienced individuals, as in the United States, but by long-established investment trusts, other financial institutions, and wary family solicitors who read and carefully weigh prospectuses. This is in accordance with a business tradition in England which forbids feverish finance and high-pressure salesmanship. England has nothing resembling Wall Street's fearful and wonderful distributing machinery. Furthermore, practically all English buying takes the form of direct subscription, so that the investor always has a direct common-law right of rescission for misrepresentation against the issuer, and sometimes against the banking house. England is a legal unit—process runs throughout the country; and it is a small country, in which service and suit are easy. England knows no problem like ours of the practical inability of the investor in Nebraska to sue an underwriter in New York. The simpler and swifter methods of the English trial of cases both civil and criminal are also a factor in the English investors' protection; false and dilatory defenses by clever lawyers have short shrift in British courts; Lord Kylsant could probably not have been convicted in the United States. Under these circumstances, therefore, there may be little harm in England in confining the right to damages, given the prospectus-studying English investor by his Companies Act, to those damages which be can show resulted from a fault in the prospectus, such damages being measured by an amount which he can relate to the fault in the prospectus.
(2) The average American investor will often never see the registration statement and will therefore not be able to prove that he relied upon it in his purchase; nevertheless the value of his security will inevitably be determined by the reaction to the registration statement of the investment analysts and the professional investing class who will read and rely upon it.
In America, however, securities marketed in the grand manner are offered under high pressure to small, unprotected, individual investors, not directly by the issuer or the originating underwriter, but by the last in a chain of many intermediaries, each seller of which, under advice of his lawyer, carefully represents to his buyer merely what his seller represented to him. Consequently the American investor has no effective right of rescission for misrepresentation at common law, and has to be given it by the Securities Act if he is to have it at all. Both the American method of buying securities, and the American investor's relation to the many intermediaries through whom his securities are sold to him, clearly require the express safeguard of rescission in a statute to afford the American investor the same practical protection which the Englishman substantially enjoys from the combination of English law and the English method of distributing securities.
Everyone knows that the average American investor—and it is he whom the Securities Act tries particularly to protect—does not buy his securities, but has them sold to him in a hypnotic atmosphere. But, to lean over backward, consider the methods by which that most rare of American investors—the unsolicited buyer who has $1000 of savings to put into a bond—approaches the problem. Country Doctor Jones, with his $1000, consults the investment services to which he subscribes, the president of his local bank, or possibly his friend in a brokerage house; he asks, not for details and prospectuses, but for generalized advice which will simply tell him to buy a bond of X Company. He probably does not see or care to see a prospectus, which he could not pretend to evaluate or understand. He almost certainly would never see a registration statement filed with the Federal Trade Commission in Washington. And it is even possible that none of his advisers would see the registration statement, but would, in their turn, rely upon the generalized judgment of their 'correspondents' in some large securities centre like New York.
Nevertheless, the price at which Doctor Jones, acting on such advice, would purchase his security from a local dealer, and the value it would have in his hands thereafter, would inevitably be fixed by the reactions to the issue on the part of large institutions and individual professional buyers who either purchased or refused to purchase after making their own investigations of the registration statement or after having it investigated by investment analysts in their employ. As a practical matter,—and every securities man knows this, the judgment of big buyers, not that of the scattered, uninformed mass of small buyers, determines the price of any security at any time. The value of the security in Doctor Jones's hands depends, therefore, upon the reliance of other people upon the registration statement, together with any misrepresentation or misleading omission it may include. But Doctor Jones could never prove in court that he himself had relied upon the registration statement.
If, therefore, Doctor Jones is to have effective protection against the actual loss which his pocketbook may suffer because of misrepresentations or omissions in the registration statement describing X Company's bond, he must not be required to prove an impossible case—namely, that he relied upon the registration statement which, even if it reached him, he did not read, and which, frankly, he was not expected to read. As a corollary, he should not be put to the proof, again practically impossible under American conditions, of showing a relationship between a particular misrepresentation and a particular amount of damage to the security. A damaged security should be actually worth just as much to a banker or a director who has to take it back as to a mulcted investor. The only fair and practical protection to the investor is to entitle him to give back the security to any one of its sponsors, thus putting upon them, experienced in the securities business, or at least in this security, the burden of salvaging for their own account the difference between its offering price and its damaged value.
The opponents of the Securities Act argue against the necessity of this last step a general right of rescission—by citing an artfully simplified case. Suppose, they say, a company concealed in its registration statement a contingent tax obligation which would decrease by the amount of $5.00 a share both the book and the market value of stock offered at $25 a share. Why not let the purchaser keep the security and collect damages of $5.00 a share instead of having the whole issue dumped back upon the sellers? The answer is that a case so mathematically simple would not occur once in five thousand times. As a matter of fact, even if it did occur, the careful analyst—he who ultimately determines the market value of securities after studying their registration statements—might mark down the stock much more than $5.00 a share upon discovering the omission, because of its effect on working capital position, or its revelation that management was careless or untrustworthy, or for many other reasons.
Let us suppose a much more usual case. An artificial-gas company falsely represents in the registration statement for its stock that it has no potential natural-gas competition. When the misrepresentation is discovered, the stock falls in value. There is no way on earth to measure the effect of impending competition upon the book value of the stock, or to estimate how much of its decline in market value might have been caused by the disclosure of such competition. Even if the company's stock is listed on a large stock exchange, it may, in falling, fluctuate widely; if it is an unlisted stock, particularly of a small, local company, its market may be hopelessly erratic. Every lawyer knows that in trying to prove damages in court there is no practical problem more difficult than that of establishing the market value of unlisted securities. It becomes even more difficult when the problem is to establish, not market value, but the purely hypothetical degree to which a drop in value may have been caused by a particular misrepresentation in a registration statement. In such a suit for damages, with the burden of proof on the investor, Wall Street lawyers would win every time.
Why should the individual investor, who has little enough to spend on lawyers' fees, have to undertake this difficult burden against a seller or other person who, by reason of an admitted misstatement of a material fact, is prima facie guilty rather than innocent before liability becomes even potential? Why not let the investor simply dump the sour security back upon its sponsor at the original offering price—and let the sponsor undertake to salvage what value there is left in it?
When critics of the Securities Act are pushed to the wall by this argument for practical justice to the investor, they cry that any financial house risks ruin if it puts out a big issue with the chance that it may have to take it all back. The answer to this is that a business which undertakes big volume in order to make big profits must expect big losses when big profits go wrong.
If Jones sells Brown a truck horse by representing it as a race horse, and, in an action for rescission permitted Brown under the common law, has to take back the truck horse for which he has no other purchaser, Jones may be as much 'ruined' as a great banking house which has to take back a whole issue of securities from a multitude of small investors. But, even so, the Securities Act gives the banker an edge over Jones. The banker has a last clear chance to avoid liability if he can prove that, although he misrepresented his securities, he did so in good faith after taking reasonable care and exercising reasonable competence to describe them correctly. The Street's objection to this remedy of rescission which is granted by the Securities Act comes down, ultimately, to a bold assertion of special privilege, that the Big Business of selling securities should not be legally so risky per sales unit as the Little Business of selling anything else!
To summarize. The American Act does go further than the English Act in imposing civil liability by permitting the American investor either
(1) To recover from those liable, even though the investor cannot prove that in buying the security in suit he relied upon a specific misrepresentation in the registration statement; orBut these differences are judicious adaptations to conditions peculiar to America, and they are absolutely necessary to give the American investor a fair deal. The English statute, if applied verbatim to American conditions, would on these points give the American investor no protection at all.
(2) To turn back a security for its full original public-offering price without having to prove the amount of damage arising out of any specific misrepresentation.
VII
ut,' says Wall Street, 'this heavy liability of rescission
may be tolerable against the issuing company, which presumably receives the
proceeds of the issue, and against the many varieties of underwriters who make
large profits on the issue, but it is prohibitively onerous on the directors of the issuing
company who presumably profit only indirectly from the entire transaction. The
English law holds the directors of an issuing company liable to the investor,
but that liability, like all other liability under the English Act, is only for
provable damages, not for rescission.' In evaluating this argument, one should remember that
(1) To confine the rights of an American investor to a suit in which he must prove, first, that he relied upon misrepresentation in a registration statement, and, second, that certain specific damage resulted, would give the investor no practical protection at all. Any liability of a director to an American investor must, to be effective, be in the nature of rescission.The argument is advanced that protection of the investor does not require this liability of directors: let the investor proceed against the issuing company, or against the underwriters, who, presumably, can better afford to take the load. More often than not, however, purchasers suing an issuing corporation for rescission may find that the proceeds of their purchases are no longer with the company, but have been frozen, dissipated, or otherwise lost in the business, and hence cannot be paid back. As for underwriters, it is probably true that most small issues are floated directly by the issuer to the purchaser, without the interposition of intermediary underwriters who could be looked to as responsible defendants if suit against the issuer was not fruitful; and intermediary underwriters may be able to prove that, in acting upon statements of the directors, they exercised due care and competence, and are not themselves liable to the purchaser. As a matter of practical justice it is not possible, therefore, to duck the issue of directors' liability by saying that there are plenty of other people better able to pay the investor.
(2) No director is liable to an investor under the Securities Act unless there first appears in a formal registration statement filed by him and his fellow directors with the Federal Trade Commission, the purpose of which is to induce the public to invest funds in his enterprise, a serious misstatement or misleading omission.
(3) No director is liable to an investor, even then, despite the existence of a serious misrepresentation or omission, if he can show that, individually, he used reasonable care and competence at the time of filing the registration statement to guard against such errors.
(4) The Securities Act gives each director, along with all others liable, a right of contribution against the issuing company, his fellow directors, the underwriters, and all others liable, to spread his loss on any recovery against him by an investor. In other words, the Act puts no obstacle in the way of prearrangement among all those potentially liable for the sharing of liabilities.
(5) The registration statement, with the material misrepresentation or misleading omission out of which liability may grow, is the statement of these individual directors themselves, filed with their approval and by their order. They, as individuals, are the real issuer; theirs is the decision to issue the securities; a majority of them have to sign the registration statement; any one of them who does not sign it and wants to disclaim it has at least twenty days after the filing to disclaim and resign. Even the underwriters rely for information upon the directors or upon the management which the directors have selected. This liability of the directors, then, is a fair and necessary insurance to the bankers who are also liable, as well as to the investors, all of whom put up money relying upon the care and competence of the directors.
The real question here is whether individuals, while acting as directors of corporations, are to be responsible to those whom they injure. Woodrow Wilson put the problem in classic phrase nearly twenty years ago when the New Deal was the New Freedom:—
The present task of the law is nothing less then to rehabilitate the individual . . . to undo enough of what we have done in the development of our law of corporations to give the law direct access again to the individual—to every individual in all his functions.
Corporations do not do wrong. Individuals do wrong, the individuals who direct and use them for selfish and illegitimate purposes, to the injury of society and the serious curtailment of private rights. Guilt, as has been very truly said, is always personal. You cannot punish corporations. Fines fall upon the wrong persons; more heavily upon the innocent than upon the guilty; as much upon those who knew nothing whatever of the transactions for which the fine is imposed as upon those who originated and carried them through—upon the stockholders and the customers rather than upon the men who direct the policy of the business . . . . Law can never accomplish its objects in that way. It can never bring peace or command respect by such futilities.
Society cannot afford to have individuals wield the power of thousands without personal responsibility. It cannot afford to let its strongest men be the only men who are inaccessible to the law. Modern democratic society, in particular, cannot afford to constitute its economic undertakings upon the monarchial or aristocratic principle and adopt the fiction that the kings and great men thus set up can do no wrong which will make them personally amenable to the law which restrains smaller men; that their kingdoms, not themselves, must suffer for their blindness, their follies, and their transgressions of right.
The critics of the Securities Act finally advance a 'practical' argument. No one, they say, will be willing to act as a director of a corporation which needs funds if he has to assume the risks of being careful and competent, or having to share with other careless or incompetent sponsors of the corporation's appeal to the public the burden of making investors whole. American business will be directed completely by dummies. It is noteworthy that the Street's propagandists, when pushed to the wall, ultimately rely on this kind of 'practical' argument, which amounts to saying that:—
1. No matter how just or socially expedient the Act may be, bankers and corporation directors just will not take its 'risks.'It should be frankly recognized that this raises the simple issue of whether it is possible for Congress to regulate the securities business at all. Can the law be made to serve the interests of a democratic community, or must it be written to conform to the wishes of the financially powerful? In short, must the law bow to a capital strike?
2. American financing cannot be done except upon their terms.
As a matter of fact, the threat of dummy directors is a bugaboo. The Act took good care, in Section 15, that this should not happen, by providing that the real parties in interest could not avoid liabilities through dummies under their control. Nor will unndesirable resignations occur on any important scale. The unreasoning fear reported to be current among directors has been deliberately drummed up by Wall Street's loose talk of fantastic liabilities. But it will cool down. The average business-man director will learn that under the Act, as under all law, he can rely for his protection upon his own common-sense judgment; that the Act's standard of due care and competence, before juries of common-sense men like himself, will require him to pay only that decent attention to the corporation's business which stockholders and other investors expect of those who are supposed to be running it in return for benefits received.
In a practical world, no one thinks or expects that directors serve corporations solely for the nominal fees they get. A director serves to protect his large stockholding interests, or for an occasional salary, or connections, or influence, or for other business reasons. All this will not be abandoned overnight. Directors who have a real interest in a corporation through stockholding or otherwise, and a sufficient knowledge of its operations not to be afraid to try to tell the truth about it, will not desert either the corporation or their emoluments. Big stockholders will either hang on to their directorships or get competent representatives to attend to their interests, paying them in proportion to risk and service. The Act will undoubtedly cause considerable shifting in the interlocking and highly 'dressed' picture hitherto presented by the Directory of Directors. The lawyers who should be merely professional advisers, the big names who decorate corporation reports, the 'kept' directors who represent short or inquisitive interests, will resign. Only they will mind!
The same reasons which require that directors assume responsibility for their statements require that accountants, engineers, and other experts be liable for want of due care and competence in representations in the registration statement which can be specifically attributed to them. The banker and the investor risk their money in enterprises and the director acts because of the expert service which these specialists sell and for which they are well paid. It is particularly important, therefore, that every factor be utilized to compel these experts in enlightened self-interest to take the greatest care. It is also important that public opinion should not permit accountants to charge outrageous additional fees to recertify for a registration statement to be filed under the Act their own audits of former years for which they have been adequately paid, and on which the company, the bankers, and earlier investors have already relied.
VIII
he Street puts this case. Suppose a securities distributor
in St. Louis takes what is called a 'selling-group participation' of
$50,000 in a $50,000,000 issue originated by a great New York house.
Theoretically, the Securities Act makes it possible for all investors—even those who have bought the securities from other distributors in Boston,
Seattle, and New Orleans to come out to St. Louis and put the St. Louis house
upon proof of its due care and competence if it is to avoid having to pay the
'outside' investors for their losses. That, say the critics, is inequitable to
the St. Louis house. At this point it is necessary to explain certain phenomena peculiar to the American method of distributing securities. Before the war, most American issues sold through an underwriter were bought from the issuing company by a single originating underwriter, and sold by that underwriter's salesmen directly to dealers at a standardized commission given by way of discount. The dealers, in turn, sold to retail customers. It was a slow, careful business: a good originating house 'brought out' comparatively few issues a year, and had time to make sure of their quality.
After the war, a certain well-known house in the Street invented the high-pressure device of the so-called 'selling group.' The house which 'found the business' entered into a kind of partnership arrangement with a selling group of possibly scores of dealers all over the United States. By this arrangement, each member dealer became in effect a partner in stated proportions with the originating house and with other members in sharing both the risks of selling the issue and the profits of an open-market pool manipulation in the security, which, for additional compensation, the originating house would operate as 'manager' of the group for a stated period of sixty days or more.
From the retail dealer's point of view, pool profits were far more lucrative in good times than fixed dealers' commissions. From the point of view of the originating house, selling-group partnerships with such outside dealers as were willing to take the gamble greatly increased the speed with which it could unload from itself the greater part of the risks of selling an issue. This very speed made it necessary to originate more and more hastily prepared securities in order to keep the complicated selling-group machines supplied with something to sell; and the absorption of investment funds by these high-pressure sales machines forced conservative houses, which would have preferred to do business on the slower basis of quality, to adopt similar tactics in selfpreservation. Finally, these competitive tactics brought half of the investment world to smash.
The Securities Act draws a careful line between those retailers who sell on a fixed commission and the selling-group participants who want to go into pool partnerships with the originating underwriter. The term 'underwriter,' by the express wording of the Act, 'shall not include a person whose interest is limited to a commission from an underwriter or dealer not in excess of the usual and customary distributors' or sellers commission.' Such a retailer, like his salesmen, is liable only to an immediate purchaser to whom he sells under false representation or without revealing what he then knows is a defect in the registration statement.
But all selling-group partners, sharing profits with the originating 'underwriter,' are themselves 'underwriters' within the Act, and each is theoretically liable, like partners in any other business, to suits by every purchaser who may buy securities marketed by the partnership on the basis of a false registration statement—unless, of course, any particular participant can show his own care and competence in the matter. The investor, whose protection is the first interest of the Act, may recover against whichever of such participants is most accessible to suit; he does not have to chase an elusive defendant all over the country. Of course, as a practical matter, an investor who finds, on suing, that his local member of the selling group is judgment-proof, will naturally move, not against the minor members of the selling group in other localities, but against the responsible originating house in New York or Chicago. But the St. Louis house can protect itself against even theoretical risks on any particular issue by conducting its business in one of two ways:
1. It can be satisfied with a straight dealer's discount on its sales, without taking a flyer in pool profits with the originating house.The Act, although it forbids any arrangement whereby an investor waives his rights under it, in no way interferes with any arrangement for indemnity between sellers. The eternal ingenuity of the Street, which has never experienced difficulty in finding a way to divide profits, can safely be relied upon to work out the equally practical problem of dividing losses. Small dealers may feel, perhaps, that big houses will not give them issues to sell on straight commission or with provision for indemnity; but if they stick together, the big houses will have to come around. The principle of 'noninterference with honest business' does not require that adequate protection of investors be sacrificed in order to preserve a technique of high-pressure syndicate salesmanship which, entirely apart from any Securities Act, has already wrecked many investment houses and well-nigh ruined the investment business.
2. It can insist that it will not participate in a selling group, when it does not feel sufficiently sure of the registration statement and the quality of the issue, unless the selling-group agreement includes an arrangement by which the originating house and others o the inner circle satisfactorily indemnify the St. Louis house and other smaller participants against liability for misrepresentations in the registration statement.
Any scheme which confined the liability of a selling-group member to those to whom he sold directly or derivatively would raise, for an investor holding a bearer share of stock or bond, the impossible problems involved in proving his chain of title. The Act has to try to protect more than the first purchaser of a security. That first purchaser may be only a speculator for the rise or a straw intermediary intended to insulate liability. The ultimate investor whom the Act wants to protect may buy at the end of a whole chain of other buyers and sellers that is, on a stock exchange through which the security is really being distributed, from an anonymous seller who passes on a piece of paper already passed through many hands, endorsed in blank or 'in a street name.' How could such an investor prove from what original distributor he derives title? If the Act provided that responsibility should not exceed participations in the selling group, it would be perfectly possible to divide the paper participations in such a way as to throw responsibility under the Act most heavily upon irresponsible houses, while a secret division of the real profits could be effected without the knowledge of the law. The proposal that only those underwriters who signed the registration statement should be liable would make it possible for any number of strong houses really to sponsor an issue through selling groups' support with the names of unimportant houses signed to the registration statement. These points are suggested simply to indicate some of the practical problems touching the protection of the investor which have to be faced the moment an attempt is made to adjust the theoretical equity between underwriters.
IX
t is possible now, after all that has been said, to state
the fundamental scheme and philosophy of the Securities Act. It proceeds on the
realistic assumption that the ignorant and overreached investor is going to continue to be with us; that he has not 'learned his
lesson,' and probably will not be permitted to do so. Utopian theories of
teaching the small investor overnight that he should not sink his money in securities
until after he has made the kind of investigation which he is not qualified to
make and which, in any event, he lacks the power to make—are not a
practical answer. 'It is a condition which confronts us—not a theory.' The Act is practical. It looks upon an investment transaction in this way. On one side is a small investor who pays his money. On the other is a self-constituted, interrelated group who receive the money—the issuing corporation, its directors, its bankers, and the experts they employ on the issue. By agreement among themselves, that group divides the money and its direct or indirect benefits. The portions and the interrelations constantly vary. The receiving group alone knows the 'inside story.' The investor knows nothing, and usually can learn nothing. If, when securities turn out damaged in his hands, he is forced to prove reliance upon the registration statement, and to prove specific damage as well; if he is compelled to thread the maze of interrelations to find the particular person in the receiving group who is to blame and from whom he traces his title—his task is practically hopeless.
The Act, therefore, makes all members of this receiving group who cannot prove their individual competence and care, with relation to the security, jointly and severally liable to any investor to take back a damaged security at not more than its original offering price. All are held because the omission of any will create loopholes and arguments that practically may release all. The Act then does practical justice to the defendant who is sued by giving him an express right of contribution over against any and all of his fellow members of the receiving group who are likewise liable. It assumes that the 'smarter' receiving group, who long ago learned how to agree among themselves when it came to dividing up the profits of an issue, can, by voluntary agreement, either at the time of offering the security to the public or later, achieve the task which no law can attempt--that is, of arranging among themselves an equitable risk of the losses incident to their intricate transactions.
The defenders and the critics of the Act find it impossible to reach agreement because of a fundamental difference in their points of view. The Act looks at the investment transaction from the point of view of 'the investor first'; it lays down those provisions which are necessary, as a practical matter, to protect him, and puts the burden upon the group who get his money to take care of their own interrelations within the bounds of those necessities. The critics see primarily how inconvenient such protection of the investor is going to be to themselves, and how upsetting to the well-worn ways of their selling business. Quite honestly, they cannot conceive why it is not more desirable to sacrifice the protection of the investor than to change their methods of doing business.
But no American Administration need apologize to the Street for attempting to regulate a business as socially expensive as our securities business has proved to be. Nor need it be squeamishly embarrassed if, in its regulation of such a business, it has perhaps not confined itself to the absolutely necessary minimum. The forthcoming test on the inviolability of the Securities Act offers a real opportunity to draw a line on issues much more fundamental than any that may be involved in squabbles over statutory language. We have come to the point where we shall have to take sides! And those who have more than a few years to live, or have given hostages to fortune in children to live after them,—those who do not relish a 'recovery' which shall simply be a seat on a new powder barrel with the fuse already sputtering,—ought to know on which side they stand.
Copyright © 1934 by Bernard Flexner. All rights reserved.
The Atlantic Monthly; Feb 1934; Vol. 153, Iss. 2; pp. 232-250.