PROLOGUE

Arecent survey of more than four hundred chief financial officers of major American corporations revealed that almost 80 percent of them would have at least moderately mutilated their businesses in order to meet analysts’ quarterly profit estimates. Cutting the budgets for research and development, advertising and maintenance and delaying hiring and new projects are some of the long-term harms they would readily inflict on their corporations. Why? Because in modern American corporate capitalism the failure to meet quarterly numbers almost always guarantees a punishing hit to the corporation’s stock price. The stock price drop might cut executive compensation based on stock options, attract lawsuits, bring out angry institutional investors waving antimanagement shareholder proposals and threaten executive job security if it happened often enough. Indeed, the 2006 turnover rate of 118 percent on the New York Stock Exchange alone justifies their fears.¹

The problem has been noticed. In 2006 two of the nation’s most prominent business organizations, The Conference Board and the Business Round-table, published reports decrying the short-term focus of the stock market and its dominance over American business behavior. They each suggested a variety of solutions to allow executives to manage their businesses for the long term in a manner they saw fit without constantly having to answer to the market’s insistent demands for continuous price appreciation. The problem of business short-termism caused by the link between executive incentives and the stock market has become a popular subject of discussion in business, academic and policy circles. It was the central problem that I addressed in a book of my own in 2001.²

There is little question that short-term market behavior has created an increasingly troublesome business problem over the last twenty-five years. But the stock market’s pressure on business and business’s response is nothing new. The short-termism of the late 1990s and early twenty-first century simply is an exaggeration of a quality that was embedded in the American economy a hundred years ago. The typical public corporation we know today, what I will call the giant modern corporation, was created during the merger wave of 1897 to 1903. It gave birth to the modern stock market. As it did, it transformed speculation from a disruptive game, played by a few professionals and thrill-seeking amateurs that from time to time erupted into a major frenzy, into the very genetic material of the American stock market, American business and American capitalism.2

The roots of the modern American stock market lie in the creation of the giant modern corporation. Born of the seeds of destructive competition that seemed to threaten the future of industrialization in late-nineteenth-century America, the giant modern corporation provided a solution that at first promised to stabilize new businesses and maintain the upward trajectory of industrial growth. But the stock market that it brought into being quickly came to be the main thrust behind business, the power behind the boardroom. The stock market started as a tool that helped to create new businesses. It ended by subjugating business to its power.

The modern stock market became an exacting taskmaster for American managers. It came to drive their investment, operating and planning decisions, and the path of American economic development itself. The market transformed from an institution that served businessmen by providing the means of making things and selling things. It became instead a thing apart, an institution without face or form whose insatiable desire for profit demanded satisfaction from even the most powerful corporations it created. In the end, the modern stock market left behind its business origins and became the very reason for the creation of business itself.

The significance of the market’s development was not fully appreciated by regulators of the time. Controlling the perceived monopoly power of giant trusts was the issue of the day. Thus it was through the lens of monopoly that most contemporary observers and almost all lawmakers understood every aspect of the merger wave that created the giant modern corporation, including its causes, the legal forms it assumed, questions of operating efficiency and management and, perhaps most important of all, how the new corporate combinations were financed. While commentators were close to unanimous in locating the underlying cause of the merger wave in businessmen’s attempts to control the often destructive competition that came to plague many of the new industries of the industrial century, they were equally unanimous in their agreement on its immediate and proximate cause—the opportunities it created for financiers to create wealth for themselves.3

Destructive competition had been a problem for years. But it was only during the last few years of the nineteenth century that business distress combined with surplus capital searching for investment opportunities, changes in state corporation laws, and the creative greed of private bankers, trust promoters and the newly evolving investment banks created the perfect storm that shifted the production goals of American industry from goods and services to manufacturing and selling stock. Within twenty years the strong ripples of the merger wave had transformed the nineteenth-century industrial corporation into the giant modern corporation, and the stock market into the focus of American business life. While regulators were embroiled in questions of monopoly, the speculation economy subtly took form.

The history of the creation of the giant modern corporation and the modern stock market is complex. It is a story of industrial development, intellectual transformations, innovations in law and finance, rapidly changing social trends and the federal government’s attempts at regulation. By the end of the period all of the ingredients for the modern stock market were in place and the major regulatory outlines of the securities laws that would be passed a decade hence had been laid out in Congress. Those laws took the speculation economy as a given.

The legal and regulatory changes of this period were driven by transformations in finance and the stock market. Waves of watered stock created by the giant modern corporation brought average Americans into the market for the first time. The instability of these new securities and the corporations that issued them provided enormous opportunity, both intended and not, for ordinary people and professionals alike to speculate, leading sometimes to mere bull runs and sometimes to widespread panic. This type of speculation had long existed in American markets. Whether or not the merger wave had taken place, whether or not the financial and business transformations had occurred, this type of speculation would almost certainly have continued.

New conditions brought with them a new kind of speculation. Modern historians understand speculation in terms of the type I have just described, the type of speculation that characterized market bubbles in 1899 and 1901, 1928 and 1929, the mid-1960s, and 1998 through 2000, among others. But the lasting kind of speculation as it was understood by some perceptive observers at the beginning of the last century was speculation intrinsic in the capital structure of American corporations. This second type of speculation permanently changed American business and the way it was regulated. It created an economy inseparable from speculation. That economy was embedded in a market characterized by increasing numbers of small common stockholders.4

The modern stock market developed in three distinct stages. The first was the direct product of the merger wave, which drew substantial numbers of middle-class investors into the market for the first time. Starting with railroad bonds, which were considered the only truly safe corporate investment, they began to buy the somewhat riskier preferred stock of the new industrials, and sometimes even the highly speculative common stock, as investment opportunities multiplied through the beginning of the twentieth century. They came and they stayed, some of them, through the Rich Man’s Panic of 1903. They were joined by others, sobered by the financial carnage but faithful to the new finance. Together they built a bull market that lasted until early 1907.

Writers and thinkers from many walks of life began to come to terms with the changes the new economy had brought to America. This they did by reaching back to what they had known from an earlier time, by reinventing the stock market as a new form of property, a property that could fill the evaporating role of the land and small business in classical American life and thought. Leaders, progressive and conservative alike, joined to encourage their countrymen to own this new property, hoping to restore greater equality of wealth and build a strong defense against creeping socialism. I exaggerate only a little to say that this idea of corporate securities as the new family farm helped to legitimate the stock market as an American institution, even as the plutocracy continued to dominate it.

The modern market continued to develop in the wreckage of the Panic of 1907. Nineteen-eight marked a year of strong market recovery, although recovery masked the beginning of a broad economic depression. The market first rose and then dropped by a quarter in 1910 to a plateau where it held tenaciously until 1914. Like mammals in the age of disappearing dinosaurs, small investors increased their numbers, held their securities and began to pick among the bargains that were the leavings of the plutocrats. Common stock began to be considered safe for investment, and its higher promised returns made it an attractive alternative to preferred stock and a favorite with small investors.

The third and final stage of the modern market’s development began with the reopening of the New York Stock Exchange in December 1914 after months of darkness that fell as the guns of August roared. Not until April did the party really get going but, when it did, it erupted in a roaring bull market that continued straight up until the “return to normalcy” in 1920. It was sobered by only one bad year when the United States entered the war and had to figure out how to finance its own participation.5

This was a different market than those that had come before. Brokers were honing their sales tactics and, by 1919, the securities arms of national banks, like “Sunshine Charley” Mitchell’s National City Company, were driving the development of retail brokering into branch offices from Manhattan to Middletown. Individual investors found themselves more comfortable with common stocks as war prosperity brought high returns from companies churning out war materiel. And the Liberty Bond drives of 1917 and 1918 created 25 million new American investors. The brokerage industry watched, salivating, anticipating the day when the Iowa farmer no less than the New York lawyer realized he could do better than to take the bargain-basement interest on his Liberty Bonds and turned them in for a share of the new corporate boom economy. A long year of depression followed Harding’s election and, in 1922, the great bull market of the 1920s began to take flight.

Like the modern stock market, securities regulation, as one of several federal responses to the dislocations caused by the merger wave, also grew in three steps. While each phase looked to disclosure as its central regulatory device, each had a distinctly different goal and used the tool of disclosure for a distinctly different purpose. Naturally there was overlap. But what we recognize as modern securities regulation, consumer-type investor protection, did not become its purpose until after the First World War.

The first phase of securities regulation grew out of federal attempts to regulate monopoly by controlling the watered stock created by the combinations of the merger wave. This was the antitrust phase of securities regulation and ran from the beginning of the century until 1914. Antitrust reform proposals and the related federal incorporation movement tried to compel corporate disclosure of financial information in order to reveal the true values of corporate capitalizations to help the federal government identify and prosecute monopolies under the Sherman Antitrust Act. The United States Bureau of Corporations, created as an investigatory body in 1903, embodied this antitrust policy. The securities market was of no particular concern in its own right.

The second step in the development of securities regulation, antispeculation regulation, overlapped the antitrust phase. It began almost immediately following the Panic of 1907 and continued in full force until its failure in 1914. From that point on it reemerged in fits and starts until it reached fruition in the Securities Exchange Act of 1934. Like the antitrust phase, the antispeculation stage was driven by the effects of the watered securities that flooded the market following the merger wave. But this time the goal was not to regulate monopolies. Rather it was to protect American financial stability, and particularly the banking system, which was episodically threatened by financial institutions’ taste for stock speculation of the traditional type, either directly or by making large and highly profitable margin loans to brokers and speculators. Disclosure again was emphasized, but again as a regulatory tool. The purpose of disclosure during this second stage was to enable regulators and banks to control overcapitalization in order to maintain the safety of bank portfolios, not so much for the security of any individual bank but for the safety of the system as a whole.6

The final development of securities regulation aimed at consumer protection. It began with a model of Wilsonian progressive legislation, proposed after the war by the Capital Issues Committee in a form that would serve as the matrix for the Securities Act of 1933. This was the modern type of mandatory disclosure, grounded in a philosophy that providing information to individual investors would allow them to make self-reliant, informed investment decisions and keep the market efficient, safe and stable. While the first stages of securities regulation were grounded in the new collectivism of the early Progressive Era, this final phase philosophically was born of the unique combination of individualism within collectivism that characterized Wilson’s brand of progressivism. It was also the stage of securities regulation that institutionalized and legitimated the speculation economy.

The story proceeds as follows: The first three chapters describe the creation of the giant modern corporation, the legal changes that made it possible and the financing techniques that created the modern stock market. Chapter Four examines the first stage of the development of the modern stock market, paying particular attention to the way that social and cultural changes helped to legitimate the stock market as part of American society. Chapters Five through Seven trace the federal government’s attempts to make sense of the economic transformations created by the giant modern corporation, showing an evolution from antitrust to the beginnings of securities regulation, all thematically unified by the dominant focus on corporate securities at each stage. In Chapter Eight I show the shift in the quality of the market during its second stage of development from the end of the first decade until the First World War as ordinary Americans turned from investing primarily in bonds and preferred stock to embracing speculative common stock as a favored investment vehicle. Chapter Nine examines the first failed attempt at federal securities regulation during the early Wilson administration and the way that it began to establish the conceptual bases and, in a crude way, the regulatory mechanisms for the successful regulation that would be passed by the New Deal Congress following the Great Crash of 1929. Chapter Ten concludes the history with a look at how the federal government’s need for massive financing during the war and the Liberty Bond drives that satisfied it created new ways of marketing securities and a giant new class of investors and potential investors, even as federal moves toward securities regulation completed their conceptual development toward consumer protection. I conclude by reflecting briefly upon the development of this story over the succeeding eighty years and its consequences for the future of American business and the American economy. 7