The Security Exchange Act
( Originally Published 1939 )
IN years gone by, during prosperous times when people were I anxious and willing to buy stocks, some stocks were subject to manipulation and control. The sky-rocketing of a few stocks has been known to carry an entire market with them. In such instances, it was the result, not of what the manipulators had done, but the psychological effect upon the people in seeing stocks rapidly advance. The public was the force which constituted demand, and as the demand became greater and greater, naturally prices went higher and higher. The dissemination of such prices will always give rise to excessive speculation and its concomitant evils.
Such a condition prohibits a real and proper appraisal of security values, and, in turn, it causes an unreasonable expansion or contraction of the volume of credit, necessary for the business activity of the nation. Anything which interferes with a proper appraisal of security values, also prevents a fair calculation of taxes owing to the government, as well as the state, and further prevents a fair valuation of collateral for bank loans. This quite naturally obstructs the operation of our national banking system.
The vast national interest of the public in securities, ranging from tiny hamlets to congested cities, was of such magnitude that excessive speculation could precipitate a national emergency. Anything which precipitates a national emergency, imposes a severe burden on national credit. What happens? Unemployment becomes widespread, trade becomes dislocated, and the general welfare of the entire country becomes affected.
This condition is intensified if there is a sudden and unreason-able wholesale fluctuation of security prices. And anything which involves the welfare of the nation to such an extent, and which is conducted through interstate commerce, such as the security business, quite naturally concerns the government. Thus, with the ad-vent of the New Deal into power, the 1933 and 1934 Security Exchange Act was created.
This Act, which I will discuss briefly, because the full text and technical language of it may not be clear to the average investor, was designed to regulate the sale of all securities, whether on security exchanges, over-the-counter, distributed by unlisted dealers, or the companies themselves.
The 1933 Act requires that all securities, coming within the jurisdiction of the Act, be registered in Washington. The registration statement demands that full details of the company be set-forth. This includes the balance sheet, and how the valuation of the companies assets and liabilities were determined, etc.
After having submitted the registration statement, it does not become effective until twenty days have elapsed after filing. At the option of the Commission the effective date of the registration can be postponed, either before or after registration and effectiveness. The Commission can, if they deem it necessary, issue a stop order at anytime against the securities offered. Usually such stop orders are issued if the registration is incomplete or contains any untrue statement or omits any material fact. The company, which the stop order is issued against, can have it removed by amending the registration to comply with registration requirements.
The 1933 Act also requires that the prospectus, used in the sale of the security, should likewise setforth the pertinent information required in the registration statement. The Act defines the prospectus as any notice, circular, advertisement, letter or communication, radio or otherwise, which directly or indirectly offers any security for sale.
The Commission has no power to pass upon the value or the soundness of any security. They are not judges. They do demand, however, that the investor be fully informed about all of the facts pertaining to the security. With such information, the investor is free to decide whether or not he wants to invest. Speculative issues can still be issued and the public is still free to buy them. In my opinion it would seriously jeopardize or retard progress if such was not the case. Many securities which are now rated in the gilt-edge class were once regarded as rank speculations.
All security exchanges must be registered with the Commission before any security transaction can be executed on them. The registration includes all pertinent facts pertaining to the exchange, which embraces its organization, its rules for membership, etc.
The principle thing, as far as the investor is concerned, is that the exchange agrees to expel, suspend, or discipline, any member whose conduct is not strictly in keeping with just and fair principles of trade.
There is a great deal of criticism for and against the Securities Act. An Act which attempts to control and regulate a complicated financial structure involving billions, with its thousands of ramifications, cannot be expected to be letter perfect.
Nevertheless, it must be remembered that the Act imposes theoretical and rigid restrictions against men who have secured their knowledge by hard practical experience, and while there are many desirable features of the Act, there are many others which appear to the writer to be unwise and impractical.
In subsequent chapters I have related in detail the operation of "pools" and "boiler rooms." The elimation of these evils are unquestionably a godsend to the investor, and every reputable stock house is thoroughly in accord with them. Millions of dollars, yes untold millions, have been lost through pool operations and misrepresentation of many stocks. The public have a right to be given full and explicit information as to what they are buying, and it is manifestly unfair that the public should continue to be looted.
During 1933, when alcohol stocks were favorites, one particular stock was manipulated from 20 to 85. When you effectively halt wash sales, matched orders, and market rigging, at their very inception, together with the dissemination of false information, very few pools can get under way.
Such things have always been prohibited by responsible ex-changes, nevertheless, as I attempted to explain in the chapter devoted to pool operations, the exchange is oftentimes powerless.
The reader can see for himself, how members must execute orders; and as long as non-members are not regulated and con-trolled by criminal law, market rigging will continue. I mean by market rigging, the buying and selling of stock at the same time, without any practical change of ownership, merely to give a stock the appearance of a great deal of market activity and thus generate the price upward. Stock brokers are also forbidden to induce their customers to purchase or sell their securities; hence the evil of handing out calls to broker's clerks, to influence buying, is definitely halted.
Yes, the Security Exchange Act contains many desirable features, but like the stern parent who leans backward, I ask what is going to be the effect upon the child? In this instance, the child is our nation at large.
One paramount evil which has already manifested itself was the rule which required a purchaser to pay fifty-five percent of the stock's purchase price. Was that right? A person can buy an automobile, a home, a house full of furniture, or anything else which is manufactured by industry, without having to pay over one-half cash. Why the discrimination?
You were told that the higher the margin, the less likely you were to be wiped out. This is ridiculous; if the investor would remember that margin is the minimum, and not the maximum, upon which he can trade. How about when prices start to fall? Margins become impaired even with fifty-five percent. If an investor has had to put up his "all" in the first instance, he is unable to take advantage of the fall in prices to average up. Thousands who might buy, refuse to do so, because they consider fifty-five percent an excessive margin. Their buying would ordinarily stem declining prices. Again we encounter the infallible law of supply and demand, the greater the supply the lower the prices. As wild prices swing through the list, the stock market grows on what it feeds. Bearishness begets bearishness. When layer after layer of selling has been gone through, necessitious margin selling begins. Again your supply increases.
While, as I said before, the regulations required fifty-five per-cent from a man who wanted to buy, there was no such restriction imposed upon the man who wanted to sell. True there were rigid restrictions imposed upon bear operations, nevertheless, there were hundreds of professionals who would prefer playing the market on the down-side, rather than the up, simply because it required less money. If a broker so wished, he could take fifteen percent margin from those who wished to sell, but he was forced, in accordance with law, to demand fifty-five percent from those who wished to buy.
If you were somewhat market-wise, and you encountered a dull market, with opinion divided as to whether the next trend would be up or down, what would be your reaction under the circumstances? Possibly you would rather risk fifteen percent in the belief that the market was going down, rather than fifty-five percent on the assumption that it was going up. And remember—a man who buys stock on margin must pay interest on the unpaid balance, but the man who sells stock short has no interest to pay. Thus we encountered in the Security Exchange Act, what appeared to be a one-sided regulation.
This brings us to the favorite subject of many politicians who know their politics better than they know their economics, that is, the prohibition of short-selling. To prohibit short-selling would inject many new and unseen perils into the function of all stock markets. Short-selling is the only thing which keeps the market in balance. Every person should remember that every time a share of stock is sold short, it must at some later date be repurchased in order to cover the short sale.
Take your runaway markets in 1929 for instance, What caused it? What can cause prices to rise higher and higher, out of all proportion to value, except a constant and increasing demand which could not be checked by short-selling? Suppose there had been no short-selling. No semblance of balance could have been maintained. It is impossible to predict to what heights stocks would have soared or to what depths they would have dropped.
Short-selling has time and time again proven a soft cushion against disastrous debacles caused by runaway markets. When the time comes to cover, there is a purchaser for the stocks offered by people who are casting them overboard, either through fear or their inability to meet margin requirements. Hence short-selling, through its repurchases, is the instrument which, in such debacles, provides a market and institutes recovery.
You have often seen the so-called evils of the wheat pit dramatized in press and pictures. As in the stock markets, you hear of politicians, in their ignorance, favoring legislation to prevent short-selling. What would happen if they were successful? Have you forgotten your fundamentals of economics? If so let's examine several principles.
A miller in Minneapolis has a mill with a capacity of two million barrels of flour. His sales organization extends through-out the world. In order to meet world competition, he must often quote prices months in advance.
Say for instance that his agent sells 50,000 barrels of flour in India. This flour is sold at a specific price, sometimes months in advance. In addition to quoting a bona fide price with delivery months away, the miller must also arrange his cargo space, insurance, etc.
To finance the manufacture of this sale, and possibly a million other barrels, he must naturally seek bank credit. He needs the sum of two million dollars to buy his raw material, meet payrolls, etc., until he can convert the wheat into the finished product, flour, and secure foreign or domestic exchange in payment.
The banker is agreeable. The company is in excellent condition, but still two million dollars is a great deal of money.
"What price are you going to pay for your wheat?" he queries the miller.
"That I dont know."
"You mean you don't know whether it will cost fifty cents a bushel or one dollar a bushel?"
"Well, last year it only averaged seventy-five cents a bushel, and there's a larger planting this year. Should be able to get it cheaper."
"Granting that," the banker replied, "but what about drouths, dust storms, floods and other providential hindrances? Suppose wheat sells for $1.25 per bushel. If you're basing your calculations on 75c wheat, you would suffer a loss of one million dollars. We can't lend money under such hazardous conditions."
Thus the miller would find himself unable to finance his business. On the other hand, if he can reply to the banker, "Yes, I know what my wheat will cost. I've bought two million bushels of futures at 85c per bushel." Then the problem narrows down to manufacturing and sales, with which he is thoroughly familiar. He knows approximately what it will cost to manufacture and deliver flour in India, and his prices were quoted accordingly.
Here we find the short-seller contributing to the basic economic structure of good business. The miller, by contracting with the short-seller, is able to take the speculation out of his business and place it on the shoulders of the speculator where it belongs.
What applies to the miller applies to practically every enter-prise engaged in the vast empire called American industry. Every known type of raw material is purchased weeks, months and even years in advance. When you destroy short selling, you create a condition of hand to mouth buying and hand to mouth selling. Our recent era of depression has given us a fair idea of the undesirability of this.
Thus we can establish one fundamental and economic truth; that a broad market for the free buying and selling, not only of securities but commodities as well, is absolutely essential to the smooth functioning of our entire economic system.
Despite the predictions by the misinformed, it is doubtful if the Security Exchange Act will ever be the panacea for our financial problems. Take for instance the security markets of September and October 1937. Despite the millions of words which have been advanced by theorists, despite the fifty-five percent margin, despite the rigid rules and regulations, the security market went to pieces and definitely wiped out around seventy-five percent of the gains made by a two year bull market.
What caused this twenty billion dollar loss?
Certainly not manipulations or pool operations. Certainly not bear raids. Then what? What part did the abstract theory of fifty-five percent margin play in this debacle? As prices started to tumble, would not the shock have been cushioned if the public could have bought securities without paying over one-half-cash?
If this is not true, then what broke the stock market? Or who broke it? If it had been a few years ago, you'd have said that the "economic royalists" broke it. If not them, then it was the manipulators, or the insiders who did it. If evidence was offered that it wasn't this class, then the uninformed would say that it was the promoters who misrepresented the values, or that it was the brokers who induced people to gamble on small margins, or banks who lent them money to buy with, and then squeezed ac-cording to the Wall Street law of greed.
You were promised with the enactment of the Security Ex-change Act that this could never happen. They were going to so police the Street that there would never be a repetition of the 1929 debacle. How could this be? Simply because the SEC had the power to put a man in jail if he misrepresented one word or omitted one material fact about securities. It has the power to make people tell when they bought or sold securities in their companies, to examine companies books, or do just about anything they wished.
Never again could the scheming broker induce people to gamble on thin margins for the sake of making his commission. Never again could the banker squeeze, nor could the pool operators manipulate a stock. No, the New Deal created a people's guardian, and in effect said, "Wall Street is now safe for you."
Then what happened?
The people were fleeced again. Who did it?
Winthrop W. Aldrich, Chairman of the Board of the Chase National Bank, definitely fixed the thinness of markets, and the resultant evils, as the result of Federal acts and agencies. He listed among the causes of lowered efficiency, the capital gains tax, high income taxes, elimination of trading by insiders, inquisitorial visits by the Security and Exchange Commission, uncertainity in the laws relating to pegging and manipulation, and the margin regulations.
"The recent drastic break in prices in the stock market." he said on October 14, 1937, before the Rochester Chamber of Commerce, "reveals an impaired efficiency of the stock market which is not a matter of concern for security dealers alone. It is highly important to investors all over the country, and to every business corporation which needs or is likely to need new capital, or which has maturities of existing issues to refund. It is a matter of concern also to the federal treasury, and to every state and municipality, and agricultural credit corporations which contemplates new issues or which has maturities to meet."
Mr. Aldrich went on to point out that the combination of Federal and New York State estate taxes amounts to twenty two percent for estates of one million dollars, forty percent for five millions, fifty percent for nine millions and over seventy percent for seventy-five millions. To pay such taxes, large blocks of securities must be liquidated. The liquidation of the whole of large estates, in a thin and inadequate stock market, might easily bring in less than enough cash to pay the taxes, not to speak of the fact that nothing whatsoever would be left for the heirs.
Mr. Aldrich points out that before the creation of the Security Exchange Commission, it required an average sale of 13,000 shares of stock to bring about a one percent decline among the representative issues, and whereas the same stocks have been recently put down one percent on average sales of from 2,000 to 3,000 shares. He draws a sharp line of distinction between regulations designed to increase the honesty of the stock market, and those which tend to make impossible the normal functioning of a mechanism which is an essential element of our economic system.
The writer believes that Mr. Kemper Simpson, Economic Adviser to the Security Exchange Commission, hit the nail on the head, when he said, on October 4, 1937, as he resigned from the Commission:
"It does not seem entirely fair to pass the buck by stating that buyers of securities are fools that could not have been saved from their folly. No one can deny that many of them think too little of income and too much of speculative profits, but the events of the last few years have certainly not aided in converting them from speculators to investors. He who calls buyers of stock fools can be properly asked by them just what they should have done with their money? The banks did not want it and gave them little or no return. Bond yields were not attractive, and in too many other investments there was the same objection."
Mr. Simpson was taking issue with certain high officials for having said, "that buyers of securities were fools that could not have been saved from their folly." In the same statement he continued:
"Before closing this statement I must not fail to point out what has probably been the weakest part of the Commission's policy since its inception. It has never shown any real interest in gathering a staff of competent men who are primarily interested in reasonable but efficient administration of the Acts and who would be content to make a career of public service. Moreover, the Commission's confidence has been put almost entirely upon those members of the staff, who come down for a while, merely in order to acquire through Government service, the prestige and experience which they plan to make use of in the business world. My chief reason for making this statement is my hope that it may help to bring about the kind of Commission the trusting investor has a right to expect."
Mr. Simpson is a sincere and capable economist. The Comsonable but efficient administration of the Act and who would mission lost a valuable man when he resigned. He has issued a serious indictment against the Commission. What difference does it make if the public is exploited on one hand by various people to test theories and gain experience, or on the other by market manipulators, if in the end they lose their money?
The stock market has always been regarded as a barometer of business conditions. Always, when prices suddenly break, men look about for some hidden cause or some sudden change in the tempo of business. It would be ironical if well intentioned legislation should continue to demoralize and confuse the very ones that the nation look to for its prosperity and the Government looks to for its taxes.
It is hoped that the Commission will soon take steps to clarify what people can or cannot do, in language which everyone can understand. Ordinarily when company officials see their stock "selling off" in the market, for no good reason whatsoever, and knowing the strength of their own internal organization, they would quickly rally to its support. However, they are afraid to do that any longer. They know that they can be accused of "pegging" the stock, and are subject to prosecution.
The Security Exchange Act was and is a great law, if it will confine itself to the legitimate policing of security markets to in-sure honesty and square dealing for the investor. When, however, it starts to interfere with the smooth functioning of our great financial machinery then it utterly fails in its purpose. The twenty billion dollar drop in prices during September and October 1937, under its rigid code, is an indictment which defies contradiction.
Shortly after the drastic break, a new ruling was quickly manufactured lowering margin requirements to forty percent instead of fifty-five. But why make it forty percent?
Were you not told on good authority, by men who should know, even though they had never had actual experience in Wall Street, that fifty-five percent margin requirement meant safety for the investor?
Evidently they found out what every banker and professional market operator knew, that it was ridiculous to ask the investor for 122 percent margin on his purchases, and that's what it amounted to. If you bought $10,000 worth of stocks you were forced to put up $5,500, thus having put up 122 percent margin against the unpaid balance of $4,500. This rate was an increase from the old days of 20 or 25 percent to 122 percent.
Even though it came too late to save the investor their billions, after they had been told that Wall Street was safe for them, the recognition of the mistake and the reduction of the margin is commendable.