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.
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.
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.
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.
It 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.