TEN
MMUFACTURIIVG SECURITIES

Our branch offices throughout the United States are already working to make connections with the great new bond-buying public. Our newer offices are on the ground floor [We] are getting close to the public… and are preparing to serve the public on a straightforward basis, just as it is served by the United Cigar Stores or Child’s Restaurants.” So “Sunshine Charley,” president of the National City Company, lectured his salesmen. Mitchell, known as the greatest bond salesman of all time, was sharing his retail brokerage vision with the new recruits. And it was Charley Mitchell, perhaps more than any other American, who was the complete embodiment of the incredible transformation in American business, social and economic life that had begun more than twenty years earlier.¹

Mitchell graduated from Amherst in 1899, four years behind his partner in prosperity, Calvin Coolidge. He started his professional life in Chicago, working as a salesman for Western Electric. After promotion to assistant manager in 1905, Mitchell moved to New York where he worked as an assistant to the president of the Trust Company of America, one of the trust companies that J. P. Morgan helped to bail out during the Panic of 1907. His education forged in this trial by fire, Mitchell formed the brokerage house of C. E. Mitchell & Co. in 1911.

In 1916, Frank Vanderlip of National City Bank called upon Mitchell to head the bank’s securities affiliate, National City Company. National City, one of the new organizations used by national banks to get around the laws that prohibited them from dealing in securities, had recently absorbed N. W. Halsey, a brokerage house with an unusually developed national network. Halsey’s president, Harold Stuart, left to form his own business. The resulting vacancy gave Mitchell the chance to define the modern securities market and make it a central part of American culture. National City sold bonds. Not until 1927 would common stock form a regular part of its inventory. Regardless of the kind of securities it sold, it completed the transformation of securities from mere investments or speculative playthings into something very much like consumer products. This was Mitchell’s legacy. It was the final thread that tied together the speculation economy.²246

The National Banking Act meant to keep national banks out of the securities business. The Act limited the powers that national banks were permitted to exercise, and dealing in securities was clearly not one of them. Banks evaded this restriction by claiming it was among their incidental powers. The comptroller of the currency responded by contradicting this interpretation of the Act. Some banks still invested, and the comptroller had eased his position slightly over the years since 1902, but the stricture remained pretty clear. In response, several banks began to form separate companies known as investment affiliates to engage in underwriting, brokerage and investment activities.

Investment affiliates were separate from their banks, complying technically with the law. But they were two sides of the same coin. National City Bank declared a 40 percent dividend to encourage its shareholders to buy company stock and they did. The stock certificates for each company were printed on the opposite sides of the same sheet of paper. A stockholder could not sell one without selling the other. And the stock was held by trustees for the shareholders so they could not even vote.³

There were several different methods of achieving this goal of marrying a securities affiliate to a bank so that for all intents and purposes they operated as one. The First National Bank issued The First National Company’s stock in the name of six trustees to be held for the benefit of its stockholders. Chase National Bank created its affiliate as a subsidiary and then spun off its shares directly to its stockholders, who in turn put the stock in trust with Bankers Trust Company. Some bolder national banks owned their trust companies directly as subsidiaries. No matter which of these or several other techniques the banks used, their shareholders remained unified so that the relationship between the bank and its affiliate was assured.

While the banks could not engage in the securities business directly, they effectively invested by providing the capital for their affiliates’ activities. Needless to say, this exposed the banks’ assets to precisely the kinds of risks that had brought down the trust companies in the Panic of 1907. The practice came to an end in 1933 when banks and their affiliates were torn apart by the Glass-Steagall Act. But in the days before the Crash, Sunshine Charley had built the biggest retail securities brokerage in the world, and his public cheerleading had helped to make the securities market a new national pastime.⁴247

The 1920s was, of course, the explosive decade in the market and the decade when Mitchell and his company realized their promise. It was the decade in which all of the earlier sales and speculative techniques were concentrated and perfected, and new ones like investment trusts, the predecessors to today’s mutual funds, were created. The vastly increasing middle class, measured by annual incomes over $5,000, expanded by two-thirds between 1922 and 1929. Consumer culture had arrived. “Rayon, cigarettes, refrigerators, telephones, chemical preparations (especially cosmetics), and electric devices of various sorts all were in growing demand…. For every $100 worth of business done in 1919, by 1927 the five-and-ten cent chains were doing $260 worth, the cigar chains $153 worth, the drug chains $224 worth, and the grocery chains $387 worth.” The almost 6.8 million automobiles on the American roads in 1919 grew to 23 million by 1929. And there was yet another popular item for consumers to buy—Sunshine Charley’s bonds.⁵

Mitchell’s sales techniques were in the vanguard of the expanding brokerage business. But his vision was realized, and his techniques refined, during that most patriotic of capital campaigns, the Liberty Bond drives of the First World War. Americans were sold the new investments by volunteer investment banks spurred on by volunteer committees, coupling patriotism with a safe investment. The combination of advertising and salesmanship used in the Liberty Bond drives catalyzed the transformation of the American middle class into the American investing class. While a postwar slump in the market delayed things a bit, by the end of 1921 the great transformation was on its way to permanence.⁶

In its debut issue of July 30, 1919, the short-lived popular financial magazine, The Street, explained why it had begun publication: “Previous to the war the investing class in this country was extremely limited in numbers…. 25,000,000 Americans now own Liberty Bonds… and are already interested as potential and actual investors in American securities.” In the issue’s lead article, a former assistant treasury secretary praised the brokers who volunteered their time to sell the bonds and noted that “Their reward in the future will come not in commissions from the Government for the sale of Government securities, but in a wonderfully well-educated and eager market for securities of the highest type of excellence and merit.”⁷

I will conclude by tracing the critical prelude to the 1920s, the path of the American securities market as it became a consumer market. This period also included the final conceptual transformation of securities regulation from the overcapitalization concerns of antitrust and banking stability to a disclosure-based consumer protection law as the market emerged from the prewar depression and the end of Wilson’s legislative program to leave America on the cusp of its “return to normalcy” and the Coolidge prosperity. For by that cold March day in 1921 when a sick, defeated and broken Woodrow Wilson rode from the inauguration of Warren Gamaliel Harding to his final home on S Street in Washington’s Kalorama neighborhood, all of the ingredients of modern American corporate capitalism were in place. The ideas that would coalesce into the New Deal securities legislation had all more or less been put on the table: common stock had become accepted as an investment security suitable for the middle-class investor, and the middle class was buying; modern securities selling methods through retail brokerages and aggressive sales techniques had developed; the giant modern public corporation was a fact of life; and the business of America was finance. This is the story of those final years.248

WALL STREET IN A TIME OF WAR

The New York Stock Exchange reopened for full trading on December 12, 1914, although it prohibited short sales and futures contracts and required all settlements to be in cash. The Exchange’s restriction of the practices that it had defended so forcefully during the Pujo hearings made perfect sense in the new sensitive and uncertain economic environment. Europeans, desperate for money to finance the war, held $2.7 billion in American securities, suspending a Damocletian sword that could skewer the American markets in the event of a major European sell-off. The fear of a sell-off remained palpable and the balance of trade had yet to reach its extraordinary level in favor of the United States that would shore up the money markets. So it was not only reasonable of the Exchange but also perhaps its only prudent move to impose strict limits on traditional speculation. After all, part of the history of the American stock market up until that point had been concern with the destabilizing effect that speculation had on the overall economy. After almost three years of depression and an uncertain economic future, stability was crucial.

Americans had nothing to fear. Although $500 million in American securities made their way back from Europe relatively quickly, followed by another $1.5 billion by the end of July 1916, the sales were orderly and the anticipated panic never occurred. A substantial portion of the returning securities were pledged by European sovereigns who had bought them up as collateral for American loans, although the governments also liquidated many of them on the American market. Large shipments of Allied gold to the United States prevented these sales from creating massive interest rate increases. Moreover, an informal trading market had developed several weeks after the exchanges closed and prices on this market, while lower at first than before the war had begun, were reasonably stable and even returned to July levels by the time the exchanges reopened. Pundits like Roger Babson encouraged small individual investors to buy securities within two weeks after the market’s close, and The Wall Street Journal touted investing as the way to beat the high cost of living.249

Individual investors responded slowly, but surely. A bull market began to appear in March following an erratic but generally increasing market during the first quarter of 1915. The Exchange lifted all trading restrictions on April 15 and the market began to soar. According to Benjamin Graham and David Dodd, the Dow rose from 57 at about the time the exchange reopened to a peak of 110 at the end of 1916. Alexander Noyes cited a study showing a rise from 58.99 on February 15 to 101.51 in mid-November. Stock exchange historian Robert Sobel dated the beginning of the bull market to the start of the year. Regardless of the precise date, market performance was extraordinary.⁸

Return to Prosperity

There was an economic boom to match. Nineteen fifteen began with the same fear and pessimism that had come to characterize American industry despite the obvious need for war materiel in Europe. The Wall Street Journal was early to complain that there was not enough money around for the anticipated industrial expansion and encouraged corporations to sell securities to the public. All of the belligerents were technically insolvent, so while American industrialists understood the dramatic potential for increased demand, they remained unsure of how Europe would pay. Part of the answer lay in the shift of the world’s financial capital from London to New York in the fall of 1914, with significant foreign funds left for safekeeping in New York banks. Later came massive foreign shifts of gold to New York to pay for war materiel. Foreign borrowings increased dramatically, with half a billion in Allied bonds sold in the United States during 1914 and $750 million more in 1916. The proceeds came right back to the United States to pay for U.S. exports.⁹

Noyes noted a 347 percent export expansion between 1913 and 1916, in contrast to the 112 percent increase between 1897 and 1906 that had helped to fuel the merger wave. Obviously steel and other war-related industries prospered after the first quarter of 1915. But agricultural exports, including record crops of wheat and cotton (after the near-disaster in the latter industry toward the end of 1914), and manufactured goods created record surpluses in the American balance of trade with Europe. The twelve-month value of exported wheat alone reached $333.5 million on June 15, in contrast with $88 million and $89 million during the same periods over the two preceding years. Wilson’s prediction of imminent prosperity a year earlier had come to pass.¹⁰250

Once the economy got rolling and the stock market with it, the growth in the latter was not entirely steady, although the trend for all of 1915 was up. Events like the sinking of the Lusitania in May 1915 caused temporary market breaks. More interesting, as Noyes reported, were the price breaks on rumors of peace. Americans had quickly become accustomed to their boom economy after years in the financial wilderness. Rumors of possible mediation in 1916 sent the market down for brief periods. The market was also soft during the lead-up to Wilson’s squeak-by reelection over Charles Evans Hughes, but finished the year with some real strength.

On April 2, 1917, Wilson delivered his war message to Congress. Within two days Congress declared war. The shift from a neutral war economy to that of a belligerent had already been reflected in market prices, which had been declining since the beginning of the year. American investors might have been disillusioned under different circumstances as the market turned from its high of 110 down to 65.95 at the end of the year. But 1917 was a critically important year in the development of American corporate capitalism. That was the year that Americans of all walks of life and from every city, town and rural district of the nation began to become investors.

We have seen that the vanguard of the middle class had become avid investors in stocks and bonds by 1914. But the Liberty Bond drives were different. This time, it was war. Americans’ massive, widespread participation in the Liberty Bond campaigns and the federal government’s aggressive marketing techniques brought the idea of investing in securities to Americans of even the most humble circumstances and to the furthest reaches from Wall Street. Well before those bonds had a chance to mature, the new class of American investors would look to the stock market as the place to put their money.¹¹

When the United States entered the war it was no longer the beneficiary of the European conflict. It now had significant financial needs of its own. The prosperity created by two years of war-financed industrial boom as a neutral meant that the nation had stored-up wealth with which to finance its effort. Taxation was always a way to tap into this wealth, but McAdoo, charged with financing the war, thought that the vast amount of money he needed would make raising it all through taxes impossible. He planned initially to raise half the money through taxes and half through bond issues. But he dramatically reduced the tax portion as the war progressed. His prewar estimate of “several billion dollars” would prove to be very much on the low side, especially in light of the fact that the United States wound up spending $2 billion a month for postwar expenses alone. The cost of war was more than taxes could handle.251

McAdoo later recalled studying Civil War financing earlier in his life and it was to the financing of that war that he turned for guidance. He had little but criticism for Salmon Chase’s efforts, except for his decision in the middle of the war to turn over the job of selling government bonds to Jay Cooke. McAdoo also turned to the investment bankers except, unlike Chase, he refused to pay investment banking commissions to market the bonds. He argued that “any kind of war must necessarily be a popular movement. It is a kind of crusade; and, like all crusades, it sweeps along on a powerful stream of romanticism. Chase did not attempt to capitalize the emotion of the people, yet it was there and he might have put it to work.” McAdoo capitalized that emotion exceedingly well.¹²

The Liberty Loans

The president signed the first War Finance Act on April 25, 1917. It authorized the Treasury to issue debt of up to $7 billion, $5 billion of which was to be in bonds and the rest in short-term notes. McAdoo was given discretion to determine the amount and terms of each issue. Consulting with bankers and other experts, he decided to raise $2 billion in long-term debt at 3½ percent, a below-market interest rate. Paul Warburg was among the few encouraging bankers, most expressing their doubts that such an unprecedented issue could be absorbed by the people, especially at an interest rate so low. The experts were worried, McAdoo recalled, that Americans did not understand bonds. It was still a very small number who owned any. To this concern, McAdoo replied, education was the answer. They graduated from this education into modern capitalism.¹³

The problem of the low interest rate was a different matter. Money market rates in New York ranged from 4¾ to 5¼ percent. It was important to the war effort that the bonds were issued at par in order to demonstrate America’s financial strength. Besides, the war effort would almost surely require additional financing, so maintaining the bonds at par was essential to ensuring public confidence in the investment. But bonds issued at rates of more than 1 percent below market would almost certainly not sell at par. Fortunately, the War Finance Act had stipulated that the bonds were to be exempt from most federal, state and local taxes. Although the bonds issued under the first act were the only ones to be fully tax exempt, the tax exemption proved to be essential in sustaining the value of the bonds.

The bankers helped McAdoo understand that public financial education was essential to the success of the bond drive. But McAdoo also knew that he had to stir up popular enthusiasm in order to get the bonds sold. His idea was to pitch the sales drive as opening a “financial front,” not unlike the military front in Europe. It would give women, and men who were unable to serve overseas, the sense that they were full participants in the war effort. The bonds would also be sold on the installment plan, which made it possible for nearly every American to buy them. This method also introduced ordinary Americans firsthand to a form of margin buying.252

McAdoo claimed to have been influenced by Cooke’s selling methods during the Civil War, and this is surely true. But he was also influenced by the early German bond campaigns to finance their own efforts. By 1916, Germany was saturated with bond advertisements, and the “names of large subscribers were ostentatiously published in German newspapers.” The German bond drive was a success, and while the British sneered, they so avidly adopted the German techniques in their own financing campaign that the Germans described the British selling effort as a distasteful circus.¹⁴

McAdoo’s method was to sell as locally as possible. This would make it easier for volunteers to use the personal touch as a sales pitch and also would provide the chance for them to use peer pressure and public shaming as sales tactics. Each of the new Federal Reserve districts was constituted as a subcommittee of the central War Loan Organization, and in the later drives was responsible for selling its own quota, which was determined as a function of the district’s wealth. The banks created Liberty Loan committees in every city in their districts. Everyone from bankers to Boy Scouts was recruited in the effort. “Widely known men and women in every walk of life immediately dropped all other business and turned their undivided attention to the loan. Bankers and business men generally accepted leading positions in the sales campaign, prominent state and national officials and other widely known orators took the platform to urge an enormous oversubscription and a veritable army of publicity men began to bombard the public with printed Liberty Loan ammunition.” Bond buyers were issued buttons that proclaimed their patriotism. And the publicity drive mushroomed with the later bond issues. As Sunshine Charley would observe and adopt, “it was in the unremitting personal appeal to large audiences … that the movement surpassed every previous demonstration of the kind.”¹⁵

The first drive was a stunning success, as were subsequent drives. Newspapers and prominent businessmen rather hyperbolically declared the first issue to be the “best investment ever offered.” But the Liberty Bond drives were nothing if not hyperbolic. Frank Vanderlip, the man who hired Charley Mitchell, called the Liberty Bonds “the highest grade investment in the world today” and encouraged wealthy investors to borrow money if they needed to in order to take up their share. Charles Clifton, president of the Pierce-Arrow Motor Car Company, was said to be investing his entire fortune in Liberty Bonds, buying on the installment plan.253

It was not just the investment quality of the bonds that brought out the buyers. Newspapers and civic leaders insisted that it was the patriotic duty of all Americans to buy Liberty Bonds, aided by editorial pitches from the likes of Teddy Roosevelt and leading citizens throughout the country, not to mention the famous posters that made inducing guilt into a fine art form. The national baseball commission asked “every player, manager, business manager, and owner” of the World Series-contending New York Giants and “Shoeless Joe” Jackson’s Chicago White Sox to buy at least $100 of Liberty Bonds. Investing had become literally as American as baseball.¹⁶

According to one contemporaneous estimate, and based upon the numbers we have seen, it is likely that, at most, several million Americans were regular investors before the war. That was to change dramatically. Small investors were especially targeted during the first two Liberty Bond drives, and sales were structured so that almost everyone could afford to invest. The first drive used two thousand salesmen; the second planned to use six thousand. Bonds were sold on the installment plan with interest charges offset by interest on the bonds, creating a virtually cost-free way for small investors to buy. Banks lent bond buyers money to purchase bonds on the security of their future income and Congress expanded national bank power to lend on the security of Liberty Bonds before the fourth loan in October 1918. Vanderlip encouraged businesses to buy bonds and sell them to their own employees in monthly installments.

It worked. Every one of the four Liberty Bond issues and the final Victory Bond issue was oversubscribed, starting with the $2 billion in 3¼s receiving over $3 billion of subscriptions. Four million Americans bought bonds in the first drive, 99 percent of them in denominations of $50 to $10,000. Almost 9.5 million citizens bought bonds in the second drive, 18 million in the third, and almost 23 million in the fourth bond drive (which took place during the devastating flu epidemic of 1918). Almost 12 million bought Victory Bonds. While there was overlap, including considerable buying by banks, financial institutions and other corporations, unprecedented numbers of Americans were buying securities for the first time. And they were buying them in unprecedented amounts. By the end of the Victory Bond drive in April 1919, conducted by McAdoo’s successor, Carter Glass, the federal government had raised $21.3 billion in war debt alone, starting from a total federal debt of $1.2 billion in April 1917.¹⁷254

Despite all the signs of war prosperity, the stock market took a substantial dive after America’s declaration of war against Germany, partly because of an outflow of capital for war loans to the Allies and partly, according to Noyes, because it became clear that the combination of war taxes and the federal government’s control of profiteering would limit industry’s surplus war profits. But the market began a steady climb in late 1917 that did not peak until the end of 1919, when it experienced an expected postwar adjustment that lasted until the final quarter of 1921.¹⁸

Training Grounds for Brokers

Perhaps the most important aspect of the Liberty Bond drives for the development of the speculation economy was the participation of the new and growing national bank securities affiliates like Sunshine Charley’s National City Company, as well as the national banks themselves. Few national banks had established securities affiliates by 1917, although by the time of the Glass-Steagall Act national banks had affiliates engaged in at least sixty-four different kinds of businesses legally prohibited to the national banks themselves, ranging from the securities and real estate businesses to investment trusts and insurance agencies. Some banks did not bother to establish the affiliates needed to comply formally with the law and invested in and underwrote bonds directly through their bond departments. Well before they began buying, selling and underwriting securities, these banks, with the blessing of the banking law, loaned margin money as well as longer-term money on the security of securities. This portion of the banking business grew with the stock market and was one of the factors leading national banks to develop research staffs and expertise in the securities business.¹⁹

The first time the banks used this expertise on a significant retail scale was during the Liberty Bond drives. “Practically all national banks became familiar with the technique of distributing securities during the War.” Fifty-six percent of the total subscription to the first drive was made by national banks, both for their own accounts and for customers. National banks and 3.5 million of their customers were allotted almost half of the second drive and more than half of the total of the third and fourth drives. The same was true of the Victory Bond drive. Like the other patriotic workers ensuring the success of the loans, these banks worked without compensation. As Sunshine Charley put it: “Banking houses are not only giving up their chances of profit along ordinary lines but they are giving the salaries of their employees to the United States government, who, through the Liberty Loan committees, is now controlling such employees. The bond salesmen themselves … are giving their services as freely as are the bankers themselves.” Patriotic as this was, there would be compensation. “The only commercial reward in view … is that which may come from the development of a large, new army of investors in this country … who may in the future be developed into savers and bond buyers.”²⁰255

The Liberty loan drives provided a graduate education for bankers and securities salesmen. As they learned, they developed relationships with potential investors and, as one commentator said, “won their confidence, partly because [they]… offered bonds of unquestioned soundness. Individuals, formerly prejudiced against all types of securities, became security minded and potential customers for future issues of corporate securities. The … salesmen could argue that the corporate securities which they had for sale were as safe as government bonds and the yield far in excess.” This was certainly true before the days of federal securities regulation, and the brokers took full advantage of their opportunities.²¹

Many middle-class Americans did not wait for the end of the war to become investors in corporate stock. There were reports as early as January 1917 that Western farmers were becoming significant stock buyers. And not just stock buyers, but margin buyers, anticipating that they would pay the balance of their purchase prices when their crops sold. The market was down, making it a time of bargain buying, although oddly some investors preferred to invest at higher prices. Small investors continued to show interest in the market as the war progressed and the economy boomed, even as larger investors hesitated for fear of the tax burden they would face on their expected gains. While investors were interested, they sometimes needed some persuasion to get into the market, and brokers were actively and aggressively selling. As the war went on and optimism continued, many individuals who had bought small-denomination Liberty Bonds sold them in order to invest in higher-yielding corporate securities. And investment advice columns (including the once-conservative Wall Street Journal) began to encourage individuals to invest, not only in bonds but also in stock.²²

THE CAPITAL ISSUES COMMITTEE

The market was doing a remarkable job of taking care of America’s war finance needs. Patriotism and peer pressure helped to raise money for the government at below-market rates. But the new habit of investing and the lure of profit began to undermine patriotism as an investment strategy. I noted earlier that the Liberty Bonds held their value reasonably well during the war, but they still dropped to 97 in 1917 and to a low of 92¼ in 1918, as buyers sold their bonds to invest in more profitable alternatives. Investment opportunities exploded as the war economy went into high gear. American industry needed large amounts of capital for production and expansion to meet the demands put on it by the war. The bull market of 1918 showed the market expanding.²³256

This situation presented a problem. At the same time that the federal government was trying to sell Liberty Bonds to raise money for the increasingly expensive war effort, private industry was working to raise money, too. Huge federal borrowings paid for huge federal orders, and American industry was scrambling to expand its production capabilities fast enough to fill them.

America was prosperous, but there was only so much cash. Vanderlip claimed that the Liberty Bonds had tapped into capital resources that did not even exist, that they would have to be bought on the strength of future income. Claiming that “all past savings are already invested,” he said: “This war must be financed, not out of the past savings, but out of future savings. Future savings for the moment are not available, and some other device must, therefore, be brought into play.” The devices, as we have seen, were offering Liberty Bonds on the installment plan and making bank loans available to buy the bonds. But they did not provide the funding for industry.²⁴

The financial situation was serious, building toward collapse in 1920. But that was the unforeseeable future. And, foreseeable or not, the war had to be paid for. The stock market was in a steep decline. Liberty Bonds, large loans to the Allies and money used to repurchase American securities held in the belligerent nations had limited the sources of available capital for business expansion.

The investment market was already thoroughly demoralized … and there was practically no free money seeking investment. Savings banks held large amounts of illiquid securities at the same time that they faced the prospect of substantial withdrawals by depositors to buy Liberty Bonds, and commercial banks were saddled with heavy government loans and short-term paper, and were compelled to accept as collateral for business expansion loans securities that were unacceptable for Federal Reserve rediscounting.

As had been true of every down market since at least the Panic of 1907, illiquidity created worries about the stability of the banking system.²⁵

This unprecedented financial competition between the private sector and the federal government created an extraordinary problem. Most of the money loaned to the Allies and raised during the Liberty Bond drives was being spent in government purchase orders from those very American industries that were starved by government fundraising for the expansion funds to meet those orders. War surplus taxation and the discouragement of profiteering that would be more formally (if extra-legally) enforced by Bernard Baruch and the War Finance Corporation capped corporate abilities to fund expansion with retained earnings at levels closer to those that had preceded the war. Corporations had fixed costs represented by the need to service their own debt and American investment habits at the time still demanded the regular payment of dividends on preferred stock and, typically, common stock as well. At the same time, while industrial production was critical to the war effort, not all products were created equal. Capital markets, while they might move money to profitable investments, were not the place to determine financing priorities for a nation that had temporarily reconfigured as a war machine. Somebody had to help direct the allocation of capital.257

The job initially fell, as so many wartime finance jobs did, to the extraordinary treasury secretary, William McAdoo. McAdoo was helped by the banking community itself, as well as the patriotic fervor that had made the first Liberty Bonds such triumphs of finance. In November 1917, the president of the Investment Bankers’ Association (IBA) repositioned bankers’ traditional approaches to underwriting, putting as the first priority the question of whether a proposed financing was important to the war effort and as the last question whether the banker would profit from the deal.

As early as September 1917, members of the New York Liberty Loan Committee worked to limit money available to stock traders by raising the call money rate and rationing it by giving government and commercial borrowers priority, but this proved insufficient. Among the problems this group and other volunteers faced was that bankers and industrialists, no less than the capital markets, were ill-equipped to decide what was, and what was not, important to the war effort. Doubt often resulted in paralysis and even important financings were stalled. Bankers began to ask McAdoo for his advice and approval and he fulfilled that role. Following its annual convention in November 1917, at which the wartime conservation of capital received a great deal of attention, the IBA proposed a committee to McAdoo and the Federal Reserve Board.²⁶

It is worth pausing before going on to note the unusual role played by the War Finance Corporation and, in the context of this story, the particular role played by the Capital Issues Committee (CIC). Business had called for regulation before, most prominently in the years before the FTC Act, when so many sought guidance from the Bureau of Corporations as to whether their actions would violate the Sherman Act. But the finance community—Wall Street—was, as we have seen, stubbornly resistant to the idea that any but themselves could or should have anything to do with the conduct of American capital markets. Yet even as the Bolsheviks toppled the Russian government, creating a domestic fear that would result in the Red Scare and Palmer raids of the autumn of 1919, the secretary of the treasury of the United States was telling investment bankers and industrialists whether and how much capital they could raise to run and expand their businesses. Within months this role would be assumed by a committee of members of the Federal Reserve Board, just as the federal government itself (with McAdoo at its head) would take over the operation of the nation’s railroads. That committee, in its first report after its formal reconstitution by Congress in 1918, operated on “the theory of the law creating the committee that every dollar of private credit was an asset of the Government which must not be put to a nonessential use during the war.” It was, perhaps, as close to a Marxian moment as the United States has ever come. And, most important for our story, it was a moment of highly intrusive, if technically noncoercive, federal intervention in the financial system that would provide a precedent for coercive, albeit far less intrusive, governmental financial regulation in another crisis just over a decade ahead. But in that later crisis Wall Street would be far less willing to cooperate.²⁷²⁵⁸

In any event, Wall Street and industry, as well as states and municipalities that had their own financing needs, cooperated so thoroughly that Mc-Adoo was swamped. In his annual report to Congress for the year, he made it clear that he needed help. McAdoo turned to the Federal Reserve Board. He asked Paul Warburg, C. H. Hamlin and Frederick Delano to come up with a plan to review all proposed financing for consistency with the war effort. Within weeks, this small committee announced its plan, which was to create a newly constituted Capital Issues Committee consisting of those three Federal Reserve members and a staff. The CIC would examine the timing of proposed financing and its importance to the war effort. The CIC was to be aided by each of the regional Federal Reserve banks, which themselves would be helped by volunteer committees of bankers in order to enable the Committee to obtain local expertise.

This process of committee formation and procedure was, for the most part, done in a manner that could at best be described as extra-constitutional. Probably its legally saving grace was that the committee had no enforcement power and that application for approval was purely voluntary. At the same time, it was an agency organized by and within the government, and its persuasive capacities were undoubtedly for that reason greater than might have been the case with a purely voluntary organization. The New York Stock Exchange, always eager to stave off the threat of direct federal regulation, required that all issuers receive CIC approval as a condition to listing. It might therefore be exaggeration to claim, as one historian of the Committee wrote:259

Although the Capital Issues Committee of the Federal Reserve Board and its whole organization was a purely voluntary one without a legal basis and with no power of compulsion, it soon built up a system that secured the confidence of the business world and succeeded in reaching and controlling the vast majority of capital issues of sufficient size to warrant attention. This success was due to the whole-hearted and patriotic response of financial houses and organizations throughout the country.

Evidently this patriotic self-denial was insufficient, because by March McAdoo and Warburg were asking Congress for the legislative underpinning that would make the system mandatory. McAdoo wanted all corporations issuing more than $100,000 of securities outside the ordinary course of business to apply for and receive a license from the War Finance Corporation prior to selling them. Drawing upon the same military vocabulary that led him to describe the Liberty Bond efforts as a “financial front,” he explained the proposal to Congress as the financial equivalent of the selective service, ensuring that slackers as well as patriotic volunteers would share the burdens of war.²⁸

This time Wall Street failed to respond with enthusiasm. Patriotism, the volunteer spirit and moral suasion were one thing. Compulsion was another. The Investment Bankers Association, among others, opposed the plan, and, instead of the mandatory licensing that McAdoo wanted, the War Finance Corporation Act of 1918 created the seven-member Capital Issues Committee as a body separate from the War Finance Corporation, authorized only to determine whether a particular securities issue was “compatible with the national interest.” Continuing the basic structure of the original Federal Reserve Board committee, committees on capital issues were established in each Federal Reserve district. In order to prevent the CIC from maintaining an indefinite postwar existence, it was to dissolve six months after the war ended unless the president had earlier declared its work to be unnecessary. In the event the Committee, which was created in April, disbanded in November shortly after the armistice was signed.²⁹

The Committee took its role quite seriously and expanded its powers by narrowly interpreting the exceptions provided by Congress. As one historian described it, “By the end of the summer of 1918 the situation was so well in hand that it was virtually impossible to obtain large sums for capital outlay unless the project in question met with [the Committee’s approval], and this applied to State and local governments, as well as to private firms.” In October, the Committee’s enforcement director announced that the CIC would review every securities issue, whether or not submitted voluntarily, and would call upon all of the resources of the government to stop the sale of those it disapproved. Economic Vigilance Committees were organized in every Federal Reserve district to investigate and report upon all unauthorized issues. McAdoo, who by then had justifiably assumed his place with Hamilton and Gallatin among America’s great treasury secretaries, fully approved these new developments.³⁰260

By the time the Committee suspended its work on December 31, 1918, it had received 2,289 applications for new issues of securities in an aggregate amount of just over $2.5 billion. It processed an additional 1,020 applications between the armistice and December 31. According to the Committee, the simple number of applications understated its effective control over capital allocation. It noted that “numerous applications” were “voluntarily withdrawn,” and that “large numbers of prospective applicants yielded to the informal suggestions made by the committee and its district committees that their enterprises or projects should be postponed until after the war.” The Committee most likely did not overstate its effectiveness. In addition to the support of the NYSE, it also had the support of the Investment Bankers’ Association (since the process remained voluntary), the American Bankers’ Association and the United States Chamber of Commerce. Members of these associations served on the district committees and local committees that undoubtedly had influence over local businessmen and bankers whose business networks were interdependent. Moreover, the National Association of Blue Sky Commissioners, those officials who had the power to approve or forbid securities issuances in their states, also backed the Committee’s work, further supporting the Committee’s view of its own effectiveness.³¹

The Committee saw its work as transcending capital allocation in wartime. The same addition of 25 million, mostly new, investors in the American capital markets that had led Sunshine Charley to lick his chops also caught the attention of the regulators. In its first report to Congress the Committee wrote that if its work had continued, it would have asked for the power to protect these new investors from “unscrupulous promoters” seeking to part them from their Liberty Bonds in exchange for “worthless stocks.” The Committee recommended that Congress empower a government agency to continue the “federal supervision of securities issues,” stating:261

At no time has the obligation been so definitely placed upon the Government to protect its public from financial exploitations by reckless or unscrupulous promoters. The field has been greatly enlarged by the wide distribution of Liberty bonds, and the purveyor of stocks and bonds is no longer put to the necessity of seeking out a select list of prospective purchasers with money to invest. He now has the entire American public, and the transaction becomes one of persuasion to trade—to trade a Government bond bearing a low rate of interest for stocks or bonds baited with promise of high rate of return and prospect of sudden riches.

The government had taken advantage of the peoples’ patriotism to use their capital. Even if securities regulation had not previously been a federal obligation, according to the Committee it was now. The Committee devoted over half of its final report of February 28, 1919, to again emphasize the need for federal action, noting that “regulation of security issues has long been an established practice among many nations which enjoy highly developed financial systems.” The world had changed. The United States was the new world economic and financial leader. As the Liberty Bond market shifted to an active and more widespread stock market that for all intents and purposes became our modern stock market, Congress’s perception of the need for federal securities regulation began to grow and assume its modern form.³²

THREE WAVES OF MARKET DEVELOPMENT AND THE RISE OF MODERN SECURITIES REGULATION

The third stage of the development of the modern stock market was under way. The bull market of the merger wave of 1897 to 1903 brought middle-class Americans into the market for the first time as investors, in contrast to the random speculators and European bondholders who had long been active. While the Panic of 1903 tempered the bull market and ended the first stage of the modern securities market, it sustained a slow if steady growth in market participants up through the Panic of 1907 which, after a brief period of respite, began the second stage. The second stage, which lasted roughly until the market closings in 1914, was different from the first in that individual investors appear to have been rapidly and steadily increasing their investments in common stock. Bonds still dominated, but now high-quality industrials as well as railroads were seen as the gold standard of investment instruments, both in stocks and bonds. Speculation itself was becoming more mainstream as average investors bought common stock. The increasing availability of information in newspapers and magazines in the form of investment advice and financial reporting as well as the slowly increasing (if still rudimentary) availability of corporate information made the purchase of corporate securities somewhat less of a gamble than it might have been, although the information remained nowhere near universally reliable.262

The third and final stage of the modern market began with the bull market of 1915 and did not end until the Crash of 1929. True, there were interruptions, like the bear market of 1917, the financial collapse of 1920, and the depression of 1921, but these were blips in an otherwise continuous process in which investing and, especially, investing in common stock, became not only the central ownership participation of the American middle class in American economic life but also the dominant focus of American business. Styles of investing changed, as common stock overtook bonds in the 1920s and investment trusts offered small investors the kinds of diversified portfolios that reemerged with the rise of mutual funds in the 1960s. But all of the ingredients of the modern stock market were in place by the end of World War I. Just as Sunshine Charley had predicted, “the people became educated [by the Liberty Bond drives] and accustomed to investing, owning and dealing in such bonds. It was but an easy step across to investments and dealings in industrial stocks and bonds which promised much larger returns.” Thus it seems reasonable to date the start of the final stage of the speculation economy’s development as the bull market of 1915.

The transformation in the American securities market was paralleled by the development of modern securities regulation, also in three stages. The first two stages ran from the dawn of the century to the enactment of the FTC and Clayton Acts in 1914. Their principal concern was antitrust. The first stage, encompassing the occasional calls for securities regulation that occurred prior to 1907, was really little more than a variant on the general issue of corporate power, the same issue that was captured by the dominant antitrust and federal incorporation movements. While investor protection was a concern, if a distant one, it was grounded in the rapid changes in the economic and financial dynamics of American life. The investment community, while growing, was still very small, and despite speculation by small investors was generally limited to the well-to-do. The issue of investor protection was thus a part of, yet deeply subordinated to, the other issues that arose in the federal attempt to control corporate power.

The second stage properly dates from the Panic of 1907 until 1914, during which we have seen a developing federal concern with securities regulation. This initial movement for federal securities regulation was also relatively unconcerned with the well-being of investors. The issue was the stability of the banking system and the national economy. The specific problems focused on were restraining overcapitalization and its monopolizing tendencies and the threat to the banking and overall economic system caused by the way that overcapitalized corporations encouraged speculation by financial institutions and individuals. Both overcapitalization and speculation increased market volatility in ways that were significantly destabilizing; securities regulation talk during this stage appropriately focused on market regulation aimed at exchanges and banks. This second stage effectively ended with the enactment of the Federal Reserve Act and the death of the Owen bill in 1914, although Untermyer and others periodically attempted to resuscitate the latter legislation. Various iterations of the Rayburn common carrier bill continued until its passage in 1920 but, as I noted in the last chapter, that bill was intended to be an antitrust measure rather than an investor protection measure.263

The third stage of modern securities regulation began with the third stage of market development. As I discussed in the last chapter, its seeds lay in the Owen bill’s attempt to include investor protection in what was, in essence, a measure designed to restrain speculation. But it really took its modern form, and essentially the form that the Securities Act of 1933 would take, with bills introduced in Congress in 1919, the year following the ballooning of American investors through the Liberty Bond drives.³³

Before going on, though, it is worth taking a moment to examine the first securities bill introduced specifically for the protection of investors. Distinct from any of the other securities measures of this period, it provides a fascinating transition from the federal incorporation movement to securities regulation. Although drafted to apply only to “quasi-public” corporations, it differed from other bills in that it addressed neither stock nor exchanges but rather the individual shareholders of the corporation. This December 1915 bill, entitled “A Bill to Provide a Remedy for the Relief of Wronged and Defrauded Shareholders,” gave investigatory powers to both the ICC and the attorney general to determine whether a corporation was being run in a manner that deprived the minority shareholders of their property and rights. This approach made the bill the only piece of corporate legislation introduced during a period frequently described as heavily influenced by Brandeis that truly bore the stamp of his influence and principal concerns. Other People’s Money, Brandeis’s 1915 book compiling his Pujo-inspired artides in Harper’s, is commonly understood as focusing on securities disclosure and the dominance of the Money Trust. While this is superficially true, his undeniable goal in those essays, and in most of his corporate work, was the protection of minority shareholders from the depredations, or perceived depredations, of the control group. Although the bill went nowhere, its focus on internal corporate affairs represented perhaps the last gasp of the federal incorporation movement and, perhaps, the last attempt to ensure industrially oriented finance, before the full turn toward modern securities regulation.³⁴264

MODERN SECURITIES REGULATION: THE LEGAL ACCEPTANCE OF THE SPECULATION ECONOMY

The third stage took place in two steps, embodied in two different bills that embraced two different visions of investor protective securities regulation and the federal government’s role in the process. The first, introduced by Democrat John Marvin Jones of Texas, was a somewhat retrograde populist approach of the type embodied in state blue-sky laws. While more sophisticated than some, it was broker-oriented legislation that focused on disclosure of the terms of the selling effort rather than the details of the issuing corporation and, more important, on the substantive fairness of the offering to buyers.

The second bill, introduced in the House by Colorado Democrat Edward Thomas Taylor, was very close to the modern type. Drafted by Bradley Palmer, counsel to the Capital Issues Committee, and FTC member Huston Thompson, it was similar to consumer protection laws, requiring disclosure by the issuer sufficient to enable investors to make intelligent decisions in the purchase and sale of securities. Unlike the intrusive fairness inquiry to be made by the government under Jones’s bill, the Taylor approach was far more in keeping with Wilsonian regulation, giving the government the power to oversee corporate self-regulation under the law rather than evaluating the quality of corporate behavior itself.³⁵

Jones introduced H.R. 15399, on January 30, 1919. While aimed at investor protection, this bill was not yet in the modern form of regulation. Instead, it was a federal version of state blue-sky laws that attempted to regulate securities sales in states other than the issuer’s state of incorporation. It made the payment of sales commissions to brokers the triggering factor and would have required every corporation issuing stock across state lines to file an offering plan with the FTC. The filing would describe the financing plan in detail, including promoters’ compensation and brokerage agreements. The FTC would then have the authority to permit the sale following its finding that “the sale of stock will be fairly and honestly conducted both to the corporation and the public.” The bill also contained an antifraud provision giving buyers a right of action against a bond required to be posted by the corporation. A similar bill would be introduced by Representative Edward Denison in 1920 and almost unanimously passed by the House.³⁶265

The first bill to look like modern securities regulation was introduced by Taylor on the same day, with a second version introduced two weeks later. Entitled “A Bill to Require Publicity in Prospectuses, Advertisements, and Offers for Sale of Securities,” the measure specified the information that had to be required in advertisements for the sale of securities by any one person mailing or publishing more than three such ads within a given month. Specifically, it required that all such materials include information as to the commissions and expenses of the offering, as well as a notice that the issuer had filed certain mandatory information, including reasonably complete financial information, with the secretary of the treasury. That statement, which would have resembled the registration statement required under the 1933 Act, was to be signed by the issuer, its president, other chief executive officers, treasurer and a majority of the board. This bill was also the first proposed legislation providing a specific defense, a defense that ultimately would become known as the “due diligence” defense and extended to all signatories of the registration statement except the issuing corporation.³⁷

The fact that securities regulation did not return to the public agenda until 1919 should come as no surprise, given the federal preoccupation with other more pressing matters. Indeed the armistice brought other problems, too, at home as well as abroad. Postwar domestic consumer prices had gone out of control. The cost of living had increased so dramatically that the president addressed the subject, and the need for legislation to control it, in a speech he delivered before a joint session of Congress in August 1919, not long after he had returned from Versailles. While a substantial portion of the speech addressed the treaty and the relationship between its ratification and economic well-being, it also represented a brief revival of Wilson’s economic progressivism, couched in distinctly Wilsonian terms. Publicity was a significant remedy for the high cost of living, the president said. Goods should be “marked with the price at which they left the hands of the producer,” much like the labeling required by the Pure Food and Drug Act. After all, the American consumer did not need paternalistic regulation. Instead, “the purchaser can often take care of himself if he knows the facts and influences he is dealing with and purchasers are not disinclined to do anything, either singly or collectively, that may be necessary for their self-protection.”

But this was not all. Wilson, pulling a progressive regulatory thread through the preceding nineteen years, suggested that all corporations engaged in interstate commerce should be federally licensed on terms that would prevent price gouging. Finally, as an aside apparently suggested by Attorney General A. Mitchell Palmer, he said:266

May I not add that there is a bill now pending before the Congress which, if passed, would do much to stop speculation and to prevent the fraudulent methods of promotion by which our people are annually fleeced of many millions of hard-earned money. I refer to the measure proposed by the Capital Issues Committee for the control of securities issues. It is a measure formulated by men who know the actual conditions of business and its adoption would serve a great and beneficent purpose.

That bill was the Taylor bill, the clear and direct predecessor to the 1933 Act. This was classic Wilsonian economic progressivism as it had developed during his first few years in office, relatively unintrusive, disclosure-oriented regulation, designed for the needs of business to be largely self-regulatory.³⁸

One can reasonably infer from the Taylor bill that the work of the Capital Issues Committee might well have made the world safe for stockholders. The bill applied to corporations issuing stock and their underwriters. It would have required highly detailed information about the issuer’s finances and business, to be included in a statement signed by the same people identified in the earlier Taylor bill and filed with the secretary of the treasury before the securities could be offered to the public. Every purchaser of shares in the offering was presumed to have relied upon the information in the filed statement and could bring an action both for rescission and damages if any of the information was “false in any material respect,” with strict liability imposed upon the signatories. The bill also provided criminal penalties for willful violation. The treasury secretary was given the power to make rules and regulations necessary to enforce the act, as well as the power to “prescribe forms upon which the said statements” were to be made.

Its concerns were quite different from the legislative efforts during the first two phases of securities regulation. Antitrust had gone off on its own course with the FTC Act, the Clayton Act and the Supreme Court’s rule of reason. Speculation was still a concern, but the focus had shifted from the stability of the economy through the behavior of financial institutions to the well-being of the American people, who had become the new corporate financiers. Gone were the occasional attempts to tame finance in the service of industry. The new legislation accepted the speculation economy that had been embraced by the American people as the natural and correct order of things financial.267

While the Investment Bankers Association had endorsed federal securities legislation at its annual convention in 1919, securities historian Michael Parrish wrote that the Taylor bill “incurred the hostility of the IBA,” although IBA general counsel Robert Reed generally praised the bill while it was pending in Congress. The IBA endorsed the Denison bill. It was conceptually quite distinct from the market-oriented securities laws initiated by the Taylor bill that would ultimately flourish.³⁹

Thus was the state of the market and regulation as the nation entered the presidential campaign season of 1920, the election year that would bring business back to the White House and Republican domination through the succeeding twelve years. Woodrow Wilson, embittered by the battle over the Treaty of Versailles and the League of Nations and significantly incapacitated by illness, had long since turned over economic leadership to his treasury secretary and, in any event, had lost his effectiveness in office. McAdoo had resigned to return to private life, although he would before long come back to politics, and Carter Glass had taken his place. The financially uneducated Glass had proven to be one of the most financially effective and influential congressmen in American history and would in the future return to the Senate to champion the post-Crash law that would bear his name and dismantle the securities empire that Sunshine Charley had built. But Glass’s time in office was brief.

Warren Gamaliel Harding would bring to the post of treasury secretary the patrician and decidedly pro-business Andrew Mellon, whose preference for the good old days of the plutocrats would be reflected in his brief implication in the Teapot Dome scandal. The man who would replace Harding spent the fall of 1919 at the statehouse in Boston where he fulfilled his role during the days of the Red Scare by firmly suppressing a police strike. Sam Untermyer had served as an advisor to McAdoo and gone back to his law practice, from which he would be called upon in 1932 by Franklin D. Roosevelt to prepare the first, and ultimately rejected, draft of the administration’s securities bill, a draft that looked very much like the Owen bill of 1914.

American investors, with their Liberty Bonds trading below par, had yet to await the outcome of a brief postwar depression, accompanied by a big enough increase in the cost of living that the term “HCL,” or high cost of living, became a figure of speech. The combination of depression and HCL was brought on in part by an orgy of postwar consumer luxury spending, which Noyes contemptuously noted was a result of the workingman’s failure to understand the real decline in his earnings. Instead he saw only the inflationary fact that “more money than he had ever seen before was pouring into his hands [and] his instinct was to spend it.” Consumers demanded highpriced goods, and the higher the prices, the better. The inevitable downturn saw consumers’ strikes, characterized by the creation of “old clothes clubs” in the spring of 1920, with retailers competing to cut prices and deflation beginning to shrink the economy. Liberty Bonds traded at new lows. But it would not be all that long before Coolidge was in the White House, prosperity returned, consumerism flourished, the stock market roared and all that money invested in Liberty Bonds began the great bull market that would end in the sickening autumn of 1929. The speculation economy in the form of the modern stock market and its regulatory correlates were in place and ready. “For the blood of the pioneers still ran in American veins; and if there was no longer something lost behind the ranges, still the habit of seeing visions persisted…. Still the American could spin his wonderful dreams—of a romantic day when he would sell his Westinghouse common at a fabulous price and live in a great house and have a fleet of shining cars and loll at ease on the sands of Palm Beach.” The speculation economy had arrived.⁴⁰ 268