Mr. Flexner has confused the issues by countless irrelevant statements and innuendoes which will inevitably inflame the existing prejudice against bankers. He defends the Act by attacking bankers. He talks about the securities business as 'the securities game.' He states or insinuates that Wall Street, a term he uses to describe the dominant class of bankers throughout the country, is stupid, dishonest, profiteering, antisocial. Of course there are dishonest and antisocial men in the banking business, just as, unfortunately, in every other business; but to charge that all or even a majority of bankers are such is an accusation that no reasonable person will believe. His article purports to 'call the bluff on an ugly campaign of propaganda.' Is it in any way wrong or immoral or ugly for anyone to appeal for the modification of a law if he believes that in its present form the law is socially harmful? Is it wrong for those familiar with the subject to express their honestly held views? Is freedom of speech to be denied?
Again Mr. Flexner confuses the issues by attacking Wall Street lawyers. All this is the familiar 'red herring' method of argument. Many an experienced court lawyer uses it when he has a bad case: he tries to divert the minds of the jury from the real issues by arousing their sympathy for his side, or their hatred for his opponent. Mr. Flexner describes the criticisms of the Act as 'wildly exaggerated,' 'absurd,' 'laughably ridiculous.' It is an insult to the intelligence of the readers of The Atlantic Monthly to try to convince them by such tactics. Again Mr. Flexner charges that the critics of the Act are guilty of bad faith and do not honestly believe that their own criticisms are valid, and that the amendments which they propose should not be taken at face value, but are artfully and deceptively designed not to amend the Act but to destroy it completely. Such a charge is really preposterous. It is bad enough to call a man a fool because he differs with you, but to go further and say, 'John Smith must be dishonest if he says I am wrong; he can't honestly believe it'—such cocksureness and self-assumed moral superiority are indefensible.
Let us turn now to the first real issue: is the fundamental purpose of the Securities Act sound?
The answer is clearly 'yes.' The purpose of the Act is to furnish adequate information to prospective investors in new securities.
Mr. Justice Brandeis in his Other People's Money has set forth in detail the importance of publicity in this field. His arguments are so convincing on this point that there is no possible question as to their validity, and it would serve no purpose to elaborate them here. The only serious criticism which has been made of the desirability of the Act in general is that made by certain constitutional lawyers who believe that, under the Constitution, legislation of this type should be adopted by the states and not by the Federal Government. In any broad approach to the problem this argument can be ignored. If the Constitution, properly construed, prevents a Federal Securities Act, amend the Constitution!
Since Mr. Flexner has questioned the good faith of those who, while professing agreement with the purpose of the Act, nevertheless advocate amendments, the writer believes himself to be justified in quoting his previous public statements on the question of publicity.
As far back as March 1925, at a meeting of the Academy of Political Science, I said:
While most corporations publish annual statements which give to the stockholders complete information in regard to the company, nevertheless many corporations fail to do so. The balance sheets and the earnings statements which are published are frequently in such form as to conceal from the stockholder the true facts about the condition of his company. It is therefore suggested that all corporations with more than a minimum number of stockholders should be legally required to publish balance sheets and also earnings statements in a standard and readily understandable form to be prescribed by law.
Two suggestions can be tentatively set forth. The rst is that the requirement of standard annual earnings statements, above referred to, be increased so as to compel monthly earnings statements to be published. The effect of this would be materially to cut down the advance information of the insider and thus to prevent him from taking as great an advantage of the stockholder as at present.
A second suggestion which is advanced with even more hesitation than the preceding one is that directors of corporations should be required to file annually a sworn statement as to all transactions had by them in the stock of the company of which they are directors. It is believed that such a requirement would materially lessen the tendency of directors to deal in the stock of their company on the basis of advance information, and would assist in raising the standard of business ethics in this regard.
Again, at a meeting of the American Bar Association in September of the same year, I stated:—
In order intelligently to exercise the right to vote for directors, some machinery must be created whereby the security holders can be given full information about the company's affairs. Many corporate reports fail to disclose full information, and a requirement of publication of uniform balance sheets and earnings statements would help materially in this respect.
This belief in the fundamental importance of publicity in corporate affairs is not merely the view of one individual, but is held by the great majority of the responsible leaders in Wall Street.
It is a simple enough matter to require that adequate information must be given to the investor. The difficulty arises in deciding what penalty to provide if the information given is incorrect. Here is where the real conflict arises on the Securities Act. Of course, if the information is intentionally incorrect and there is fraud, the sky should be the limit as far as penalty is concerned. 'What, however, should be the penalty if the mistake was made in entire good faith because of some act of oversight, of which we all are occasionally guilty? Murder deserves one penalty, automobile speeding another. What is the appropriate remedy in this case?
To answer this question, the extent and importance of the evils which the Act is designed to correct must be weighed. Some supporters of the Act believe that if it had been in effect during the boom years the larger portion of the losses to investors in securities would have been prevented.
This view is largely erroneous. The great losses suffered through securities purchased in the boom years have been due primarily to the effect of the world-wide depression, which has caused values and prices not alone of securities but of all commodities to fall precipitously. In some cases mismanagement has caused the losses. But fraud, error, or omission in circulars has only occasionally been their cause. With comparatively few exceptions, the losses suffered by investors in securities have been due to the fact that the investors and the investment bankers, like everyone else in the country, mistakenly believed that the New Era was here to stay. The Securities Act will help in requiring full information, but, whether amended or not, it will not prevent security investors from suffering losses due to economic causes.
No clearer statement of this can be found than that of Mr. George W. Edwards, a severe but fair critic of American finance. In an article in the Harvard Business Review he writes:—
It is generally believed by the public that its heavy losses have been due to the issuing of fraudulent securities by the investment bankers. As a matter of fact there have been only a few cases of fraud actually proven against investment bankers. The various federal hearings on financial legislation did not, with the exception of the case of Kreuger and Toll, disclose conclusive proof of fraud in the case of any of the securities listed on the New York Stock Exchange, which represent the greater volume of the issues floated in past years. Even in the case of foreign bonds there were only a few cases of misrepresentation which would have brought such issues under the operation of the Securities Act had it been in force at the time. Fraudulent securities were sold in the period before the financial crash, but the amount was small in comparison to the total amount of securities issued.... In other words, the main errors of financial policy, namely the issuing of securities of poor quality and of too great a supply, are still outside the scope of the Securities Act.
The question of what reforms are desirable in order to correct or mitigate in the future the errors referred to by Mr. Edwards is, of course, outside the scope of this article. It is clear, however, that the Securities Act will never accomplish these results.
The thesis of this article is that under the Securities Act, to paraphrase the words of Gilbert and Sullivan, the punishment does not fit the crime. The Act imposes too severe penalties for honest mistakes. These penalties are far more severe than those in England, which has had legislation upon this subject developed over a period of many years and now existing in the form of the Companies Act of 1929.
What is the basis for this view? Bear with us if we are a little technical.
1. In England, if a circular contains an honest mistake, the investor can recover only to the extent that the mistaken statement caused damage to him. Under the Securities Act, he can recover even if the loss was in no way caused by the mistaken statement, and he can recover the full price he paid on the original offering.
Apply this principle first to some other business. John Smith buys an automobile with shatterproof windows. Some time later, while the car is standing in front of his home, a tree falls upon it and demolishes it completely. John comes out and looks sadly at the wreck. Suddenly his face lights up and he says to his wife: 'Don't worry. Do you see those windows that are broken to bits? Well, the dealer who sold me the ear said they were shatterproof and they weren't. It is a material misrepresentation, and so, under the new Truth in Automobiles Act, I can get back the whole amount I paid for the car.'
This illustration isn't funny. It isn't absurd. It is an exact application of this provision of the Securities Act. Under the English theory, of course, he could only recover the difference in value between ordinary glass and shatterproof glass.
Take a case not of automobiles but securities. Assume the Act was in effect when an industry such as the bicycle business was in its heyday. Stock was sold on a prospectus that contained a material mistake as to the company's earnings for a prior year. If the bankers had used due care they would have found out this mistake. Years afterward the new competition of automobiles arises, and nine years after the security was sold the bicycle company goes bankrupt because of such competition. An investor employs a lawyer who discovers the mistake in the circular, and the investor sues the bankers or directors and recovers the full amount that be paid for the stock nine years previously, although there was absolutely no relation between the mistake in the prospectus and the loss suffered by the investor.
What possible defense is there for such a result? To allow full recovery in such a case is to give the investor a Christmas gift and to make someone else pay for it. In England, of course, he would recover only the difference in value between the stock when he bought it and what it would have been worth at the time if the earnings statement had been correct.
If it is urged that the case put above is an unusual one and will rarely occur, the answer is short—that there are innumerable cases where there may be an honest mistake in a circular about a material fact and yet where the loss suffered by the security holder is in no way caused by such misstatement, but by subsequent mistakes of management, general economic conditions effecting a decline in the values of all securities, or other factors.
It has been claimed that, admitting the Act is wrong in imposing liability where the mistake in no way caused the loss, yet at least it is so difficult to prove that a mistake in a circular caused any particular amount of damage that this proof should not be required. Of course the amount of damages cannot be proved scientifically in any branch of the law, but is determined by rough justice. This is no reason for abolishing proof of damages in one particular field of the law. Moreover, looking at the problem realistically, juries must decide these questions, and one can rest assured that no investor suing a director or banker will be deprived of his just due because of theoretical doubts as to the exact amount of damage to which he is entitled.
2. The second difference between the English and American laws is that the English law permits recovery only by an investor who purchases the stock on the offering in reliance upon the prospectus. The Securities Act, on the other hand, permits recovery by anyone who may have purchased the security, upon a stock exchange or otherwise, within ten years after the original offering and even if he never saw the prospectus containing the mistake.
Apply this principle also to some other business. John Smith buys a house upon the representation of the seller that all the pipes in the house are brass. In fact they are not. After a year, John Smith sells the house to John Smith 2nd, who in turn resells it; and, after a succession of such sales, in the ninth year the house comes into the hands of John Smith 9th. Real estate values then decline. Having learned in some way, after his purchase, of the incorrect statement made by the original seller to John Smith 1st, John Smith 9th, who has never previously heard of the misstatement, is allowed to recover from the original seller.
On the face of it, this result is absurd. Yet the Securities Act requires it. Under the English law, of course, he could not recover.
Mr. Flexner, in his article, argues that a difference between the English and American law in this regard is justified because of the difference in the methods of distributing securities in the two countries. Summarized briefly, this claimed difference is that the great bulk of securities are purchased in England by experienced investors, while in America securities are distributed through salesmen to small, inexperienced investors throughout the country. This inexperienced American investor, Mr. Flexner then goes on to. state, 'probably does not see or care to see a prospectus.'
This statement by Mr. Flexner was undoubtedly an inadvertence. Under the Securities Act the American investor who purchases on the original offering, or within a year thereafter, must have the prospectus delivered to him if interstate commerce or the mails are used in connection with the sale. The Act makes it a criminal offense for anyone to sell a security to him through the mails or in interstate commerce without a prospectus being delivered at the same time, provided the purchase is made upon the original offering or within a year thereafter.
The American investor who thus purchases a security from the issuing bankers or any dealer connected with the distribution, upon an original offering or within a year thereafter, would be fully protected under the principle of the English Act. He would have not the slightest difficulty in proving that he had relied upon the prospectus, since it must have been delivered to him.
The person who would not be protected under the English Act but would be under the American Act is not the bona fide investor who purchased the security through the solicitation of a salesman, but the man—often a speculator who, some number of years after the public offering, bought the security on a stock exchange or elsewhere without ever having seen or heard of the prospectus. 'What is there in American conditions which makes it fair to give such an individual the right to recover from the original directors and underwriters with whom he has had no contact of any kind, upon the basis of a circular issued years before, which he has never seen or heard of, and which has in no way induced him to purchase the security?
The point has been made that both in England and in the United States an investor who buys in the open market may be indirectly affected by a circular or registration statement which he has never seen, because of the creation of a general public belief based upon the statements in the circular or registration statement. 'Whatever validity there is to this argument, it would seem to be fully met by the provision in the Securities Act requiring that the circular be delivered on all sales within a year after the original offering, provided that the Act were amended to permit recovery by persons who bought in intrastate transactions within a year after the original offering, even though reliance could not be. proved. For, as has been stated in an article in the Yale Law Journal by Professors Douglas and Bates: 'In most cases after a year or so the statements made in the registration would have become outmoded and wholly discounted by a host of other factors.'
3. A third difference between the English and American laws is that the English law imposes liability for an incorrect statement unless the director or investment banker can prove that he had reasonable ground to believe it to be true. The American law adds to the English law the further provision that, in determining what constitutes reasonable ground for belief, the standard of reasonableness shall be that of a fiduciary.
This difference also is a very practical one. The standard of care imposed upon a fiduciary is that imposed upon a trustee. It is substantially greater than that imposed upon an ordinary business man. Just how much greater is a matter of legal debate. However, the draftsmen of the Securities Act certainly believed that it imposed a higher degree of care or they would not have taken the pains to add this requirement to that contained in the English Act.
The importance of this difference can best be appreciated by a practical example. During the boom period there was a great deal of chain-store financing. It never occurred to anyone at that time that long-term leases might be a liability rather than an asset. Yet, as a result of the depression, many of those chain stores which had long-term leases were compelled to go into bankruptcy, whereas the more fortunate stores with short-term leases have survived. Assuming that the Securities Act had been in effect at the time such securities were issued, should a court hold that, since a fiduciary is held up to a higher standard of care than an ordinary business man, failure to set forth the terms of the leases in the prospectus constituted the omission of material contracts not made in the ordinary course of business, which if he had used due care he would have mentioned, and that therefore he is liable? Hindsight is always better than foresight, and even under the British Act difficult questions of this kind arise; and juries in small communities naturally prejudiced against corporations and bankers will tend to decide such questions in favor of the small investor. Is it fair to impose a still further burden upon directors and bankers by setting up a more severe standard?
These questions, like most other questions under the Securities Act, are jury questions, and anyone familiar with the decisions of American juries in negligence cases knows that one of the real differences between England and America is the tendency, natural in a democratic community, to favor Main Street and not Wall Street. Who can say how much this will be increased when the judge in his charge to the jury must state that in determining whether the defendant has used due care they must judge him, not by the standards for an ordinary business man, but by the higher standard for a trustee?
There is a further practical side to the matter. If a mistake occurs in the registration statement, the burden of proof is on the defendant to show that with due care he could not have found it. Even if the fiduciary provision is omitted, he will still frequently have great difficulty in establishing his defense, although it may exist. How many of us could, if called into a court of law to-day, prove with respect to some transaction we entered into ten years ago that we acted reasonably and with due care, when it has since developed that the transaction has turned out badly? Under the Act, the presumption is not of innocence but of guilt, and frequently an innocent man may be unable to overcome this presumption because of loss of records, death or absence from the country of the expert, partner, or employee who made the investigation of the particular company, or for other reasons.
4. The fourth difference between the English and American laws is that under the English law a director or banker is not liable if there is a mistake in any of the financial statements in the circular provided they have been verified by competent accountants. The Securities Act provides that the director or banker will be liable in such a case if the accountants have made a mistake, unless he can sustain the burden of proof that he had reasonable ground to believe that the statements were true.
In order to be safe under the American law what further investigation must the directors and bankers make? Must they employ a second firm of accountants to check the first? Why, in the absence of intentional fraud, if they have employed competent accountants to verify the figures, should they not be able safely to rely upon the accountants' report?
There is no reasonable answer to these questions. The American Act imposes an unfair burden in this regard upon the director and banker.
5. There is a fifth difference between the English and American laws. Under the English Act a member of an underwriting syndicate is not liable unless his name appears on the prospectus. The Securities Act provides that every member of the underwriting syndicate is subject to liability even though his name does not appear on the prospectus.
Accordingly, in order to avoid liability, the practice is frequently followed in England of having on the prospectus only the company's name or the name of some finance corporation formed for the purpose. In America the practice is to have the names of the leading underwriters and also of the more important participants, and frequently, on a large issue, the names of numerous bankers appear on the circular.
Furthermore in America, while one or two banking houses in one of the large financial centres usually originate new financing, it is the practice to form syndicates consisting of investment bankers all over the United States, each taking small participations in the underwriting. For example, take the case of an issue of $5,000,000 of bonds, on which a net profit of 3 percent is paid. The two leading investment houses will each take a participation of $500,000 upon which their net profit will be $15,000 each, and forty investment houses throughout the country will each take a participation of $100,000, upon which their net profit will be $3000 each. If, subsequently, it should appear that through an absence of due care a material mistake had crept into the circular, the holders of the $5,000,000 of bonds could recover the whole $5,000,000 from either of the two leading bankers, each of whom made a profit of $15,000 on the transaction, or from any of the forty other bankers, each of whom made a profit of $3000.
This result would, on the face of it, seem inequitable and an undue burden upon the investment bankers. While it might be answered that any single investment banker could sue his associates and obtain contribution from them, it would be possible in many cases either that the associates were not financially responsible or, if a period of ten years had elapsed before suit had been brought, that his associates had gone out of business.
It would seem much fairer to amend the law so as to provide that no single investment banker could be sued for more than the total number of bonds representing his participation in the transaction and sold by him to the public. It should be noted that this suggestion is not to amend the American law so as to conform with the English Act by relieving those whose names do not appear on the prospectus; this would be going much too far in permitting bankers to avoid liability. However, even if the recommendation just made were adopted, it would be possible that one of the leading bankers who had made a profit of $15,000 would have to take back $500,000 of the bonds which at the time may have proved worthless. And this would be the case not because of any fraud on his part, but merely because of the failure to use due care in discovering a mistake made by others.
Certainly an act which in its amended form would impose this risk of liability upon the bankers could not be said to be an act giving the bankers 'Sovereign Immunity.' On the contrary, investment bankers may well claim that the imposition of as great a liability as advocated in this article creates a risk which a prudent business man would not assume. Liability may rarely exist, but when it does the banker will probably be ruined; a 1 per cent chance of losing $5,000,000 is far more serious than a 50 per cent chance of losing $1000. And there is no other business in which the consequences of an innocent mistake can be as disastrous as they will be to the investment banker even if the Securities Act is amended to the extent proposed here. No dealer in automobiles is subject to the risk that, because of a single mistake, he can be successfully sued for an amount far greater than his capital and sufficient to bankrupt him several times over. Certainly no one can reasonably say, as does Mr. Flexner, that the acceptance of the amendments proposed in this article would be a great victory for Wall Street and would completely destroy the effectiveness of the Act.
What will be the effect on American business if the Act is not amended?
Investment bankers are at the present time exceedingly unpopular. The cause of this unpopularity is in large part the fact that so many of the securities sold by them during the boom period have declined in value. However, the question is not whether investment bankers or any other group are deservedly or undeservedly unpopular, but whether they fulfill a necessary social function.
The furnishing of long-time capital is an essential cog in any economic system, whether capitalistic or communistic. It is necessary for the refunding of existing issues, for the furnishing of capital to new businesses, and for the enlargement of facilities of existing businesses. Without it our entire industrial system would be jeopardized. And not only is this true in general, but it is especially true during a period of emergence from a great depression. This is an economic truism, but so important is it that a quotation will be of interest.
Mr. Leonard P. Ayres in The Economics of Recovery says:—
The unemployment that results from the decreased demand for durable goods is most of the depression unemployment. It can be cured by the sale of corporation bonds, and it is probably true that that is the only way it ever has been cured in our long economic history except by the advent of war.
Who should carry on the activity of furnishing this essential long-time financing? There are critics of the existing economic system who believe that this function should be assumed by the government. Professor A. A. Berle, Jr., writes in the Yale Review:—
In a word, it is not surprising that there is a definite movement to take many of the attributes of finance away from investment bankers and put them into the hands of the government.
Mr. G. D. H. Cole, in The Socialization of Banking, advocates a National Investment Board which
would have to possess authority to raise capital from the public by borrowing, as such existing agencies as the Central Electricity Board are already authorized to do; and the government would be in a position, if it so desired to guarantee these National Investment Board issues in whole or in part, in the same way as it has in the past guaranteed certain Public Utility issues for example, in the case of the London Underground Railways. The Investment Board, thus raising its capital from the public, would then be in a position to reinvest it in approved schemes of economic development.
There is not sufficient space in this article to discuss whether or not this programme is desirable. It must be assumed for the purpose of any discussion of the Securities Act that investment banking is to be conducted by individuals and not by the government; if the government is to take over the underwriting business, no Securities Act will be needed.
Who are these individuals to be? Under recent federal legislation, commercial banks have been forbidden to carry on this activity directly or indirectly except in the case of municipal or government bonds. Investment bankers thus remain as the only individuals to exercise this function, and they must be permitted to continue in business subject to proper regulation.
Would you, as a reasonable man with some capital, wish to enter the field of investment banking if the Securities Act remains unchanged? Would you wish to jeopardize your entire capital every time you took an underwriting participation and incur the risks of liability which arise under the Act not from fraud or dishonesty but from failure to live up to the requirements of care imposed? Would you, for a profit commensurate with the normal business risks in the transaction, subject yourself to contingent liabilities amounting to hundreds of times your profit?
Perhaps you would, and then again perhaps you wouldn't. No, it is not sulkiness or passive resistance to the Securities Act which makes investment bankers reluctant to underwrite new issues if the Act is not amended.
Just how much effect the Securities Act already has had is difficult to say. Undoubtedly some critics of the Act have gone too far in pointing to the small number of new security issues since July 1933 as evidence of the effect of the Act. The truth certainly is that the most important factor in producing this result has been the general business and financial condition of the country. It is impossible to measure scientifically the effect of the Securities Act as an obstacle to new financing. Very substantial effect it has had. Notwithstanding existing conditions, there has been since July 1933 a large amount of new offerings of municipal securities of both good and doubtful credit, which are exempt from the Securities Act. There are industrial issues, of at least as good credit rating, the issuance of which has been prevented by the Securities Act. Specific instances could be named where this has been true.
Of course it is not true that while the Securities Act remains unamended there will be no new financing subject to it. While up to the present time, with few exceptions, there has been no financing of major importance, undoubtedly there will be companies that have maturing bond issues which even in this market can easily be refunded. The directors of such a company are faced with the alternative of refusing to register the new refunding issues, with serious consequences to many thousands of the company's existing security holders, or of assuming the serious risks of the Act. The fact that they elect to choose the latter course will, of course, be no evidence that the Act has not a great deterrent effect upon new securities. Most directors and bankers, notwithstanding some views to the contrary, still have a sense of social responsibility, and will, if need he, subject themselves to personal risks to save their company and its stockholders from receivership. Where no such emergency exists, however, the same directors and bankers will be loath to incur such risks merely for the purpose of raising additional capital to improve or expand the plant of their company.
There is every reason to believe that if the Securities Act is not amended the following results will appear:—
1. It will be vastly more difficult for even the best companies to raise needed capital.
2. The profit spread demanded by such bankers as will be willing to assume the greatly augmented risk and the fees charged by experts will be substantially increased. The burden of this additional expense will of course fall on the stockholders of the companies selling the securities.
The ultimate result of all of these consequences may be to force the government to step in as the only or chief source for the supply of capital either for new enterprises or for the refunding of obligations of old enterprises.
Mr. Flexner, in his article, charges that, to the extent that the Securities Act is a deterrent on new financing, it is due to a boycott against the Act engineered by the bankers in reliance upon opinions of their counsel, who have conjured up wholly imaginary fears with respect to the operaÐtion of the Securities Act in a campaign to bring about its amendment.
The charge that lawyers have attempted to conjure up bogy men is baseless. The criticisms of the Act made above are not fanciful. The provisions of the law discussed above are clear. The dispute is solely whether those provisions are unfair and impose unreasonable risks upon directors and bankers.
There are numerous other criticisms of the Act which might be made. The writer has, however, carefully avoided commenting on any point on which lawyers might differ as to what the correct construction of the Act is. There are many provisions of the Act which are doubtful and ambiguous, and which if given a construction adverse to directors and bankers would even further increase their risks. That this is the view not only of corporation lawyers but of impartial students is evidenced by the following statement by Professors Douglas and Bates in the Yale Law Journal:—
There are many uncertainties and obscurities in the Act. Hence the ultimate interpretation as to its scope or applicability to many transactions and individuals is of necessity unpredictable. Once a transaction is held to fall within the Act, the nature and extent of liability remain uncertain.... If, therefore, it is the desire of Congress 'to protect the public with the least possible interference to honest business' in accordance with the President's mandate, the Act should be amended promptly not so as to change its fundamental principles but in order to make it unambiguous, clear, and consistent.
In any discussion of the ambiguities of the Act, fairness requires that praise be given to the Federal Trade Commission for the administrative rulings which they have been making under the Act and through which they have attempted to remove such ambiguities and mitigate some of the hardships of the Act.
The Securities Act in its present form will have a particularly harmful effect with respect to directors. Under the Act the new and greater liabilities described above are imposed not only upon underwriters but upon directors. They are imposed equally when a corporation issues securities to the public, when it gives its stockholders the right to subscribe to additional stock, and in certain forms of corporate reorganizations.
These new liabilities are imposed upon directors who themselves, in contradistinction to the bankers, are making no profit out of the transaction. They may be small stockholders or large stockholders, but as stockholders their interest in the company is only that of the other stockholders who are not directors. Again, they may be merely representatives of institutions owning securities of the company; or again they may be directors having no appreciable financial interest in the company, but asked to serve upon the board for the benefit of their business advice and experience. Why should such men be subjected to the new great liabilities of the Act which flow not from dishonesty or fraud but from errors or omissions in a circular or registration statement dealing with facts as to which they cannot have personal knowledge and with respect to which they must rely upon the officers of the company and others?
It is very easy to say that directors should know all about the business of their company. As a practical matter this simply is not possible. The only persons who can know all about the business of any company are the officers who devote their entire time to its affairs. Even then, in the case of a large company, no one officer can know all about everything. Yet the registration statement for which the directors must be responsible contains multitudinous facts which no one person can possibly know about. Has the reader any idea what is in a registration statement? Anyone who thinks that a registration statement is like the short circular required by the English Act, which can be easily read and checked by each director, is living in a fool's paradise. Although it may seem incredible, under the Securities Act the registration statement of a large company will of necessity be a printed book of two or three hundred pages. How can a director possibly himself check the correctness of everything in it, using the high standard of care required by the Act in making this check? An inadvertent error may make him liable for the whole issue. If he has relied upon honest and competent executives carefully selected; if he has employed expert accountants and counsel of integrity and standing and has honestly relied upon them, it would seem that he has fully discharged his duty. To impose a further duty of checking seems impracticable.
The liabilities imposed by the Securities Act upon directors are unreasonable. If the Act is not changed it will tend to have the effect of reducing boards of directors to the operating officers of the companies. Such a result would be socially most undesirable. No one familiar with the affairs of corporations can fail to realize the importance of having upon their boards of directors men of broad business experience and judgment who themselves have no direct connection with the operation of the company and who can bring to bear upon the company's particular problems the experience gained in wider fields. The liberalizing effect upon operating officials of the point of view of outside directors is not generally realized.
It is of course true that a practice has developed in the United States of having large and unwieldy boards of directors, many of the members of which know nothing about the corporation's affairs and merely lend their names to it. This practice is properly to be condemned, and the Banking Act of 1933, in reducing the membership of boards of directors of banks to a maximum number, is the expression of a sound policy. However, it would be equally unsound to create through the Securities Act a situation where no outside directors would be willing to continue to serve and the officers of our vast corporations would be left as the sole directors.
For the legitimate protection of these outside directors, the Securities Act should be amended so as to include the section in the British Act providing that, with respect to a director, if it appears 'that he has acted honestly and reasonably and that, having regard to all the circumstances of the case, including those connected with his appointment, he ought fairly to be excused for the negligence, default, breach of duty or breach of trust, the court may relieve him either wholly or partly, from his liability.'
Some of the effects on bankers and directors if the Securities Act is not amended have been pointed out. There is another very important effect of the Securities Act in its present form. This effect will be produced on the existing holders of securities of all companies which may hereafter have to finance. It also will be produced upon the credit standing of such companies.
These effects proceed from the fact that the Securities Act imposes a further and additional special liability upon the corporations themselves issuing new securities.
In an action against underwriters and directors there is always the possibility of a defense upon the ground that the mistake in the prospectus could not have been discovered by one using a fiduciary's standard of reasonable care.
In an action against the corporation itself, this defense is not permitted; the liability is absolute if there is a material mistake in the prospectus.
The effect of this provision is that if, with the best of intentions, a material error or omission appears in the prospectus, and even though it could not have been discovered if the highest standard of care possible had been lived up to, nevertheless the purchaser of the security can recover the purchase price from the company unless it can be proved that he knew of the error or omission at the time of his purchase. From this it follows that if the company has gotten into financial difficulties, or is in bankruptcy or receivership, someone who purchased common stock ten years previously may have a claim against the company ranking equally with the claims of creditors.
This means that bona fide bondholders, merchandise creditors, and commercial bank creditors may have to share the company's assets in bankruptcy with common stockholders just because there was an unavoidable mistake in the circular. The existence of this liability may put in jeopardy the credit of any company which has sold stock within ten years.
It is impossible to see how this result is a just one. Needless to say, of course, the English law is contrary. This absolute liability provision of the Securities Act also applies another way.
The Act provides that anyone who controls a company is likewise absolutely liable in the same way as the company itself. The Act does not define 'controls,' and, as has been well stated elsewhere, 'no one knows what "controls" will be held to mean.' At any rate, it certainly includes an individual or an estate or a charitable institution, like the Hershey Foundation, which, while having no active control over a company's affairs, owns a majority of the voting stock or a lesser amount sufficient to assure the election of the board of directors.
What possible reason is there why such a stockholder should be held absolutely liable because the corporation in which the stock is owned has, in issuing a security, accidentally made a mistake in a circular, and when there has been present not only no dishonesty but not even any carelessness? This result, which, of course, is not produced by the English Act, is indefensible.
Obviously, this criticism of the 'control' provision of the Act does not mean that it should be entirely eliminated. It is only in the type of case discussed above that it produces an unsound result. Of course underwriters should not be permitted to avoid their proper liabilities by forming dummy companies with a nominal capital to carry out their transactions.
The issue in the so-called fight on the Securities Act is a perfectly simple one. Like most legal questions, it is a matter of degree and of where to draw the line. On the scales of justice must be balanced, on the one side proper protection to investors, and on the other side the avoidance of undue burden upon legitimate business. The writer does not object to protection to investors. On the contrary, he believes in it whole-heartedly and would join the supporters of the Act if the issue were its repeal instead of merely its amendment in certain respects. If all false issues are ignored and
the arguments presented above are considered on their merits, the writer, at least, is convinced that a majority of impartial readers must agree that the Securities Act needs amendment.
If this conclusion is accepted, how shall amendment be accomplished? Speed is essential, since it is desirable to remove as promptly as possible the existing brake on new long-time financing. At the same time, it is necessary to create machinery to ensure that the amendments proposed are carefully drawn, reasonable, and do not go too far.
To that end the following dual programme is suggested:—
First: Immediate enactment by Congress of the eight amendments proposed in this article. All of them are merely proposals to eliminate differences between the Securities Act and the English Act. Even if the views herein set forth are deemed in part unsound, no great social harm could result if, for a period of six months or a year, American investors were to be given protection which is greater than that accorded to English investors. On the other hand, the advantage would be that during this period the harmful effects on business, which many persons believe to exist under the present form of the Act, would be eliminated.
Second: The appointment by President Roosevelt of a committee with a personnel of such unimpeachable standing that it will command public confidence. Such a committee might properly include in its membership an industrialist, an investment banker, a corporation lawyer, an economist, a professor of law, a legislative drafting expert, an accountant, one of the draftsmen of the present Act, and a member of the Federal Trade Commission. Such a committee should be instructed to make a thorough study of the Act and of possible amendments, and be required to hold full public hearings at which all points of view may be presented, and to report its recommendations within a period of six to twelve months so as to enable Congress at its next session to enact well-considered and permanent legislation upon this subject.