Stock Market Control

STOCK MARKET CONTROL
TWENTIETH CENTURY FUND, INC.

This study has been made under the auspices of the Twentieth Century Fund, Inc., founded by Edward A. Filene, President of William Filenes Sons Com pany of Boston, Massachusetts.
T r ustees:
Edward A. Filene, President
Newton D. Baker Bruce Bliven Henry S. Dennison
John H. Fahey James G. McDonald Roscoe Pound
Owen D. Young
Evans Clark, Director
11 WEST 42ND STREET NEW YORK CITY

A SUM M ARY
OF THE
RESEARCH FIN D IN G S A N D RECOM M ENDATIONS

OF
THE SECURITY M ARKETS SU R VEY STAFF

OF THE
T W E N T IET H CEN TU R Y FUND, INC.
EDITORS:
EV A N S CLARK J. FREDERIC DEW HURST ALFRED L. BERNHEIM M ARGARET G R AN T SCHNEIDER
D. APPLETON-CENTURY COMPANY
INCORPORATE D
N EW YORK
LONDON
vi
J. Frederic Dewhurst, cooperated and advised closely with the tech nical staff from the outset to the conclusion of the survey. Able editorial and general research assistance was rendered by Margaret Grant Schneider. Margaret G. Myers acted as special adviser on questions involving all aspects of banking and credit. Noel Dowling, Professor of Constitutional Law at Columbia University, acted as legal adviser to the staff and passed upon the many questions involving the constitutionality of the recommenda tions. David Stock is among those who rendered valuable assis tance. His experience as a former counsel to the Banking and Currency Committee of the United States Senate in its investiga tion of stock market practices, made him especially well qualified as a consultant to the staff. A mass of factual data, some of which had never before been available to the public, was put at the disposal of the Fund through the good offices of the New York Stock Exchange. Among Exchange officials who were helpful in this way were Richard Whitney, President; Allen L. Lindley, Vice-President; Paul Adler, a Governor; J. Edward Meeker, Economist; J. M. B. Hoxsey, Executive Assistant to the Stock List Committee; L. R. Harrison, Secretary to the Business Conduct Committee, and Jason Westerfield, Assistant Secretary of the Exchange. These gentlemen are, of course, in no way responsible for the conclusions and recommenda tions presented in this volume. The findings and conclusions of the senior research staff were in every case submitted to one or more authorities for review, and on the basis of criticisms thus obtained revisions were made which, it is believed, have greatly improved the presentation. The con clusions, however, are those of the staff members themselves, and no responsibility for them should be imputed to any of the reviewers. Among those who have read one or more chapters are the following: Leonard P. Ayres, Vice-President, Cleveland Trust Company; Charles A. Dice, Professor of Business Organization, Ohio State University; C. O. Hardy, Brookings Institution; Russell Leavitt, Moodys Investors Service; H. L. Reed, Professor of Economics, Cornell University; Colonel Malcolm C. Rorty; A. Vere Shaw, Investment Counsel, New York City; and John F. Sinclair.
FOREWORD
In the late summer of 1933 the officers of the Twentieth Century Fund, Inc., foresaw the immense public demand for stock market regulation which the 1934 session of Congress would bring to a head. They also realized that there would be need for public enlightenment in direct proportion to the interest aroused. Those concerned with the Fund have keenly appreciated the notable achievements of the Senate Commit tee on Banking and Currency in informing the American people, through its hearings, on the subject of stock market abuses. They have realized, however, that an unbiased, non political and objective picture of the security markets and their practices would be welcomed by the public as a back ground against which to judge the value of legislative and other efforts to curb the evils of the past. This volume is the result. In the following pages an attempt has been made to state, in as clear and simple terms as possible, how the security markets are organized and how they operate. In contrast to most other books on the subject, however, this volume at tempts to pass critical judgment on market practices. As in formed criticism demands a standard of values it has also been necessary to consider the functions the markets should perform in our economy to serve the best interests of the nation as a whole. Nor have the authors of this volume stopped with what is so often called "merely destructive criticism. In the final chapter a concrete, and we hope a constructive, program for the regulation and control of the markets has been suggested. vii
FOREWORD
This volume is in the nature of a preliminary digest of an immense amount of materialsubsequently to be published in fullprepared by a corps of over 30 economists and assis tants during the months of October, November and Decem ber, 1933. Under the active supervision of Mr. Alfred L. Bernheim, Director of the Funds Security Market Survey, the field was divided among eight senior staff members. Their reports have furnished the basis for this book. In offering this volume to the public its authors wish to express their appreciation to a large number of persons, both members and non-members of the New York Stock Ex change, who, with great generosity, gave assistance to the staff. The officers of the Exchange and many of the leading brokerage firms placed at the Funds disposal hitherto un available records which proved to be of the greatest value in the survey. Over a hundred specially informed persons, asked by the staff for their opinions as to the best ways of curbing existing evils in the interest of the more efficient functioning of the markets, made detailed and valuable sug gestions. A score of others devoted time and effort to read ing the tentative drafts of the research reports and have given the staff the benefit of their criticism. To all of these helpful cooperators the Fund wishes to express its sincere gratitude. Finally it should be said in all fairness that this study has been designed primarily to discover whether weaknesses exist in the mechanism of trading rather than to give an academic description of the markets. Because of this objective little emphasis has been placed on the various positive ser vices which the marketsand especially the organized ex changesperform in our economic life. The mere fact that the public can still buy and sell securities within a few moments after issuing their orders, while the holders of real estate find their assets frozen, is a tribute to the technical efficiency which the security exchanges have reached. The
viii
FOREWORD
activities of the New York Stock Exchange in raising the standards of corporate reporting in the United States are another example of the public service rendered by the Exchange. Furthermore, the exchanges cannot be held responsible for all of the evils popularly attributed to them. The ex changes are often reflections of wider movements in our economic life. For example, the speculative boom of the late 20s was not confined to security speculationit was a con tagion that affected all our affairs. Nor can the markets be held responsible for all that goes on in them. After all, even the most highly organized exchange does not itself buy and sell securities. It merely furnishes facilities for so doing. Those who transact business in it are not acting as em ployes of the exchange, but as agents for the trading public or their own firms, or are dealing on their own personal account. In dwelling on the evils of the market the authors of this volume have not been concerned with assessing blame or with the calculation of responsibility. They have concen trated on shortcomings, not to castigate the markets, but to contribute towards their more efficient performance.
E vans C la rk
Twentieth Century Fund, Inc. 1 1 West 42 nd Street New York City February 21 , 1934
ix
CONTENTS
O r g a n iz a t io n o f S e c u r ity M a r k e ts S u r v e y Forew ord C h a p t e r I. T h e P u b l ic 's S t a k e
in t h e
v
v ii S e c u r it y M a r k e t s
1 1 2 3 7 7
1. 2. 3. 4.
American Securities W ho Owns Stocks and Bonds The Multitude in the Market The Consequences of Market Fluctuation a. On Individuals
b. On Banks
c. On Endowed Institutions and Insurance Companies 5. The Markets and Business
C h a p t e r II. T h e M a r k e t s
as
7
9 10
T h e y Sh o u l d B e
13 13 13 14 15 16 17 17 18 19 21 23 23 23 26 28
1. The Markets in Economic Theory 2. The Functions of the Markets a. Directing the Flow of Savings into Investment b. Convertibility into Cash c. The Evaluation of Securities
C h a p t e r III. T h e O r g a n iz a t io n
of the
M arkets
1. A a. b. c. d.
Birds Eye View The Exchanges The Over-the-Counter Market The Houses of Issue Perspective
2. The Organization of the Exchanges a. The New York Stock Exchange b. The New York Curb Exchange c. Other Exchanges
C h a p t e r IV. T h e O p e r a t io n
of the
M arkets
30 30 32 38
1. The Flotation of New Issues a. The Investment Banker b. Procedure in Flotation of New Issues
xi
xii
CONTENTS
c. American vs. European Practice d. Changes in American Practice: The Banking and Securities Acts of 1933 2. Trading in Old Issues The Exchanges a. The Securities Traded In ( 1 ) Listed Issues ( 2 ) Requirements for Listing on the New York Stock Exchange b. Exchange Members and Their Function (1 ) The Commission Broker (2 ) The Two Dollar Broker ( 3 ) The Odd-Lot Dealer (4 ) The Floor Trader (5 ) The Specialist ( 6 ) The "Bond Crowd ( 7 ) The Inactive Member c. Methods of Trading 42 44 48 48 48 49 52 53 53 54 54 55 56 57 57 63 65 65 65 66 67 67 68 68 69 69 70 71 72
3. Trading in Old Issues Over-the-Counter

C h a p t e r V. E u r o p e a n S t o c k E x c h a n g e s
1. General Comparison a. Government Control b. Relation to Banks c. Listing Requirements d. Term Settlements e. Trading in Options f. General Character of Trading 2. Special Characteristics of Foreign Exchanges a. London b. Paris c. Berlin d. Other Exchanges
C h a p t e r VI. A C r it iq u e
of the
S e c u r it y M a r k e t s
1. The Ultimate Tests 2. Investment vs. Speculation 3. Types of Trading and Market Functions a. The Evaluation of Securities b. Marketability and Price Continuity c. Directing the Flow of Savings
74 75 77 77 83 85
CONTENTS
d. The Volume of Speculation e. Margin Trading and Speculation 4. Margin Buying a. Bank Credit and Brokers Loans b. Brokers Loans and Plant Expansion 5. Short Selling a. Short Selling and Security Prices ( 1 ) In Relation to Major Trends (2 ) In Relation to Short Swings ( 3 ) In Relation to Individual Issues b. Stock Exchange Regulation c. The Effects of Short Selling 6. Manipulation in the Security Markets a. Pool Operations b. Artificial Market Activity c. Collusion between Pools and Specialists d. Abuse of Options and Trading by Corporation Officials ( 1 ) The Origin of Options ( 2 ) The Life of Options (3 ) Conclusions e. Publicity in Market Manipulation ( 1 ) Correlation of News with Pool Operations (2 ) Subsidized Column Writers (3 ) Organized Publicity for Profit f. Use of Customers Men g. The Banks and Manipulation
C h a p t e r VII. I n f o r m a t i o n
and
xiii
86 89 90 90 93 95 97 97 98 102 103 105 107 108 HO HI 114 115 117 118 118 119 120 121 124 125 127 128 130 131 132 134 136 137 139 141 144
A d v iso r y S er v ic e s
1. The Stock and Bond Tickers 2. Official Reports of Corporations a. New Issues The Securities Act b. New Issues Listing Requirements c. Periodic Corporation Reports (1 ) The Essentials of Proper Reporting 3. Financial Manuals a. Security Ratings 4. Advisory and Forecasting Services 5. Investment Counsel
xiv
CONTENTS
a. Rates and Fees b. The Record of Performance 146 146 148 150 151 152 153 155 156 157 158 160
1 62
6. Brokerage House Advice a. The Difficulties of Impartiality b. The Activities of Customers Men 7. The General and Financial Press a. News Tickers (1 ) Shortcomings of News Tickers b. The Financial Press c. The Daily Newspapers ( 1 ) Newspaper Abuses d. General Periodicals
C h a p t e r VIII. C o n c l u s i o n s
and
R e c o m m e n d a t io n s
1. The Base Line for Recommendations 2. Summary of Recommendations 3. Analysis of Problems and of Recommendations a. Federal Regulation of Security Exchanges ( 1 ) The Problem ( 2 ) Recommendations b. Federal Regulation of Over-the-Counter Markets ( 1 ) The Problem (2 ) Recommendations c. Federal Incorporation A a ( 1 ) The Problem (2 ) Recommendations d. State Incorporation Laws ( 1 ) The Problem ( 2 ) Recommendations e. Corporate Accounting and Reporting ( 1 ) The Problem ( 2 ) Recommendations f. Brokerage Firm Customer Relationship ( 1 ) The Problem (2 ) Recommendations g. Customers* Men (1 ) The Problem ( 2 ) Recommendations
162 164 165 165 165 167 168 168 169 170 170 172 173 173 173 173 173 174 175 175 176 176 176 177
CONTENTS
h. Margin Buying (1 ) The Problem (2 ) Recommendations (a ) Those Rejected (b ) The Proposed Method of Control (c) Expected Results (d ) Difficulties i. Short Selling (1 ) The Problem (2 ) Recommendations j. Specialists (1 ) The Problem (2 ) Recommendations (3 ) Effect of Recommendations k. Pool Activities (1 ) The Problem (2 ) Recommendations 1. Financial News (1 ) The Problem (2 ) Recommendations (3 ) Suggestions to Newspaper Publishers m. Investment Counsel (1 ) The Problem (2 ) Recommendations n. Statistical Data ( 1 ) The Problem (2 ) Recommendations 4. Scope of Recommendations 5. Effect of Recommendations on Security Business a. Immediate Effects b. Long Time Effects
xv
177 177 179 179 182 184 185 186 186 187 188 188 191 192 193 193 197 199 199 201 202 202 202 203 203 203 204 205 207 207 207
CHARTS
1. 2. 3. 4. 5. 6. Share Transactions on the New York Stock Exchange Share Transactions in the United States The Flow of Savings into Investment How Securities Are Distributed Some Routines for Cash Transactions Routine of a Margin Purchase 1 5 20 33 43 58 59
xvi
7. 8. 9. 10. 11.
CONTENTS
60 61 62 78 87 94 100
Routine of a Margin Purchase 2 Routine of a Short Sale 1 Routine of a Short Sale 2 Quarterly Earnings Compared with Market Values Investment Holdings in Relation to Floating Supply and Turnover 12. Origin and Flow of Brokers Loans, 1 9 2 8 -9 13. Total Short Interest Compared with Stock Prices
TABLES
1. 2. 3. 4. 5. 6. Securities Held by Banks and Insurance Companies Number of Shares Sold on New York Stock Exchange Estimated Savings Compared with New Security Issues New Issues Handled by Investment Banking Houses Bonds Listed on the New York Stock Exchange Stocks Listed on the New York Stock Exchange 3 6 31 34 50 50
Chapter 1
THE PUBLICS STAKE IN THE SECURITY MARKETS

1. A m e r ic a n Se c u r it ie s
HE people of the United States have a vital stake in the proper functioning of the nations security markets. From a third to a half of the annual savings of American indi viduals and corporations or from $4 billion to $6 billion in normal yearsflows through investment channels into securities of various kinds which are traded in and evaluated in the organized and unorganized security markets. Nearly half of our entire national wealth is represented by trans ferable certificates of ownership or indebtednessstocks and bondswhich are bought and sold in these markets. It is estimated that even at the low levels of 1932, the worst year of the depression, the total market value of outstanding securities was at least $100 billion, about equally divided between stocks and bonds. On the basis of par value for bonds and book value for stocks the aggregate would approx imate $240 billion. It might be thought that because only a small proportion of the total outstanding shares or certificates of each issue is actually traded in the market in any year, the size of the nations stake is correspondingly less. Those securities which are bought and sold, however, set the value of all the rest, and therefore directly affect the economic standing of every owner of stocks or bonds. Not only do market conditions intimately affect the actual owners of these securities but, through the holdings of banks, insurance companies, and 1
endowed institutions such as colleges and hospitals, they are closely related to the welfare of the millions of Americans who have savings or checking accounts, who are the owners and beneficiaries of life insurance and annuity policies or who depend on private education or institutional medical care.
2. W
ho
O w n s Sto c k s
and
B o n ds
It is surprising, in view of the usefulness of the data, that no census or enumeration has ever been made of the holders of American securities. No one knows how many individuals own stocks or bonds, or the average amounts of their hold ings. Only the roughest guesses can be made. It is probable, however, that between 6 and 10 million individuals own bonds and between 9 and 11 million individual men and women in the United States own stock. Even assuming that almost everyone who owns bonds also owns some stock it is probably true that at least every ninth or tenth man, woman and child in the United States has a direct stake in the na tions security marketswhich means at least one family out of every three. Of the ten or eleven million stockholders in the country about one million are estimated to be employees who have been sold shares by their own employers, and another million are customers of public utilities who bought at their companys solicitation. It is probable that over onefifth of all the corporate stock outstanding is held by indi viduals with net incomes of less than $5,000 a year. Only a guess can be made as to the total value of the securities held directly by the more than 10 million individual owners in the United States. On the basis of such published statistics and estimates as are available it can be roughly estimated that the value of stocks and bonds owned directly by individuals is nearly $50 billion and may exceed this amount. Thus nearly half of the value of all outstanding securities is in the hands of individuals. But this sum, large
THE P U B L I C S STAKE
as it is, does not represent the entire stake of the American people in the securities of the United States. Through owner ship of life insurance policies and payment of insurance premiums, a considerable portion of which are invested in bonds, more than 50 million people are indirectly, but none theless vitally, interested in the security markets. More than 13 million persons have savings in mutual savings banks, and at least twice this number have deposits in national and state banks and trust companies. A majority of the popula tion, therefore, has an interest in the security markets through the investments of these banks and insurance com panies amounting to nearly $27 billion in 1932.
TABLE 1
S e c u r it ie s H e l d b y B a n k s a n d I n s u r a n c e C o m p a n ie s , 1 9 3 2
Bonds National Banks....................................... State Banks, and Loan and Trust Com panies .................................................... Savings Banks......................................... Life Insurance Companies..................... Federal Reserve Banks.......................... T o tal................................................. $6,752,000,000 6.085.000.000 4.400.000.000 6.500.000.000 1.860.000.000 #25,597,000,000
Stocks $205,000,000 384.000.000 145.000.000 524.000.000
$1,258,000,000
3. T h e M u l t it u d e
in t h e
M a rket
' The precise nature of the nations tremendous stake in the security markets is now of far more common knowledge than before the great bull market of the late 20s and the subsequent collapse. If a graphic diagram might be drawn of the myriad lines of direct and indirect influence which security prices have exerted upon the millions of men, women and children in the United States since October 1929 the results would be dramatic in the extreme. The spectacular
decline of October was a tragic precipitation of that influence, still vivid in the memory of every living adult. No one knows precisely how many people were actually "in the market at the time that is, how many were actively trading. No statistics of this sort exist. The personal ac quaintanceship of almost everyone, however, bears eloquent testimony to the fact that people of all classes in the popula tion had then the most direct and intimate stake in security prices. The amount of trading, for which figures exist, does give at least an indirect measure of the publics participation. In the pre-war decade the yearly transactions in stocks on the New York Stock Exchange averaged about 155 million shares, with maximum days trading at about 2.9 million shares. In 1925 about 450 million shares were bought and sold on the New York Stock Exchange. In 1929 the volume had swelled to the prodigious total of 1,125 millionan in crease of over 150 per cent in four years and seven times the pre-war volume. During the most active period of 1929 as many as 16 million shares were bought and sold in one day. The depression years have greatly reduced the volume of trading, largely because of the retirement from the market of hundreds of thousands of traders. In 1932 the number of shares sold had dropped to 425 million, somewhat less than in 1925. But there is every reason to believe that the general public is only waiting a substantial rise to surge back into the market again. The up-swing in July 1933 brought daily transactions again up above the 9 million mark while the years total was 655 millions a larger volume than in any year previous to 1928. Chart 1 shows the growth of trading on the New York Stock Exchange and Table 2 shows the volume of transactions by years since 1900 and for the most active day in each year.
THE P U B L I C S S TAKE
Exchange
s S t e O
-I
York Stock
N ew
1
ft
a ta X 1
H
o n th e
JL
L
TBT"
1
ft
X
1
J.
X i... : j
w
Share Transactions
X
1
X L 1
r
1 .
J
l
> X X i
IE
IT
X
1
L
I. T T
CN
_s a 3 C c <
lO O O O CM O O r
K CN CN
CN
CN
CO CN
C O
CO CN
TABLE 2
n T u m ber of
S h a r e s S o l d on N e w Y o r k S t o c k E x c h a n g e
Year 1900 1901 1902 1903 1904
Annual (*) 138,312,226 265 ,577,354 188,29 1,181 160,748,368 186,529,384 263,040,993 284,016,984 195 ,445,321 196.821.875 214,425,978 163,882,956 126,515,906 1 3 1,0 5 1,116 83,283,582 47,899,628 173 ,378,655 232,842,807
Maximum D ay (2) November 1 2 ................................... April 3 0 ............................................ April 2 1 ............................................ January 9 ......................................... December 8 ...................................... February 2 7 ..................................... August 2 0 ......................................... March 1 4 .......................................... November 1 3 ................................... June 4 ............................................... February 3 ....................................... September 2 7 ................................... December 1 1 .................................... June 1 0 ............................................. Ju ly 3 0 . . . , ....................................... September 2 8 ................................... December 2 1 .................................... February 1 ....................................... October 1 8 ....................................... November 1 2 ................................... April 2 1 ............................................ March 2 3 .......................................... April 1 7 ............................................ M ay 4 ............................................... November 2 0 ................................... November 1 0 ................................... March 3 ............................................ October 4 ......................................... November 2 3 ................................... October 2 9 ....................................... M ay 5 ............................................... February 2 4 ..................................... August 8 ........................................... Ju ly 2 1 .............................................. 1,668,250 3,281,226 1 ,995,159 1,520,700 2,881,147 1,911,800 2,731,865 2,521,574 1,667,407 1,640,350 1,663,112 1,741,974 1,279,474 871,222 1,306,690 1,662,302 3,176,800 2,058,400 1,638,900 2,503,700 2,063,300 1 ,3 4 ,500 2,129,300 1,566,000 2,616,400 3,427,100 3 ,873,700 3 ,1 47 ,300 6,942,500 16,410,000 8,279,200 5, 345 , 7 5,461,150 9,572,020
1905
1906 1907 1908 1909 1910 19 11 19 12 1913 19 14
1915
19 16 19 17 1918 1919 1920 1921 1922 1923 1924
184 536,371
143 ,378,095 312,875,250 223 ,931,349 171 ,439,693 260,753,997 237,276,927 282,032,923 452,211,399 449,103,253 576.990.875 920,550,032 1,124,608,910 810,632,546 576 765,412 425,234,294 654,816,452
1925
1926 1927 1928 1929 1930
1931
1932 1933
~Q) (2 )
York Stock Exchange Year Book, 19 3 1-3 2 , p. 67. Street Journal, January 13, 1934, p. 11.
THE PUBLI C' S STAKE

4. T h e Co n seq u en c es a.
of
M a r k e t F l u c t u a t io n s
o n in d iv id u a ls
The personal experience of millions of Americans makes it unnecessary to describe in detail the human and economic consequences of security price changes in the lives of those people who are actively in the market. Because we have no accurate statistics on the experience of individual security holders we can only guess at the personal losses involved since 1929. The total value of stocks listed on the New York Stock Exchange alone, however, shrank from nearly $89 bil lion, or an average price of $89 a share at the peak of the market in 1929, to less than $16 billion, or about $12 a share, at the low point of 1932. Bonds listed on the Ex change shrank in value by $18 billion, declining from $49 bil lion in September 1930 to $31 billion in April 1933. Of course, this decline in some instances meant only a paper loss, just as the preceding boom brought paper profits, but the effect of even paper gains and losses on individual lives is great. The indirect stake which the entire population holds in the security markets, however, is less generally understood. It is obvious that the deposits and savings of the people are jeopardized by any drastic decline in the market values of the securities into which the banks have converted them. The collapse of security values since 1929 has been one of the aggravating causes of the closing of at least 6,000 banks in the United States, involving total deposits of $3.5 billion.
b.
o n ban ks
American banks, subsequent to the war, placed an in creasingly large proportion of their assets in forms which were strictly dependent on the security markets. In 1921
half of the assets of national banks (56.3 per cent) were in commercial loans and loans to other banks while 42 per cent were invested in securities and in loans based on securities as collateral. In 1929, however, 54 per cent of their assets were in these latter classes of holdings$6,658 million in bonds and stocks and $5,114 million in loans secured by stocks and bonds as collateral. The collapse of bond prices in 1931 caused widespread difficulty for the banks, which was aggravated by the forced selling of bonds to obtain a more liquid position. If the Comptroller of the Currency and state banking supervisors had not allowed banks to evaluate their investments on other bases than market values, closings on a far larger scale than actually occurred would have followed. Not only were the depositors of the banks which closed deprived of their ready cash, but the banks which did not close were forced to demand payment of large quantities of loans to their de positors because the value of the collateral securities had drastically declined. It is not only declines in security values, however, which have an effect on the nations banking and credit structure. When prices are on the upswing a vast demand for credit arises from traders who finance their market operations on borrowed funds. In 1929 loans made directly by banks to brokers on the New York Stock Exchange for this purpose on their own account and on behalf of out-of-town banks and non-bank lendersreached the record-breaking total of $9.3 billion. These brokers loans were larger in volume than the total value of the stocks and bonds held by all the na tional banks in the country at the time, and over four times as great as all their real-estate loans. In addition to this huge volume of credit loaned by banks and others to brokers and by them to their customers, an up-swing in security prices furnishes the basis for a great
expansion of collateral loans made by banks directly to their customers. A large part of this increased credit was used to finance further market operations. Loans of this sort by national banks alone increased from $2,888 million in No vember 1921 to $6,380 million in the same month of 1929, an increase of 121 per cent. In the aggregate total loans on securities made by banks and other lenders reached the enor mous total of more than $20 billion at the peak of the bull market in 1929.
C. ON ENDOWED INSTITUTIONS AND INSURANCE COMPANIES
The endowed institutions of the nationchurches, col leges and universities, hospitals and foundations, and through them the millions of American men and women whose lives they influencehave a special stake in the prices of securities. For example, 30 institutions of higher learning in all parts of the country recently surveyed by Wood, Struthers and Company, report over two-thirds of their en dowment invested in securities 50 per cent in bonds and 18 per cent in stocks. Since the 1929 collapse colleges have suffered severely through the decline of income from the securities they own. Churches and hospitals have suffered likewise. The philanthropic foundations, finding their in come shrunk, have in many instances made large drafts upon principalat greatly depreciated market valuesin order to meet their obligations. The great life insurance companies of the nation, on the solvency of which the future security of the holders of 116 million policies depends, are also intimately tied in with the fortunes of the security markets. Of the investments of the 52 leading life insurance companies over one-third are in securities 34 per cent in bonds and 3 per cent in stock. These holdings totalled close to $7 billion in 1932. The 25 leading fire insurance companies, with total security hold
10
ings of nearly $1 billion, owned a far larger proportion of stocks. Wholesale failures of insurance companies have been avoided during the depression. The heavy drains upon their resources arising from the demand for policy loans in 1933, however, coupled with the decline of income from premiums and due to security defaults, forced the superintendents of insurance in New York and several other states to order a suspension of the life insurance policyholders right to bor row on their policies or surrender them for cash. Some large companies such as the National of Illinois failed. One block of 11,500 bank shares carried on its books at $336 a share was found to have a current market value of less than $50. The fact that such failures have been rare is due in part to the use of "convention values in valuing their assets, as well as to the conservative management of investments by most of the large companies and the rigid regulation by the state insurance commissions.
5. T h e M a r k e t s
and
B u sin ess
The influences of the security markets on general business conditions are infinite in their ramifications but exceedingly difficult to measure. In one direction, however, this influence is plain. When the prices of securities rise the paper profits of traders is increased. Insofar as these profits, whether real ized or anticipated, are spent, rather than invested or used for further trading, they furnish a direct stimulus to business activity by increasing the demand for consumers goods. Although the conclusions have not been completely demon strated, in a recent study of consumer purchasing power it was estimated that $11 billion of stock market profits were withdrawn from the market and used for the purchase of consumers goods between January 1, 1927, and September 1, 1929. Of this total it is estimated that $2.2 billion was
11
withdrawn and spent in 1927; $3.2 billion in 1928 and $5.6 billion in 1929representing about one-quarter of the net increase in the values of securities during the period. It is common knowledge that as profits mounted during the stock market boomwhether they were realized in cash or existed merely in the current quotations of securities heldthe scale of living of the traders rose; and the expenditures of the wealthy were aped by those less fortunate. Insofar as these profits were not the result of increased productive activity they had the same effect on general business as any other kind of credit inflation from which in fact they were actually derived. Just as security traders profits, whether realized or merely anticipated, increase purchasing power, so losses contract it. No one has attempted to compute the force of this depressing influence on business since the collapse in securities occurred, but in view of the extent of the decline and the widespread ownership of securities, it must have been enormous. A vast amount of study has been given to the obviously close correlation between the ups and downs of security prices and changes in general business conditions. That a correlation between the two exists no one denies. But how far the one is the cause of the other is far less clear. The security markets are commonly supposed to be a barometer of business. Some claim that they actually have a causal effect on the economic weather. A review of the rela tion of security prices to indices of general business in the United States since 1887 shows a consistent tendency of the market to anticipate by a few months the ups and downs of economic activity. Out of 14 major turning points only three exceptions have been foundthe low of June 1894, the high of June 1899 and the high of June 1929. Some correlation has been shown to exist between stock prices and business failures, the prices of coke, pig-iron and bar-iron, the number
12
of blast furnaces in operation, factory employment, financial advertising, etc.although in most of these instances changes outside of the security markets have occurred first. No concrete causal relationship has been actually demon strated by any competent investigator on the basis of these correlationseven though stock price changes on the whole seem to precede business fluctuations. Although it is possible that in the actual functioning of the economic machinery a downward motion in security prices is transmitted into a similar movement in other gears and wheels of the business mechanism, it is by no means certain that this is true. On the other hand, it is impossible to escape the conclusion that the fluctuations in business conditions will be reflected in the price of securities since the investment value of the latter arises from the activity and prosperity of business. There can be little doubt, however, that the anticipatory nature of security prices has a real influence on business by way of the psychological processes of thousands of executives who control policies. As has been pointed out by Professor C. A. Dice and others, although most business men profess to have given up any belief in the forecasting function of the market, nevertheless they are affected in their own decisions by stock prices. When prices are rising they are optimistic and willing to make long-term commitments; when prices break sharply they become timid and are unwilling to carry out plans for expansion. Though the psychological effect of stock market prices can not be measured it appears to be a powerful influence both as a depressant and as a stimulant of business activity in gen eral. It is questionable, however, whether the total effect of stock market prices on business can be as great as the total effect of business developments on the markets. Whatever the exact relationship may be, however, no one denies that the two are inextricably interwoven.
Chapter II
THE MARKETS AS THEY SHOULD BE
1. T h e M a r k e t s I n E c o n o m ic T h e o r y
".THOUGH some of the present-day writers have dis cussed extensively the functions and abuses of the security market, no recognized economic authority has pub lished a complete, systematic and thoroughly critical work on the function and influence of the markets in our modern economy. Economists have never worked out a consistent theory of the markets as, for instance, the biologists have studied a central function of the human organism like the nervous system. One would expect that some comprehensive analysis would have been made of all the functions which have been variously assigned to the security markets, of how well these functions have been performed, of whether the assigned functions are mutually consistent, and, if so, how they are related. Such an analysis would make possible an estimate of the nature and importance of any existing abuses and of their relation to the functions. In the absence of any such complete and authoritative anal ysis it is necessary to indicate briefly the functions which it seems reasonable to expect the markets to perform in our economic life in order best to serve the interests of the nation as a whole.
2. T h e F u n c t io n s
of the
M ark ets
First, let it be set down as axiomatic that security markets are essential in any economic system in which shares of own ership or evidences of indebtedness can be bought and sold.
14
The very act of buying and selling creates a market. Even a nation which had nationalized its industries would require some kind of security marketat least in government obli gations. The only conceivable state in which such markets would not be necessary is one in which no private ownership except personal possessions is allowed and in which all gov ernment revenue is obtained by taxation. Trading in securi ties can take myriad forms both of freedom and regulation but wherever evidences of ownership or debt are bought and sold there, of necessity, is a market. It appears that the mechanism for distributing new issues and for trading in existing securities should perform three functions.
a. DIRECTING THE FLOW OF SAVINGS INTO INVESTMENTS
First, they furnish a mechanism for business concerns and government agencies to obtain funds with which to carry on their activities. Or, to put it the other way around, they supply the means by which surplus income can be applied to the development of economic life. The sale and the pur chase of new issues of stocks and bonds performs this func tion. Whenever a corporation sells new stock to the public it obtains funds from those to whom it is sold. In return for his contribution the buyer becomes a part owner in the busi ness and obtains the right to share in the earnings of the corporation. When a company or a government agency sells bonds it is borrowing funds from the buyers. No share of ownership passes, but the seller agrees to pay interest to the lender and guarantees at a specified future date to pay back to the purchaser the face value of the bond and frequently pledges physical and other assets to guarantee fulfilment of the promise. It is clear, then, that the more efficient the security mar kets, the easier it is for the government and industry to
T H E M A R K E T S AS T H E Y S H O U L D BE
15
finance new developments, and conversely, for individuals with surplus funds to put them to profitable use through the activities of the State or private corporations. Whatever may interfere with the functioning of the markets obstructs the flow of savings into the nations economic development. Looked at in another way, regulation and control of the mar keting of securities can be used as a means by which the flow of savings into economic activities is regulated and con trolled. For the markets to perform this function with maximum efficiency the flotation of new issues should accelerate the flow of capital into those undertakings which answer the greatest need and retard the flow into enterprises with less justification for expansion. In evaluating existing securities and in facilitating secondary distribution the exchanges should assist in directing the flow of savings.
b. CONVERTIBILITY INTO CASH
Second, the security markets supply a means by which those who hold securities may exchange them for others or convert them into cash. The more effective the marketing processes become the easier it is for owners of stocks and bonds to sell them. It is unnecessary to describe in detail the public as well as the private advantages of such a ready mar ket. To clarify the picture imagine the indescribable difficul ties which would follow a condition in which the owner of high-grade stocks or bonds who wants to sell would meet the uncertainty and delay which faces the owner of real estate today if he is in need of ready cash. Such a situation would involve a complete revolution in banking and insur ance, not to mention the financial affairs of at least one per son out of every ten. The essentials of a ready market for securities are two: liquidity and price continuity. In other words, it must be pos
16
sible for sellers to find purchasers with the minimum of effort and the least possible delay, and at a price which varies little from the current quotations. Buyers and sellers must be brought together and there must be enough trading going on all the time so that investors will be able to buy and sell without delay and at small price variations.
C. THE EVALUATION OF SECURITIES
Third, the markets provide the economic machinery where by values are placed upon securities. It is obviously of great importance for those who hold stocks and bonds to know at any given time the amount of cash they can obtain by sell ing, just as it is equally important for those who want to buy to know how much they will have to pay. For the welfare of the nation as a whole, it is important that the price paid and the price obtainable should be as close as possible to the real value of the security. The prime essential for the efficient performance of this function of evaluation, therefore, is that the price set by trading in the markets be as close as possible to what might be called investment value. This value is based on the pres ent and future income-yielding prospects of the agencies which the securities have been employed to finance. The ideal security markets, therefore, are those (1) that produce prices for securities which are as close as possible to investment values; (2) that provide the greatest market ability and price continuity for purchases and sales and (3) that facilitate the most productive flow of surplus funds into the nations economic development. As this survey has revealed, these ideals may to a certain extent be mutually exclusive. But as large a degree as possible of each should be attained without undue limitation of the others.
Chapter III THE ORGANIZATION OF THE MARKETS ITH this conception of how the security markets ought to function, a brief review of their functional organization and of their operating methods is in order. In this chapter and in the one that follows, no attempt will be made to evaluate the actual in terms of the ideal. The imme diately following pages are merely designed to give as simple and lucid a picture as can be drawn, in view of their com plexity, of the organization and operations of the markets, both in the United States and in other leading countries. Informed and creative criticism begins with a firm knowl edge of reality and upon it builds the structure of reform in the light of the ideal. In Chapters IV and V the actual operations of the markets are objectively described, in Chap ter VI the existing organization and operations are judged and criticized by the standards outlined in Chapter II. Chap ter VII is devoted to a discussion of the sources of informa tion and advice available to the investor. In the final chapter, a specific program is developed for bringing the actual into closer conformity with the ideal. 1. A B ird' s-E y e V i e w By definition the security markets are places where stocks and bonds are bought and sold. Suppose it were possible to stand far enough away from these United States to view the entire continent with a telescopic eye. Such an observer would seeespecially in periods of great price changes 17
18
millions of shares of stock and tens of millions of dol lars worth of bonds changing hands every day throughout the country. a m E EXCHANGES Probably the first thing he would notice, however, would be the tremendous concentration of activity in the lower end of Manhattan Island in New York City. Most of these trans actions he would see concentrated inside a large building at the corner of Broad and Wall Streetsthe New York Stock Exchange. There, a thousand men are milling around on a huge floor buying and selling securities, some for themselves, although mostly for clients in and about New York. The customers, however, are scattered out through the country to the coasts and north and south to the border lines and beyond into many foreign countries. Spreading out from these central ganglia are connections by wire and mail with several hun dred brokerage houses, mostly in downtown New York but connected with branch offices in other parts of town and in other cities as well, through which orders to buy and sell are received from customers and transmitted to the floor of the exchange. Over at Trinity Place near Rector Street, a few blocks from the New York Stock Exchange, is a similar heavy centraliza tion of activity in another large buildingthe New York Curb Exchange. There also are five hundred men crowded together on a large floor buying and selling securities, and a similar intricate communication system between the ex change and brokers offices through which the orders con tinually come and go. Out around the country in various citiesBoston, Chicago, San Francisco, Philadelphiaare from 35 to 40 other cen ters of security trading in other local exchanges, although all of them are exceedingly small in comparison with the two markets in New York City. Similar lines of communication
O R G A N I Z A T I O N OF M A R K E T S
19
go out to brokers officesmost of which are also connected with the New York exchangesbut all are on a relatively insignificant scale. The observer would get a graphic picture of the over whelming bulk of the exchange share business which is con centrated in the New York Stock Exchange and the New York Curb: 85 out of every 100 exchange transactions go through them and the remaining 15 are scattered through the 35 other exchanges. The New York Stock Exchange alone handles from two-thirds to three-fourths of the exchange transactions. The New York Curb Exchange, in spite of the fact that its business is only about one-sixth of that of the New York Stock Exchange, equals in share volume all the other exchanges in the country put together. Chart 2 shows the relative amount of the business done by the American exchanges.
b. THE OVER-THE-COUNTER MARKET
In spite of the concentration of trading on the exchanges especially in downtown New Yorka vast amount of buying and selling takes place entirely outside of these buildings. Some 1,800 security dealers in New York City alone trade in securities directly with customers and each otherentirely apart from the exchanges. About 4,000 other such concerns are scattered through the country with a special concentra tion in the business sections of Chicago, Boston, Philadelphia, Detroit and the Pacific Coast cities. This trading outside of the regular, organized exchanges is called the "over-the-counter market. The observer would see that an enormous volume of buying and selling goes on over the counter, but it is much more difficult to follow be cause it is completely unorganized. No public records are kept of these transactions. They are known to each customer and dealer only.
20
Share Transactions i n th e United States
fit o lu z * I OS X
G O U D {j * ee >
JL
U B = 1 J
1. i i " 1
If -----1 1 1
IF L _.
i r 1
O
> U J
Z
. o z < X V X iu u
o
t
[Up
Ir
if
O >
X O ' O O O
rCO CN CO
CM
CO
1933
|LJp
C hart
run
Each Symbol Represents2 0 0 Million Shares
1UH
JL
___ B L
[yjp
,___ ' __ BL,
---------- H ,-1 1 I 14 ------ lL
Copyright 1934 b y Twentieth Century Fund, Inc.
Chart b y Rudolf Modley
21
While no exact information exists, it is estimated that a vastly greater number o f issues of securities are traded in over-the-counter than on the exchanges. As many of these are of smaller concerns with fewer shares per issue, however, the total dollar value of the securities listed on the exchanges is undoubtedly larger than those handled in the outside mar kets. The actual volume of trading in the over-the-counter market is not known. In the case of bonds, however, by far the greatest bulk of trading is over the counter. These mar kets provide facilities for dealings in securities which, for one reason or another, are not or cannot be listed on the organized exchanges. The kinds of securities traded in the over-the-counter markets are usually those which have one or more of the following characteristics: little trading in terest; small capitalization; limited distribution; high price; or desirability for the portfolios of insurance companies and other financial institutions. In quality over-the-counter issues range from the highest grade bonds to the most speculative stocks. Many of the over-the-counter firms specialize in certain securities and some really "make a market in their special ties. The Security Dealers o f North America and the National Quotation Bureau, Inc. furnish lists of firms inter ested in special issues and give daily quotations in bid and asked prices of more than 25,000 unlisted bonds and 30,000 unlisted stocks.
C. THE HOUSES OF ISSUE
In addition to the trading in already issued securities con ducted on the exchanges and in the over-the-counter market, a stream of new issues, varying widely in volume from time to time, is constantly being poured into the possession of the public. This process of the absorption of new stocks and bonds is just as much a part of the security markets as the
22
buying and selling of old issues. Only a very small part of this distribution, however, is handled by brokers and through the exchanges. This function is mostly performed by the socalled "investment bankers or "houses of issue. Here again there is an enormous concentration of activity in the downtown section of New York City. Out of a total of 412 main offices of members of the Investment Bankers Association in the United States and Canada, 90 are located there, and these include by far the largest firms. Corporations all over the country commission these concerns to take care of all the details of planning, producing and marketing new issues of stocks and bonds. The number of head offices of members of the Association located elsewhere than New York City is:
C h icago................. ............ Philadelphia ............ B o sto n ................... ............ Los Angeles ............ San Francisco . . . ............ St. L o u is .............. ............ Baltimore ............ ............ 85 59 58 35 30 30 27 Cleveland ............ ............ Pittsburgh............ ............ Minneapolis . . . . ............ Detroit ................. ............ C incinnati............ ............ Buffalo .............................. 25 24 23 22 22 18
Most of the new bond issues, and stock issues of new corporations, sold to the public are originally marketed through these "houses of issue. A small proportion, however, is sold direct to the individual purchaser by representatives of the issuing corporation. Public utility companies have been espe cially active in distributing their securities in this way directly to employees, customers, stockholders and the general public. Houses of issue frequently also underwrite issues of new stock of existing corporations, which are first offered to exist ing stockholders. The immediate and direct functions of the brokerage houses and the exchanges in new sales are rela tively insignificant, although brokers perform an important function in secondary distribution beyond the new issue stage,
23
and brokerage houses frequently have dealer departments which participate in the marketing of new issues.
d. PERSPECTIVE
This quick birds-eye view of the American security mar kets reveals, on the whole, an unorganized scene. Under the provisions of the Securities Act of 1933, the issuance of all new securities will henceforth be publicly reported and reg ulatedat least as to information about the issues and the houses which handle thembut, again, the trading itself is unorganized and unregulated. Laissez-faire is still largely dominant in this area of our economic life. With this very broad perspective in mind a more detailed description of the organization of the markets is in place. This can best be begun by dealing with the most important and highly organized sectionthe New York Stock Ex change. As the other American exchanges are patterned largely on the New York organization a closer view of it will help in understanding the functioning of the markets as a whole.
2. T
he
O r g a n iz a t io n
o f th e
Exch an ges
a. THE NEW YORK STOCK EXCHANGE
The New York Stock Exchange has the same sort of legal entity as a private club. It is not incorporated, nor is it a part nership. It does not, in fact, "do business in the ordinary sense of the word in spite of the fact that it owns and oper ates a large building and has a staff of some 2,400 employees. Like a club it is a voluntary, self-governing, non-profit asso ciation of members. Like a club also it furnishes facilities for its members; in this case facilities for buying and selling securities. The Exchange does not itself trade in securities any more than a club carries on athletics.
24
The great difference between the Stock Exchange and any other social club lies, not in its legal status, but in the inti mate relation between the activities of its members in the clubhouse and the economic and social welfare of the people of the United States. Even though the Exchange itself does not trade in securities the way in which its members trade is both a responsibility of the Exchange and vitally related to the public interest. Yet in spite of this public concern the public has no more control at present over Exchange practices than it has over the way the members of the Racquet and Tennis Club play squash on its courts, except, of course, that the relations between brokers and their customers are regu lated by appropriate state laws. The government of the New York Stock Exchange is the exclusive right of its 1,375 members and is exercised by a Governing Committee of 40, a President and a Treasurer elected by the membershipthe two officers for one-year terms and the Committee for four years. Its powers, both legislative and judicial, are exercised directly by the Com mittee or through 14 standing Committees, of which the most important are the Business Conduct and Listing Com mittees. Although they are very powerful, appeals from them can be taken to the Governing Committee, the power of which, in practice, is almost absolute. Not only does it pre scribe rules under which the Exchange operates, but it tries the members for violations of these rules and has the power to fine, suspend or expel those found guilty. Officials of the Exchange always maintain that these absolute powers of self-government protect the public because they are quickacting, decisive and subject to no litigation or review by the courts. The Constitution of the Exchange is written in broad, gen eral terms, but the "Rules adopted by the Governing Com mittee pursuant to the Constitution are voluminous and
25
detailed. They cover a multitude of subjects including the following:

1. Rules relating to brokers in relation to each other: a. Minimum commission charges b. Prohibition against fee splitting c. Prohibition against illegitimate advertising and provision for review by exchange authorities of copy for advertising and market letters d. Semi-annual financial statements and audits subject to exam ination by Exchange auditors from those members who carry margin accounts. 2. Rules relating to the relation of brokers to clients: a. Provisions that brokers follow just and equitable principles of trading b. Requirement that employees of members be compensated on a salary rather than a commission basis c. Requirements for adequate margins d. Prohibition against the improper use of customers se curities e. Prohibition against bucket-shop operations f. Prohibition against the manipulation of prices, wash sales, and any acts ''tending to demoralize the market.
These and many other rules frequently deprive the mem bers of profitable business but they demonstrate that the Ex change authorities recognize: ( l ) the direct bearing of the activities of members upon the public welfare; (2) their obligation to protect the public from possible trading abuses, and (3) their power to limit and regulate such trading. The history of the Exchange shows a growing tendency on the part of its governors to institute reforms in its practices especially at times of great public criticism. Whether or not the existing Exchange rules, or the power of its governors to formulate and execute new rules in the future, are sufficient adequately to protect the public interest is another matter.
26

b. THE NEW YORK CURB EXCHANGE
Many years ago brokers who were not members of the Stock Exchange used to buy and sell securities in the streets of downtown New York. This curb market, as it was called, finally took up its position in Broad Street just south of Wall Street where it operated until 1921. The brokers congregated in the middle of the street to do their trading and the trades were communicated to their offices by agents who looked on at the scene from the windows of buildings on each side. Since 1921, however, the Curb Exchange has occupied a building on Trinity Place near Rector Street. The Curb, like the New York Stock Exchange, is organ ized much as a club with a Board of Governors, elected by the members, in absolute control of all its activities. Its gov ernment, through this Board of Governors and its standing committees, its rules governing the members, its methods of trading and general procedure all are closely modeled after the New York Stock Exchange. Requirements regarding membership and listing, however, are less strict than on the New York Stock Exchange. An important variation from the New York Stock Ex change is the existence of two classes of members, regular and associate, for both of which the initiation fee is $2,500. The difference between these two, lies in the fact that the regular member in addition to his initiation fee, buys a "seat at the current market price; he is then eligible to trade on the floor of the Exchange, and should he withdraw from the Curb, his seat can be sold. The associate member, on the other hand, cannot trade on the floor but is granted substan tial rebates on all commission business transacted for him on the Curb, and his associate membership is not saleable or transferable.
27
The most notable feature of the Curb is the trading in unlisted securities. In addition to securities which have been admitted to full listing upon application by the corporation, and after the listing requirements have been fulfilled, securi ties may also be admitted for unlisted trading at the request of a member of the Curb. Transactions reported in the news papers include both listed and unlisted securities, the differ ence being indicated customarily by an asterisk or other sim ilar sign before the name of the fully listed securities. This department of the Curb has been subject to much criticism principally because issues with very small amounts of stock in the hands of the public can be traded in, and because the companies which are not regularly listed are not obligated to furnish reports or other information to the Curb. New rules, largely a result of the investigation by the Bureau of Securities of the Attorney Generals Office, New York State, April and May 1933, have considerably improved the situation. Issues cannot now be traded in if the company objects; data regarding the company must be available through such sources as Fitch, Moody, Poor or Standard Sta tistics; and companies must have an established practice of furnishing stockholders with reports at least once a year al though the Curb cannot influence accounting practice. Mention should be made of the frequent custom of the Curb in anticipating the payment and delivery date of public offerings of new securities by permitting trading in securi ties "when, as and if issued. This trading sometimes reaches a considerable volume. This unlisted trading forms a large part of the business of the Curbeven now, after the withdrawal of a large number of unlisted issues, more than two-thirds of the trading is in the unlisted group. While this constitutes a valuable source of income to the Curb and its members and helps
28
to make possible the maintenance of a costly building and highly organized trading facilities, it is questionable whether these advantages justify the obviously undesirable features of unlisted trading. A very important function of the Curb consists in creating a preliminary market for securities in which there is enough public interest, and trading has reached large enough propor tions to result in a need and demand for real trading facili ties but which are not yet eligible for listing on the New York Stock Exchange. This preliminary period on the Curb is often followed by fulfilling the listing requirements of the New York Stock Exchange and transference of trading to "the big board. Everywhere in the world where there are large organized security exchanges some preliminary market similar in function to our Curb, exists.
C. OTHER EXCHANGES
Other exchanges, of relatively little importance, however, have been organized in 35 to 40 cities. The bulk of their entire business is only as large as that of the New York Curb Exchange which, in turn, is only about one-sixth as large as the New York Stock Exchange. They have been organized largely because of particular local conditions so as to permit trading in securities which have a purely local interest, or in order to avoid security transfer taxes of other states. How ever, many of the issues listed on these other exchanges are also listed on the New York Stock Exchange. In the case of the Pacific Coast exchanges, because of the time differen tial, trading in securities listed on the New York exchanges continues several hours after the latter are closed for the day. This fact occasionally assumes considerable importance when significant news breaks after the close of the eastern ex changes but during trading hours on the Pacific Coast. The
29
effects of the trading at times may even be reflected in the opening prices the following morning in New York. With few exceptions the local exchanges follow the New York precedents in organization and control limited mem bership, club-like legal status, control by a board of govern ors or governing committee. The Denver, New Orleans, Pittsburgh and Seattle Exchanges and the Chicago Curb Ex change are, however, incorporated bodies. A few of them have a periodical call system rather than continuous trading. Most of them also allow trading in smaller units than the New York Stock Exchange. Listing requirements are, by com parison, very lax. Most of the smaller exchanges also allow trading in unlisted securities.
Chapter IV THE OPERATION OF THE MARKETS ITH a picture of the broad divisions of the markets in mind, as well as a more detailed view of the organi zation of the New York Stock and Curb Exchanges, it is now in order briefly to review the mechanics of the marketsthe various ways in which securities are bought and sold both in and out of the organized exchanges. In any consideration of the operations of the markets a clear distinction should always be made between the original selling of new issues and the trading in issues already on the market. Both are vitally important functions and each is carried on in a rad ically different way.
1. T h e F l o t a t io n
of
ew
I ssu es
The vast economic activities carried on in the United States every year result in the creation and marketing of billions of dollars worth of goods and services. In the processes of production and distribution most business concerns, and a considerable part of the population, in normal times, have a surplus of income over their expenditures. The security markets serve as the mechanism by which a large proportion of these savings are transmuted into further economic and wealth-producing activities. This process is accomplished in two principal ways: (1) by the direct purchase of securities by the individuals and busi ness concerns by whom the savings were actually accumu lated, and (2) by the deposit of savings in financial institu-
T H E O P E R A T I O N OF T H E M A R K E T S
31
tions such as banks and life insurance companies which, in turn, invest their assets in securities. Those who accumulate savings and the institutions that invest savings do not, of course, limit their security purchases to new issues. Probably a larger proportion of the nations annual savings goes, in
TABLE 3
E s t im a t e d S a v in g s C o m p a r e d w it h N e w S e c u r i t y I s s u e s
Savings (x) (Millions of dollars) Non co r porate 3387 6043 3737 494 4639 1952 3447 4126 1639 3532 724 1223 4782
Cor porate 1920 6039 1921 3732 1922 5634 1923 6332 1924 5557 1925 6555 1926 6340 1927 59 13 1928 6591 1929 6749 1930 3775 1931 1102 1932 2149
Indi vidual 6,662 5,150 5,504 6,680 7 ,H 3 7,326 8,163 9,583 n ,233 12,408 7,369 5,268 3,931
Total Savings 16,088 14,925 14,875 13,506 17,309 15,833 17,950 19,622 19.463 22,689 11,868 5.389 6,564
New Capi Per Cent tal (2) of Sav Issues (less ings Repre refunding) sented by (Millions of New Issues dollars) 3,635 3,576 4,304 4,304 5,593 6,220 6,344 7,776 8,050 10,183 7.023 3 ,U 5 (3) I ,I 92 ( 3) 23 23 29 32 32 38 35 40 4i 49 59 58(0 i8 (s)
(L ) Doane, Robert L., Measurement of American Wealth, 1933, p. 1 12 and p. 114. (2) Commercial and Financial Chronicle. (3) These figures are ex clusive of net additions to Federal issues of $1,7 8 5 million in 1931 and $3,074 million in 1934, inclusion of which would increase these totals to $4,900 million and $4,266 million, and the percentages to 91 and 65, respectively.
the first instance, into the purchase of securities already issued and on the market. Insofar, however, as a large part of the income realized from the sale of these eventually goes into the purchase of new issues the basic processes are the same. The second method is merely less direct than the first. Table 3 shows an estimate of the national savings in past years and the sales value of new securities issued. It will
32
be seen that a growing proportion of the national savings has gone either directly or indirectly into the purchase of new issuesfrom 23 per cent in 1920 to 59 per cent in 1930. The flow of new issues, excluding refunding opera tions, kept up a relatively stable volume from 1920 to 1923, increasing from $3.6 billion to $4.3 billion. The stream rose, however, to unprecedented heights in the bull market era of the late 20s. The peak occurred in 1929 when $10.2 billion worth of new issues were recorded. Since the depression the stream has almost dried up, reaching a low level in 1932 of $1.2 billion. The process whereby savings are invested in new and old securities is shown in Chart 3. In the original marketing the investment banker, as has been seen, performs the major function. He underwrites the new securities issued by govern ments and corporations requiring capital and sells them either directly to institutional investors or to the public or indirectly to the public through investing institutions, such as savings banks and investment trusts. The brokers, how ever, also make an important indirect contribution to the marketing of new securities. They facilitate the flow of part of the public savings into old securities on the organized ex changes. The proceeds of the sale of such securities are in large part used in the purchase of new securities. The regu lar trading in old issues also performs an indirect function by setting prices and making a market in which the new issues can be expected to sell. Thus the investment banker and the broker cooperate in permitting the continuous flow of sav ings to supply the long-term capital requirements of corpora tions and governments.
a.
t h e in v e s t m e n t b a n k e r
Bond issues of both old and new corporations and stock of new corporations are almost invariably sold through in-
33
ALREADY ISSUED SECURITIES
BROKERS AND THE EXCHANGES
INVESTING INSTITUTIONS 1. Savings Bank 2. Investment Trust 3. Commercial Bank's Saving Dept. 4. Trust Company 5. Mortgage Bank
CORPOR ATION OR. GOVERN MENT REQUIRING CAPITAL
PUBLIC SAVINGS (NEW CAPITAL)

INSTITUTIONAL INVESTORS 1. Life Insurance Co. 2. Corporation 3. Commercial Bank A. Eleemosynary Institution INVESTMENT BANKING HOUSE (Middleman}
This chart is from Investment Banking by H. Parker Willis and J. I. Bogen and is reproduced here by courtesy of Harper and Bros., New York. Chart 3 T he Flow
of
S a v in g s
in t o
In v e s t m e n t
34
vestment houses. New issues of capital stock of already exist ing corporations, however, are required by many state laws to be offered first to old stockholders usually by issuance of rights on a pro rata basis, in which case the services of the investment banker are sometimes dispensed with. Table 4 indicates the importance of the investment banker in the flotation of new issues. Investment houses marketed 61.6 per cent of the total corporate and foreign government
TABLE 4
N e w C o r p o r a t e a n d F o r e ig n G o v e r n m e n t I s s u e s S o l d in U n i t e d S t a t e s a n d P r o p o r t io n H a n d l e d b y I n v e s t m e n t B a n k in g H o u s e s
Total New Corpor ate (x) and Foreign Government Issues
New Corporate and Foreign Government Issues Handled byAmerican Under writing Houses (2) $6,263,000,000 5,045,000,000 2,254,000,000 622,000,000 208,000,000
Per Cent of Total Issued Through American Under writing Houses 6 1 .6 82.8 85 -4 8 7.6 4 7 .2
1929 1930 19 31 1932 1933
$10,155,000,000 6,093,000,000 2,639,000,000 710,000,000 441,000,000
(*) Including refunding. Figures from Commercial and Financial Chronicle. (*) Including refunding, but excluding United States and Canadian municipal financing. Figures furnished by the National Statistical Service, Inc., N . Y .
new issues in 1929, 82.8 per cent in 1930, 85.4 per cent in 1931, 87.6 per cent in 1932 and 47.2 per cent in 1933. These figures, it will be noted, include domestic corporate and for eign government issues but exclude municipal financing. When it is considered, however, that municipal bonds are marketed almost exclusively through "houses of issue it would appear that the proportion of all new securities that flow through the investment houses is even larger than is indicated by these percentages.
35
These figures show that in 1929 and 1933 the proportion of new securities handled by investment bankers was much smaller, and that which went directly from the issuing cor porations to the stockholders and the general public was con siderably larger, than in 1930, 1931 and 1932. For this there are several reasons. In 1927, 1928 and 1929, it will be re membered, many corporations distributed large quantities of new stock through stock dividends and rights to subscribe. In 1933 the situation was somewhat different. The total vol ume of new issues, of course, declined enormously, and the fact that the investment banking houses handled a smaller proportion of the new financing is attributed partly to the Securities Act of 1933 which made it more difficult for cor porations to have their issues bought or underwritten by bankers and necessitated direct sale by the issuing corporation to the stockholders and the public. Generally speaking, however, the bulk of new capital needed by corporations and governments is secured through investment bankers who, acting as middlemen, take over the entire issues of these new securities and dispose of them, through their widely developed organizations, to thousands of investors and speculators, as shown in Chart 3. Here it may be well to define the term "investment banker which is generally confined to one whose business it is to buy security issues for resale. Brokers, operating on a commission basis, are usually excluded from this designation though many brokerage houses now have bond or investment de partments. Investment houses are often called "bond houses due to the fact that in the past they have handled chiefly bonds. During the post-war decade, however, there was a marked increase in financing by means of stock issues. The rough practical distinction between commercial and investment banking should also be kept in mind. Though there are other factors to be considered, this distinction is
36
largely a matter of time, commercial banking involving short term advances to borrowers and operating mainly through a system of deposit and discount, although, of course, commer cial paper can be bought and sold like securities. Investment banking, on the other hand, involves long term advances through the actual purchase of negotiable securities and their subsequent resale at a profit. In this country a close connection has developed between the deposit banking business and investment banking through the creation of security affiliates by commercial banks. This resulted in deposit funds being unduly directed into investment channels, the frequent shifting of the bur den of corporation loans to the public by the issuance of securities through the security affiliates, and the undue ex ploitation of the various connections of the banks in buying and selling new issues. All this has been eliminated by the Glass-Steagall Banking Act of 1933 which forbids member banks having security affiliates, and severely limits their pur chase of securities for their own account. Investment bankers, classified by function, are divided into three classes: (1) wholesalers, (2) retailers and (3) dealers or small retailers. Most large investment houses combine the functions of wholesaler and retailer. As a matter of fact, there are now only two houses, J. P. Morgan and Company and Kuhn, Loeb and Company that are wholesalers exclu sively. Retailers and dealers often "take positions or buy in the market blocks of already outstanding securities which they dispose of later at a profit, thus participating in a sec ondary phase of distribution to be discussed later. The dealer takes little or no part in the origination of issues and derives his profits as a dealers allowance. The retailer or dealer, as has been mentioned above, is often the bond or investment department of a brokerage firm, but it is to be noted that this function as a dealer, operating on a profit in the distribution
37
of new issues, is entirely different and separate from the busi ness in old issues on the Stock Exchange on a commission basis. The origination of new security issues is the most impor tant function of the investment banker. He chooses among the various financing proposals which are presented to him thereby becoming a large factor in directing the flow of the investors savings into certain channels and away from others. He thus influences to a great extent the development and the plans of various industries and governmental units. Undoubt edly one of the great evils of the era leading up to 1929 was the competition among bankers in launching new issues. They practically forced money on, or offered undue induce ments to, foreign governments, domestic corporations, cities and real estate operators for financing unnecessary and arti ficially created projects. In this connection it is significant that before the War, when the United States was still largely a debtor nation, for eign financial houses participated in a large degree in the flotation of our new issues, and many American securities were sold abroad. The tendency since 1914 has been in the other direction. We now, on the whole, not only finance our own needs, but also have marketed in this country large amounts of foreign securities. From 1924 to 1928 the yearly volume of foreign financing has ranged from one and a quarter to more than one and a half billions of dollars, and from 15 to 20 per cent of our total financing. During the years 1914 to 1928 Europe has received nearly half of the total of American capital invested abroad, Canada and New foundland about one-fifth and Latin America about onefifth. The unfortunate recent history of many of the Euro pean and Latin American investments has brought a great deal of criticism upon investment banking practices.
38

b. PROCEDURE IN FLOTATION OF NEW ISSUES
The origination or buying of new issues may be handled by one house, or two or more investment houses, depending on the amount of capital involved, may combine to form a purchase group or syndicate. Syndicate practice is far from uniform, and in the case of large issues, there may be one or more intermediate purchase groups as well as a so-called banking group which turns the securities over to a distrib uting syndicate. Stocks, and also convertible bonds, of already established corporations, as mentioned above are customarily offered first directly to stockholders. Underwriting syndicates, however, are frequently formed by a group of bankers who guarantee the sale of these whole blocks of securities. In other words, they guarantee to the corporation the receipt of the full amount of capital required, by agreeing to purchase on the same terms as the shareholders any portion not subscribed by the shareholders themselves. The underwriters receive their compensation either as a flat commission on the whole issue or as a combination of a small commission on the whole issue plus a larger one on any portion taken up. Here too, separate syndicates and sub-syndicates may be formed. A syndicate agreement drawn up on the organization of this group, sets forth the terms under which the members par ticipate in the issue and share in the profits and in the lia bility. During the life of the syndicate, which is usually one or two months, it ordinarily assumes responsibility for main taining a market in this particular securityi.e., the syndicate manager repurchases any of the bonds or stock that are of fered in the market at or below the public offering price. The members agree, therefore, to repurchase at the cost to the syndicate any of these securities which had originally been sold through them. Records are carefully kept of these securi
39
ties so that those "dumped back on the syndicate can be traced to the member who sold them in the first place and who must then buy them back thereby losing the original profit. This maintaining of the market is an important point in American practice, for while it is not exactly rare in Europe, it has not become there a routine part of the flotation of new issues as it has here. One of the functions of the investment banker, of course, is to determine the offering price for new securities. In this he is guided by prevailing market conditions, by the trading in other securities of the same corporation, or by the trading in similar securities. It is not an uncommon practice for houses of issue to stimulate activity and rising prices in the existing securities of a corporation just before putting out a new issue. As a result of many of these factors it has come to be considered, in this country, somewhat in the light of a duty for the syndicate to maintain the market for a time sufficient to permit the absorption of the new security at the offering price. After the selling syndicate has been organized, the next step is the public offering which takes place on a prearranged date. Circulars are released and advertisements appear simul taneously announcing the essential facts and the offering price. Since the passage of the Securities Act information on issues is available before the date of public offering. It is at this point that public advertising and the bond or security salesman have played so important a role in this country in developing an extensive investing public. After the offering date subscriptions can be accepted and sales confirmed, but the customer is usually not called upon to make payment until two weeks later when temporary se curities called "interim receipts or "prepayment receipts are delivered. These receipts are negotiable and can be traded in as readily as the permanent certificates. During the interval
40
between the offering date and the date of payment, particu larly during periods of generally rising prices, it became a popular practice to "take a ride on new issuesi.e., many subscriptions were placed in the hope that the price would advance and a profit could be taken before the date of pay ment. It is when the price declines during this period that syndicates have securities "dumped back upon them ; some times when market conditions are very unfavorable the syn dicate has to buy back a large proportion of the whole issue. Transactions on a "when issued basis, especially in securities admitted to unlisted trading on the Curb, sometimes with favorable market conditions, aggregate several times the total amount of the issue. It is to be noted that up to this point in the distribution of new securities to the original buyers, the brokers, as brokers, and the organized exchanges play no direct part whatever. It is true, however, that indirectly brokers and ex changes facilitate the issuance of new securities. The presence of markets where issues can be readily traded, either over the counter or, in the case of listed securities, on the exchanges, creates an interest in securities and a more receptive attitude on the part of the community at large toward investment in various enterprises. The marketability assured through the existence of these trading facilities has made possible the growth of investment houses and the large scale distribution of new securities. Moreover, the broker and, in the case of listed securities, the stock exchanges are a very important part of the mechan ism for creating a secondary market beyond the new issues stage. The volume of new issues is small compared with the total volume of securities traded. The new securities, includ ing refunding issues, brought out during 1929 amounted to $11 billionthe largest volume for any one yearwhile the total market value of securities outstanding on January 1st
41
of that year was estimated by H. Parker Willis and J. I. Bogen in Investment Banking at $165 billion. The tremen dous volume of buying and selling after issuance represents many successive stages from the purchase by the original buyer until the securities reach a more or less permanent resting place in the investors deposit box. The original buyers of new issues can be roughly classified as ( l ) investors who buy principally for income and (2 ) speculators who plan to resell as quickly as possible for a profit. The proportion of these purchasers varies with the type of security as well as with the condition of the market. The small conservative issues go, very largely, directly to investors. The greater proportion of the large new issues of less conservative type probably goes first to the speculator. The amount of trading and the length of time involved in these stages varies, of course, with the standing of the cor poration, the type of the security, the attractiveness of the offering price and the subsequent record of the company. Sometimes securities go through the hands of hundreds of speculators over a period of several years before the corpora tion becomes firmly enough established or the value of the issue definitely enough determined to attract investors atten tion. Many issues, of course, of the decidedly speculative type never reach investors hands. In the case of unlisted securities, the total market value of which was estimated to be $40 billion on January 1, 1929, or about 24 per cent of the total value of securities then out standing, the secondary trading is handled by dealers and brokers though not the Exchange. The preliminary distribution when securities are first issued is not usually complete enough to satisfy the listing require ments of the New York Stock Exchange. Many issues there fore frequently go through a further preliminary period of trading, either as unlisted or as fully listed, on the Curb.
42
Sometimes the issue never leaves the Curb, either because the corporation itself or the Stock Exchange is unwilling to have the issue listed. In other cases, after this preliminary period, the requirements are fulfilled and trading is transferred to the New York Stock Exchange. The various interrelated phases involved in the process of complete distribution of listed securities are shown in Chart 4.
C. AM ERICAN VS. EU RO PEAN PRACTICE
Several weaknesses in American methods in the flotation of new issues appear in a comparison with European prac tice. The unhappy history of many security issues here has been considered as indication of a general lack of direction or deliberate misdirection of the flow of capital into invest ment and speculation. High pressure salesmen and inade quate or misleading information disseminated through circu lars, prospectuses and other advertising media have been especially criticized. These are some of the outward and visible signs of deeply fundamental differences in the Amer ican financing situation as compared with that in other countries. In America, long a debtor nation with young untried enter prises seeking capital, salesmen and attractive advertising material have been essential to building up a large security buying public. A distribution system has developed in which new securities have reached the buyer through successive steps, including investment banker and dealer, in which the compensation, in the form of profit, has varied and has usu ally been relatively larger in the case of speculative issues. The ultimate contact with the buyer of new securities has been through a salesman or other person representing the interests of the seller. The inevitable result of these inter related factors has been that primary distribution of new
F ro m
The Work o f the Stock Exchange, b y J. Edward Meeker, reproduced b y courtesy o f th e Ronald Press Co., N ew York.
C hart S ecurities Ar e 4 D is t r ib u t e d
43
H ow
44
issues here has been a selling proposition with emphasis on speculative advantages and price appreciation or possibilities for profit. In Europe, on the other hand, the situation has been domi nated by creditor nations with supplies of capital seeking investment. A distribution method developed there in which, generally speaking, new securities reach the buyer through a system in which only the first step, the house of issue, has been compensated in the form of a profit. The successive stages are through banks or brokers on a commission basis, with no compensation differential in favor of speculative securities. Therefore, the banker or broker in Europe is com paratively free to represent the interests of the buyer and to give disinterested advice. The result of these factors is that primary distribution in Europe has been chiefly a buying proposition with emphasis on investment for income. The practice of "pegging the market for new securities, although it exists to a certain extent everywhere, is a much more important feature of the flotation of new issues in America than in Europe. This is traceable to the general difference in attitude noted above. Here buyers, greatly in terested in price appreciation and profits, pay more attention to current quotations, while in Europe the majority of buyers, being investors, are not disturbed by variations in the price of securities bought primarily for income. In Europe, there fore, new issues are more frequently put on the market and permitted to reach price levels on their own merit and without artificial support.
d. CHANGES IN AM ERICAN PRACTICE: TH E B A N K IN G AN D SECURITIES ACTS O F
1933
Along with the growing consciousness in this country that the flow of capital has lacked proper direction have come efforts to bring about some degree of control or regulation
45
through legislation, through the banking structure and money market, and through various means of making available ade quate and proper investment information. The Banking Act of 1933, as mentioned above, has made a definite separation between the functions of commercial and investment banking. No "member banks after June 16, 1934, can have as an affiliate any corporation, association, business trust or similar organization engaged in the issue, flotation, underwriting, public sale or distribution either wholesale or retail or through a syndicate participation of stocks, bonds, debenture notes or other securities. Dealing in investment securities by national banks is limited to purchase and selling solely on the order of a customer. Investment securities are here defined as bonds, notes and debentures, and, except as specially provided, dealing in shares of stock is not permitted. This means that the undue exploitation of the various connections of banks both in the purchase and marketing of new issues is eliminated, and instead of de pending on the banking system for underwriting, supplies of investment money outside the usual deposit liabilities will be drawn upon. Because security flotations have been so largely "selling propositions in this country special efforts have been made to protect the buyer from bad faith or negligence on the part of the seller. This is the primary purpose of the Securities Act of 1933, the corporate reporting features of which are described in a later chapter. This Act requires much more complete disclosure of the facts pertaining to the issuance of new securities and also imposes great liability in connec tion therewith on the part of all those participating in the issuance and distribution of these securities. It places respon sibility upon the seller, and in a measure substitutes the prin ciple of caveat vendor for caveat emptor. Under this Act full and complete information regarding
46
the company and security in question must be available in the form of a registration statement filed with the Federal Trade Commission. Any prospectus or advertising material must contain much more detailed data than heretofore re quired by the Stock Exchange for listing. In the case of issu ance of untrue or misleading information or the omission of material facts, civil liability is imposed upon the issuing com pany, its principal executive officers and directors, all account ants and other experts having certified any part of the state ments, and each underwriter. There is no doubt that the Securities Act is a drastic piece of legislation and the arguments regarding its merits, its faults and its effect have been exceedingly heated. Its cham pions claim that it will keep many worthless and unsound securities off the market. Reference has already been made to the many unwarranted loans that were formerly forced upon foreign governments, domestic corporations, etc. by investment bankers competing for business. Undoubtedly such possibilities are considerably limited by this Act. Its ad verse critics claim that it is so rigid and sweeping as to ham per the normal flow of capital into business and industry through legitimate new issues, and that, in its present form, it invites nuisance suits and spurious claims against which our laws do not provide adequate protection. Several problems in connection with the Securities Act have arisen in cases where financing of public utilities and industries has been proposed. In some instances investment bankers have hesitated or have been unable to form a syndi cate in view of the scope of the responsibilities and the risks imposed; in others, directors have been deterred by the com plicated and confusing requirements and by the risks of suits and claims. Then, too, companies with far-flung enterprises have found it difficult or impossible to compile, verify and
47
file the vast amount of information required and still comply with the time limitations. These problems have particularly affected companies with maturities to meet. The results in these cases have been varied. Instead of issuing new securities several companies have sold some of their liquid assets, others have failed to declare, or have suspended dividends or effected drastic and often difficult operating economies. Some have exchanged new securities for old, the new being exempt in some cases from registration under the Securities Act of 1933 when no compensation to bankers is involved. Other companies hav ing planned to build or to buy new equipment have aban doned these plans for the present. Recently the possibility of American corporations carrying out their refunding opera tions in Europe and particularly in London has been dis cussed. However, it is impossible at this time to determine to what extent the drastic decline in the volume of new issues is attributable to the Securities Act. Other powerful factors have been at work the general apathy of investors, unset tled monetary conditions, the fact that many companies are already overcapitalized and relatively few need new financ ing all of these have reduced the volume of new securities. The effects that the Securities Act might have under more normal conditions are difficult to determine a priori. However, in spite of any modifications that may be found necessary to provide more careful determination of the mate riality of statements and omissions, or to assure more equit able provisions regarding liabilities and damages, there is general approval of the fundamental purposes of the Securi ties Act: to make available to the buyer full information about the securities issued and to protect him from dishonesty or negligence on the part of the seller. The usefulness of the
48
Act as a means for controlling the flow of capital and savings into industry will depend largely on future interpretations and applications, and upon the use that will be made of the more complete information that will be available. There is widespread conviction that certain provisions of the Act need to be strengthened and supplemented in order to provide for continuing publication of information of the same nature as that required at the time a security is issued.
2. T r ading I n O ld Issues T h e Ex c h a n g e s
A review of the methods of buying and selling, as these have been developed in the organized markets, is now in order. Because the New York Stock Exchange is overwhelm ingly important the practices in vogue there will be described first. Only the briefest outline will be given, largely to give definition and perspective to the picture as a whole. This outline can be divided into the following segments describ ing: (a) the securities which are traded in, (b) those who do the trading, (c) the methods by which they trade.
a. THE SECURITIES TRADED IN
(1 ) Listed Issues Several comparisons of the volume of securities listed on the stock exchanges of the country, with the total volume of securities outstanding have been made. The proportion of the total represented by securities listed on the exchanges varies, depending on the basis of calculation, from 55 per cent of all outstanding securities to 63 per cent of all bonds and 70 per cent of all stock issues. On a market value basis, estimates made as of January 1, 1929 showed that of a total of $165 billion outstanding those listed on the New York Stock Exchange represented $115 billion or 70 per cent. Those listed on other exchanges, represented about $10 bil
49
lion or 6 per cent, and unlisted securities, about $40 billion or 24 per cent. Although the market value of these issues has declined enormously since 1929 it is probable that the pro portions remain very much the same, and it is safe to say that about three-quarters of all securities outstanding are listed on exchanges, and that of all listed stocks over 90 per cent are on the New York Stock Exchange. These estimates are from Investment Banking by H. Parker Willis and J. I. Bogen. The unlisted securities vary from conservative bond issues to speculative and even fraudulent stock issues. The stock exchanges have attempted to eliminate from listing all fraudulent securities and to limit their trading to strictly legitimate, although sometimes highly speculative, issues. The New York Stock Exchange is preeminent in the vol ume of the securities traded in. On January 1, 1934, 1,568 different bond issues, with a market value of $34.9 billion, and 1,209 stock issues, aggregating $33.1 billion, were listed on this exchange. Tables 5 and 6 show the variations in securities listed on the New York Stock Exchange from 1925 to 1934. (2 ) Requirements for Listing on the New York Stock
Exchange
The predominance of the New York Stock Exchange among the organized security markets becomes more signifi cant when the procedure and requirements for listing are considered. Formal application is made by the corporation itself. The Stock Exchange does not solicit applications lest it appear to endorse or give advance assurance of listing. These applications are considered by the Committee on Stock List which either acts or makes recommendations to the Governing Committee. The applicant receives several documents, the most im-
50

TABLE 5
B o n d s L is t e d o n t h e N e w Y o r k S t o c k E x c h a n g e 0 )
Jan. I
Number of Issues i ,332 1,367 1,420 i, 49 i
Face Value
Market Value
Average Market Price $ 94-79
1925
1926 1927 1928 1929 1930 I 93 i 1932 I 933 (2 ) I 934 (2 )
$ 35 -457 .000,000 37,900,000,000 36,881,000,000 48,581,000,000 49,058,000,000 50,073,000,000 52,360,000,000 41,304,000,000 41,828,000,000
36 ,995 .ooo.ooo
1,534 1,543
1,607 1,601
1,549
1,568
$33,612,000,000 35,509,000,000 37,168,000,000 36,874,000,000 47,379,000,000 46,892,000,000 47,385,ooo,ooo 37,848,000,000 31,918,000,000 34,861,000,000
95 98
98.06 99.98
9 7 -5 i 95-59 94 63 72.29 77.27 83.34
TABLE 6
S t o c k s L is t e d o n t h e N e w Y o r k S t o c k E x c h a n g e 0 )
Jan. 1
Number of Issues
Number of Shares
Market Value
Average Market Price $62.45
1925 1926 1927 1928 1929 1930
927
1,043 1,081 1,097 i , i 77 1,293 1,308 1,278
433 ,448,561
491,615,837 585,641,222 654 ,997,126 757 ,301,677 1,127,682,468 1.296,794-480 1,318,729,621 1,311,881,157 1,293,299,931
1931
1932 I 933 (2 ) I 934 (2 )
1,237
1,209
$27,072,322,192 34,489,227,125 38,376,162,138 49 .736 ,350,946 67,472,053,300 64,707,878,131 49,019,878,459 26,693,836,532 22,767,636,718
70-15 65-53 75-93

89.O9
57.38 37.80
20.24
33 ,094 .751.244
17-35 25 59
0 ) New York Stock Exchange Year Book , 1931- 1932.

(2 ) Figures furnished by the New York Stock Exchange.
portant of which are the list of requirements, the question naire to be signed by an officer of the company, and the dis tribution statement. These documents are voluminous, and
51
requirements vary according to the kind of business in which the company is engaged and the type of security. Basically they have three main purposes, (1 ) to further the aim of creating a free and open market, (2 ) to provide assurance of the genuineness of the company and of the issue, and (3 ) to provide information for those who deal in and buy securities. The principal general requirements can be summarized as follows:
1. The form of security certificates is prescribed; certificates must be engraved as required by the Committee, by an approved company, and specified features of the issue must be clearly stated thereon. This is to prevent, the circulation of forged certificates, and to main tain ready negotiability. 2. Companies must furnish statements of their corporate structure and their past earning record. In addition to current balance sheets submitted when a stock is listed, the Exchange attempts to obtain agreements to publish balance sheets annually and earnings state ments as frequently as possible. The purpose of this is to make available current information regarding the value of the securities. 3. Separate transfer and registry offices must be maintained by the corporation in the Borough of Manhattan, New York City. The transfer office is sometimes a bank or trust company and sometimes a department of the corporation. The registrar must always be an independent institution such as a bank or trust company. The regis trar, paid by the corporation, is under agreement with the Stock Exchange and cannot register additional stock until authorized to do so by the Cctmmittee on Stock List. Listed stock certificates are not valid until countersigned by the transfer agent and registered by the registrar. Protection is thus provided against forged securities and against the secret overissuance of stock. Overissuance, such as oc curred in the Hatry case in England, for example, could not take place in a security listed on the New York Stock Exchange. 4. A statement of distribution must be submitted stating the num ber of shares held in blocks of different sizes and also the number of shares held by the ten largest stockholders of record. For the maintenance of a free and open market it is essential that not too much stock shall be held in large blocks or by few stockholders.
52
The Stock Exchange is not interested in nor does it ask for the names of the holders of blocks of stock. Its only concern, in this instance, is the assurance that ownership is widely enough dis tributed to permit the maintenance of a free market.
After the application and other documents have been examined a date is set for a hearing. The application, upon its receipt, is posted on the floor of the Exchange, so that members may be informed regarding it and may communi cate to the Committee on Stock List any information they may have regarding the company. If the requirements have been properly met the Committee recommends that the appli cation be granted. Thereupon the Governing Committee usu ally authorizes the listing. Notices are then sent out over the tickers and trading in the security may begin on the floor of the Exchange the following morning. The fact that a security has been listed on the Exchange cannot be considered as a guarantee of its value nor as an endorsement or recommendation by the New York Stock Exchange. On the whole, however, these listing requirements are more comprehensive and more carefully devised than those of any other exchange and tend to become more exact ing as time goes on. As will be pointed out in the discussion of foreign stock exchanges, these requirements have evolved partly as a substitute for and in the absence of national incor poration laws similar to the Companies Acts of England and other European countries.
b . EXCHANGE MEMBERS AN D THEIR F U N CTIO N S
In all American stock exchanges the members perform two clearly distinguishable functions: ( l ) that of the broker act ing as an agent for others on a commission basis, and (2 ) that of a trader or dealer buying and selling securities on "his own account for a profit. Regulations regarding the manner in which members ex
53
ercise these functions vary from exchange to exchange. In London the membership is clearly divided between brokers, and jobbers or dealers; the members cannot perform both functions but must declare at the beginning of the year in which of these two capacities they intend to act. In the Paris Bourse the Agents de Change or members of the Par quet (the official market) are brokers exclusively, and are not permitted to trade on their own account. The New York Stock Exchange permits any member to act either as a broker or dealer provided that he does not appear in both capacities in the same transaction. Brokers are subdivided into two main types: commission brokers and "two-dollar brokers. ( l ) The Commission Broker The commission broker is the more important of these types. He is usually the "floor member of a Stock Exchange commission house through whose order clerks and customers men orders from the public are relayed to the floor of the Stock Exchange. Here they are executed by the commission broker or floor member of the firm, or turned over by him to a "two-dollar broker or specialist in a manner to be out lined below. (2 ) The "Two-Dollar Broker The "two-dollar brokers, numbering about 300 at the present time, are not officially attached to any one commis sion house but operate as free lances, executing orders for other brokers and receiving as their compensation a share of the regular commission which the commission broker charges his customer. The name "two-dollar broker is de rived from the fact that his rate of compensation was for merly $2.00 per 100 shares of stock out of the $12.50 col lected by the commission broker, and the title is still used in
54
spite of the fact that today the two-dollar brokers commis sion varies from 50 cents per 100 shares to $3.00 per 100 shares depending on the selling price of the stock. Dealers are divided into two main classes: the odd-lot dealers and the floor traders. (3 ) The Odd-Lot Dealer The odd-lot dealer specializes in buying and selling in amounts of less than 100 shares of stock. Owing to the ex tent and size of the transactions on the New York Stock Exchange the unit for regular trading on the floor has long been 100 shares in the active stocks. In order to make a market for orders in "odd-lots of less than 100 shares, a sys tem has been developed whereby certain members specialize in buying odd lots which they "make up into 100-share lots in order to sell them and in selling odd lots obtained by buy ing and splitting up 100-share lots. It must be noted that the odd-lot dealer does not come in direct contact with the public but acts through a commission broker. The commission broker charges a commission on the trans action, as in the case of 100-share lots. The odd-lot dealer, on the contrary, is a dealer rather than a broker, and relies on the difference between the prices of his sales and pur chases for his profit. The price at which odd-lot brokers can afford to deal in odd lots varies with the activity of the par ticular stock. These orders, in active stocks, are usually exe cuted at Yg above the odd-lot price in the case of a purchase and Y & below in the case of a sale. This 1/g, plus the profits resulting from their regular trading, is the source of the odd-lot dealers income. (4 ) The Floor Trader The floor traders, of whom there are now about 80 or 90, are free lance dealers trading on their own account. They
56
they are often an important factor in making a market or in maintaining a continuous market in stocks that otherwise would, at times, become inactive and difficult to buy or sell. Specialists are also called upon to determine, by checking over the orders on their books, the proper price at which to open trading in their special stocks. Two features of the specialists work have been special targets of criticismhis knowledge of the buying and sell ing orders hanging over the market and his ability to trade for himself. It is true that there are certain restrictions re quiring that precedence must always be given to customers orders either at the market or at any given price. Even so, the objection is raised that the specialist, knowing the exist ing orders, can by his own transactions push prices up or down so that stop orders on his book become market orders. (6 ) The "Bond Crowd Another group of dealers and brokers are those who spe cialize in bonds. Trading in bonds is carried on in a room separate from stock trading. The "bond crowd consists of about thirty members of the Stock Exchange, most of whom specialize in bonds either as dealers or as brokers or as both. It must be remembered that a great proportion of the trading in bonds is done over the counter rather than on the floor of the Exchange, and the Exchange bond market has tended, therefore, to become a brokers rather than a dealers market. As in the stock market, members of the "bond crowd can act as dealers buying and selling for themselves or as brokers executing orders for a commission, but are prohibited from appearing as both in the same transaction. Regular stock brokers, who are often unfamiliar with the procedure of bond trading, frequently "give out the bond orders they receive to a bond broker, in a way similar to that in which they give orders to, and share commissions with, a stock specialist or "two-dollar broker in stock transactions.
55
execute their own orders, thereby saving the commission. Frequently they do not have offices of their own but make their headquarters with a commission house through which they clear their transactions by paying a clearance fee of $1.00 or more per 100 shares of stock. The floor trader is a professional speculator willing to buy and sell any stocks all over the floor for a small quick profit, often buying and selling the same day and balancing his transactions so that he does not usually need to receive or deliver stocks or keep money tied up in inventory. The floor trader is undoubtedly a very important factor in the maintenance of a continuous market and in stabilizing prices. The floor trader and the odd-lot dealer have been con siderably affected by the Federal and State stamp taxes levied on every sale of stock. These taxes make it impossible for both these types of traders to operate profitably on as narrow a spread in prices as formerly. (5 ) The Specialist The specialist derives his name from the fact that he con fines his transactions to one or more stocks located at the same trading post on the floor of the Exchange. He is both dealer and broker, though he cannot act in both capacities in the same transaction. He may trade for himself or execute orders, on the same basis as the "two-dollar broker, for other brokers. When the specialist receives orders that are somewhat away from market price they are recorded in his "book, which thus gives a fairly accurate picture of the condition and tendency of the market in that particular stock. The specialist is, therefore, particularly useful in filling orders at a definite price, and in executing stop loss orders. Many spe cialists trade "in and out very much as do floor traders, except that they specialize in one or a few stocks. In this way
57
While the volume of trading in bonds is not large com pared with the stock transactions the bond market of the Exchange performs an important function in establishing prices and relative values by which the large over-the-counter market in bonds, to a great extent, is guided. (7 ) The Inactive Member There remains one other class of member, often over looked, because he seldom appears on the floor of the Ex change, the inactive member. These members, numbering about 200, are usually large traders on their own account or are associated with-a firm of investment bankers. Although they make no actual use of their "seat on the Exchange, their orders being executed by others, the greatly reduced commis sion charge to which they are entitled, (from 1/7 to 1/10 of the regular commission charged non-members) makes the membership worthwhile when transactions aggregate sev eral millions of dollars.
C. METHODS O F TRADING
The securities which have been admitted to trading on the Exchange are bought and sold in three principal ways: (1 ) the outright cash purchase (or the cash sale), for which the purchaser pays in full on delivery; (2 ) the margin pur chase, in which the buyer puts up part of the purchase price in cash or securities and borrows the balance from the broker who, in turn, borrows from the banks or from some other lender; and (3 ) the short sale, in which the seller "sells short securities which the broker borrows for him. Subse quently he must buy back the same amount of the same securities and return them to the lender. Both margin pur chases and short sales are margin transactions i.e., trading with partly borrowed resources. Charts 5, 6, 7, 8, and 9 show the mechanics of these three methods of trading in
58
S O M E R O U T I N E S FOR CASH TRANSACTIONS

FOR 100 SHARES OF XYZ STOCK
BUYING SIDE
N G SIDE
'HH
M ain O ffice
S elling Customer
Copyright 1934 by Twentieth Century Fund, Inc.
Chart by Rudolf M odley
Chart 5
59
Routine of a MARGIN PURCHASE

CUSTOMER
1 . THE M A R G IN PURCHASE
ZYX stock sells at $150. Customer thinks it will go up.
1. Customer orders Broker to buy 100 shares of ZYX stock on margin; he deposits $5000 margin.
CUSTOMER'S BROKER
2. Broker buys 100 shares for $15,000. -3. Broker borrows $15,000 from Lender for payment.
LENDER O F MONEY
4. Broker gives the shares to Lender a$ security.
5. In addition to margin, Broker credits Customer with the shares and debits him with the $15,000 and commission ($25).
Chart by Rudolf Modley
Chart 6
60
STO CK M A R K ET C O N TR O L
Routine of a MARGIN PURCHASE

CUSTOMER
2. THE SELLING OPERATION

ZYX stock goes up to 160. Customer wants to take his profit.
1. Customer places order to sell.
CUSTOMER'S BROKER
2. Broker sells 100 shares for $16,000. 3. Broker returns loan and pays interest.
LENDER O F MONEY
4. Lender returns the 100 shares. 5. Broker credits Customer with $16,000 and debits him with the shares, commis sion ($25), interest ($22), and tax ($9). The profit is $919.
Chart 7
61
ROUTINE OF A SHORT SALE

CUSTOMER
1 . THE SH O R T SALE
XYZ stock sells at $150. Customer thinks it will go down. 1. Customer orders Broker to sell 100 shares of XYZ stock short; he deposits $5000 margin.
CUSTOMER'S BROKER
2. Broker sells 100 shares for $15,000. 3. Broker borrows the shares from Lender for delivery.
4. Broker lends the $15,000 to Lender a9 security.
LENDER O F SHARES
5. In addition to margin, Broker credits Customer with $15,000 and debits him with the shares, commission ($25) and tax ($9).
Copyright 1934 by Twentieth Centyry Fund, Inc.
Chart 8
62
ROUTINE OF A SHORT SALE

2. THE COVERING OPERATION
XYZ stock falls to 140. Customer wants to take his profit
1. Customer places order to cover.
O'
LU
o Q
CO
CO
Q sH
LU
o'
co
2. Broker buys 100 shares for $14,000. ~3. Broker returns the 100 shares to Lender.
ID
CO
Q
CO
LU
<
^ Lender returns the loaned money.
o
z
oc LU a
uu
5. Broker credits Customer with shares, debits him with $14,000,commission ($25). The profit is $941.
Copyright 1934 by Twentieth Century Fund, Inc
Chart 9
63
a more easily understandable form than would a textual description.

3. T rading I n O ld I ssues O ver -T h e -C o u n t e r
The enormous bulk of trading outside the organized ex changes has been emphasized before. In spite of the impor tance of the over-the-counter markets comparatively little is known about trading in them by the general public. Because of the lack of facilities for credit and for loaning securities which are furnished by the organized exchanges, margin trading in the over-the-counter markets either long or short is far less common. It is probable that the majority of trades are on a cash basis or are financed by bank credit. A typical transaction is as follows: Dealer Blank, having an order to buy 100 shares of Third National Bank stock for a customer, may call Dealer Doe and ask him for "the market on that stock. Dealer Doe replies 113-115, meaning that he will buy at 113 or sell at 115. Theoretically, the 2 point difference represents the profit Dealer Doe expects to make on deals in that stock. Dealer Blank may accept, may ask for a better price, or may go to another dealer. At times Dealer Blank may have several competing dealers on the wire, and get the best prices of each. After purchasing the stock, Dealer Blank notifies his customer that "I have sold to you 100 shares of Third Na tional Bank stock. In the case of a selling order, the same routine would be followed, except that Dealer Blank would find a purchaser for the stock and would notify the customer that "I have bought from you 100 shares of Third National Bank stock. In both cases Dealer Blank is a principal twice, that is, he both buys and sells for his own account. The dealer, as a dealer, cannot charge a commission for his services. He gets his profit from the difference between
64
his buying and selling prices. In the example cited above the two dealers split the profit obtained on the transaction. In other instances, Dealer Doe may receive the order through a broker who charges his own customer a commission on the deal, in which case Dealer Doe retains the entire profit.
Chapter V
EUROPEAN STOCK EXCHANGES

1. G e n e r a l C o m p a r is o n
HILE stock exchanges the world over have, quite naturally, a fundamental similarity in function and in the broad outlines of their growth, there have developed in the various countries distinguishing characteristics deeply rooted in racial and temperamental differences and in the varying social, economic, political and legal institutions and traditions of the people. From the complicated mass of detail revealed by a study of these exchanges certain points of real significance stand out in high relief. Surveying first the European situation as a whole we find that a few striking generalizations are justified.
a.
g o ver nm ent control
First, the Continental exchanges are in a very real sense related to and controlled by their respective governments, this control varying in degree from that in Amsterdam, where the governmental control is more theoretical than actual and amounts to practical non-interference, to the Paris Bourse, established as a government monopoly, and the Berlin Ex change where the organization and operating practices are subject to governmental regulation. The London Exchange, in contrast to other leading foreign exchanges, is a voluntary, self-governing organization remarkably independent of gov65
66
ernmental control and influence, and similar in this impor tant respect to the New York Stock Exchange.
b . RELATION TO BANKS
Second, the relation of banking institutions in England and on the Continent to the actual trading of the stock ex changes is much closer and more important than in New York. Much of the business of the London, Paris, and Berlin exchanges comes through the banks. This is due, on the Continent, partly to the prevalence of the use of bearer shares which are almost as negotiable as money and which have given rise to the custom particularly among the many small owners of securities, of depositing securities in banks which then perform a custody function. In London and Paris, where the broker splits commission with the banks, the stock exchange business is an important source of income to the banks. In Berlin this close relation ship is carried still further, for here the banks may be mem bers of the exchange and themselves transact the business of trading in securities. Indeed, in Germany the institutions that compare with our large brokerage houses are the banks which have swallowed up the commission business and rele gated the broker to the insignificant role of a mere ordertaker. In Europe branch banking has reached a high degree of development and it has become the channel through which much business reaches the exchanges. Brokerage houses, therefore, have not developed branches and, indeed, mem bers of the London Stock Exchange are not permitted to have an office outside the financial district. In America, on the other hand, we have little branch banking; members of the Exchange are not permitted to split commissions with non-members; and brokerage houses have, therefore,
EUROPEAN
STOCK
EXCHANGES
67
branched out until many of them have extensive wire sys tems and offices in many cities. In one sense, as pointed out, the relation between the banks and the security markets is much more intimate in the United States than in Europe. This arises from the fact that American banks are more heavily involved in financing stock market operations through collateral loans and brok ers loans than are European banks.
C. LISTING REQUIREMENTS
Third, none of the European exchanges has as strict and comprehensive listing requirements as does the New York Stock Exchange. This is due to the fact that the European countries have companies acts or national incorporation laws which prescribe certain corporate practices. Here, with a complete lack of uniformity in state laws and in the ab sence of national regulations similar to those found in Eu rope, the American Exchanges and especially the New York Stock Exchange have developed rigid listing requirements as a sort of substitute for national corporation laws.
d . TERM SETTLEM ENTS
Fourth, the term settlement system, in which accounts are settled up twice a month, or monthly in some instances, is an important factor in the London Exchange and, to a lesser degree, in Paris and Berlin, where term settlements are re stricted to trading in a limited number of stocks. Amsterdam has not established term trading, and, indeed, after having given the matter considerable study, definitely determined to retain its system of cash settlements. In London, where much difficulty is sometimes experienced in transferring British registered securities and often a con siderable amount of time is required, term settlements are a necessity. On the Continent, where bearer securities are
68
popular and cash settlements could become the general rule, the term settlement has often been considered as primarily a device for facilitating and increasing the volume of trad ing. Indeed, the influence of the term settlement on the type and scope of trading has often been discussed. To some extent it certainly facilitates trading, for orders can be given, and in spite of fluctuations in the market, the account does not have to be settled up until the regular settlement date. This practice is analogous to the "when issued trading in New York where a large volume of trading is often done in securities that are not yet issued and which, of course, do not have to be paid for or delivered until the date of issue. It is sometimes claimed that this custom does not actually increase speculative trading, because the very facility which it provides necessitates on the part of the broker greater care in the selection of his customers and in his requirements regarding proper references and evidence of fitness for open ing an account. On the other hand, the greater proportionate number of insolvencies on the London Exchange as com pared with New York is thought by many to be directly attributable to the term settlement.
e. TRADING IN OPTIONS
Trading in options, forbidden on the floor of the New York Stock Exchange, is permitted in the stock exchanges of Europe.
f . GENERAL CHARACTER OF TRADING
A comparison of European stock exchanges with Ameri can practice would be incomplete without mention of the very noticeable difference in tempo. The American machine is geared for higher speed. One evidence of this difference is found in the extent to which the term settlement is utilized in Europe. Another evidence of this difference in spirit is
EUROPEAN
STOCK
EXCHANGES
69
found in a comparison of the ticker systems. Tickers exist in London and Paris, but they do not compare with the Ameri can ticker system in the completeness and accuracy of their information. All of the European stock exchanges, in contrast to the New York Exchange, publish official price lists of varying usefulness and accuracy. But nowhere do we find financial news and stock quotations filling as important a place in the newspapers of the country as in America. It is true that European countries have had their great speculative episodes, but nowhere has so widespread and continuous an interest been developed in trading on the stock exchange, and nowhere have the mechanical facilities for disseminating information and for transacting business been so highly per fected.
2. S p e c ia l C h a r a c t e r ist ic s
of
F o r e ig n E x c h a n g e s
In addition to the above generalizations each exchange has certain interesting and striking characteristics.
a. LONDON
The London Exchange, for example, is unique in the vast international scope of its trading. The interests of English people have traditionally reached out over the entire world. Today there are over 5,000 securities in the official list of the exchange and it is probable that the number of issues that can be traded in, including, of course, a large number very infrequently handled, reaches 20,000. The scope of this market is largely responsible for the peculiar feature of the organization of the London Exchange, not found elsewhere the jobber system. The London Exchange alone has its members divided into two classes: the jobber or dealer, whose income is in the form of a profit, and cannot deal directly with the public; and the broker, who acts as agent between the public and the jobber and works for a com mission. Members of the Exchange cannot carry on business
70
in the combined capacity of broker and jobber; they must declare at the beginning of each year in which of these capac ities they propose to act. The jobber, in a way, combines the functions of the New York specialist and odd-lot dealer. Only with this system, in which there exist jobbers who spe cialize in various securities, would it be possible to provide a market for trading in the gigantic number of issues found on the London Exchange. In London margin trading of the kind and to the extent prevalent in New York is unknown. Brokers do not require margin of customers trading "for the account or on the term settlement basis. This fact contributes to the more per sonal relationship existing between brokers and customers, mentioned in the general discussion of "term settlement above. Credit for carrying securities is customarily arranged, not through margin accounts with brokers, as in New York, but by means of bank loans.
b . PARIS
In the Paris Stock Exchange the fundamental point of difference, as compared with all other exchanges, is the ex istence of an official Bourse, the Parquet, a government monopoly with membership limited to 70 agents de change appointed by the President of the Republic in consultation with the Minister of Finance. This appointment, once made, and paid for, carries with it property rights in the member ship which can be sold to a successor. The Paris Parquet is the only stock exchange in Europe in which membership has a transferable value similar to the value of a seat on the New York Stock Exchange. The agents de change are not permitted to trade on their own account, nor can they even advise their clients; and their income is derived exclusively from commissions. On the other hand, they have an absolute monopoly in trading in the securities listed on the Parquet.
EUROPEAN
STOCK
EXCHANGES
71
The principal of solidarite, an important feature of the Paris Parquet, is not found elsewhere. It is a mutual guaran tee by members whereby the liabilities of defaulting members are met from a general fund. This principle creates a real necessity for the close supervision by the Syndical Chamber (the governing body of the exchange) over the operations of members, and for the power of the Chamber to examine the members books at any time and to bring pressure wher ever overextended credit situations are found. In New York the Stock Clearing Corporation and the questionnaire sent out by the New York Stock Exchange to its members, per form together a function somewhat similar to the solidarite principle, in providing a check on the operations of members and a correction of unsatisfactory situations when disclosed. The Coulisse, or Curb Market of Paris, handles securities not listed on the Parquet and is not subject to the same degree of regulation as the official market. The trading on the Paris Exchange has, in general, quite a different character from that in London and New York, due to the'great relative importance of the government loans and the national debt as compared with corporate securities. This is due, in large part, to the fact that French industry and commerce is still organized very much along family lines with the ownership closely concentrated. In other words, large stock corporations with great public distribution of securities are relatively few, and create a small supply of corporate securities to be traded on the exchanges.
C. BERLIN
The most notable feature of the Berlin Stock Exchange is the fact that the close affiliation between the banks and the stock exchanges, characteristic of Europe as a whole, is here developed to an exceedingly high degree and amounts to complete domination of the Stock Exchange by the banks.
72
While stock corporations are denied membership in the ex changes of London, Paris and New York, they are admitted to the Berlin Exchange. Banking corporations form a large part of the membership and transact by far the greater part of the commission business in securities. In fact, it is per fectly permissible for banks to match orders, so that the volume of trading transacted on the floor of the Exchange represents only orders left over after all matched orders have been taken care of, with the addition of a certain number of orders transacted on the Exchange as a part of their peculiar price-fixing practice. In Germany the whole organization of industry, banking, and the stock exchanges is very closely knit. Large indus trialists, officers of industrial corporations, frequently have close relationships with banks through which their financing arrangements are made and which, at the same time, play an active part in marketing and trading in the corporate securities. Another feature of the Berlin Exchange which deserves special mention is the remarkably efficient method of clear ance by setting up a system for depositing securities and handling them by checks through the Bank des Berliner Kassen-Vereins. The advantages of this method have been fre quently discussed, but the adaptation of some of its features still remains to be accomplished as part of the evolution of the American system.
d . OTHER EXCHANGES
Holland, Austria, Belgium and Switzerland have financial centers of varying importance. Their organization and prac tices are generally similar to those of the larger exchanges. Amsterdam deserves particular mention because it preceded London as the worlds most important exchange and it still is an excellent market with a wider international scope than the other Continental exchanges.
Chapter VI
A CRITIQUE OF THE SECURITY MARKETS E now have before us a broad outline of the organiza tion and operation of the markets. W e have also a picture of the functions which they should perform in the economic interests of the nation as a whole. It is now in order to evaluate the actual by a comparison with the ideal. It is a task of immense difficulty and complexity. To accom plish it with any completeness would require time and facili ties both to obtain the necessary data and properly to analyze them far beyond the limits of this survey. All that is possible with the resources at hand is to sketch the broad outlines and to fill them in with whatever substance of fact and deduction is now at our disposal. This survey, it should be noted, has been designed to study the operations of the markets, to disclose shortcomings, and to suggest improvements. Such a purpose does not imply ignorance of or lack of appreciation of the markets effi ciency. The methods of buying and selling securities have been developed especially in the organized exchanges to an amazing degree of technical efficiency. Purchases and sales can be effectuated in a few minutes, even when the parties are as far apart as the two oceans. And, in addition, the facilities for obtaining credit, for securing information about trading, and for the clearing of transactions, have reached a degree of development which is a tribute to the American genius.
73
74

1. T h e U l t im a t e T ests
The security markets, however, cannot be judged solely in the light of their technical efficiency. Their influence on the welfare of the American people is so pervasive and powerful that they must be assessed in terms of the effective ness with which they perform the functions which it is rea sonable to expect of them. Viewed in this light it may well be that their very mechanical perfection has promoted evils which outweigh the advantages. In attempting to assess the value of the technical efficiency of the organized exchanges it should not be forgotten that a large number of issues of both stocks and bonds are not listed on any exchange and that a very large proportion of the total trading is carried on outside the organized mar kets. Some of this trading is, of course, in securities listed on exchanges, and is therefore dependent for its valuations upon the quotations of the exchanges. But there is also a group of securities not listed on any exchange, which find that they can do without the services of an organized market. Among these latter are bond issues of the highest type, most bank stocks as well as many other corporate and gov ernmental issues. The issuing companies have preferred to dispense with the alleged advantages offered by the Exchange in order to avoid disclosing information required by the Exchange or to minimize manipulation. The fact that so many companies whose shares are eligible for listing have not demanded that privilege, seems to indicate that the services of the stock exchanges are not always considered indispen sable and that a great part of the flow of savings can be directed into industry without the intervention of an ex change. On the other hand, many of the over-the-counter transac tions take place in issues of such low quality that it would
CRITIQUE
OF
SECURITY
MARKETS
75
be impossible to secure their listing on any exchange. It is the small investor who suffers most from such issues, and for him the listing requirements of an exchange are un doubtedly a safeguard. The ideal markets, it will be remembered, should (1 ) set prices for securities which as closely as possible reflect pres ent and future earnings; (2 ) furnish securities the market ability and price continuity necessary to serve the needs of investors; and (3 ) induce the most productive flow of sav ings into the nations economic activities. Unfortunately there is not nearly enough factual information about the markets in relation to the other economic activities of the nation to apply these tests with any certainty to market operations as a whole. To do so would require, for example, ( l ) a detailed knowledge of the relation which stock prices have actually borne to earnings per share both in the direc tion and in the amplitude of the swings; (2 ) comprehensive data as to relative ease of buying and selling under varying market conditions; and (3 ) fairly complete information about the extent to which there is an economically justifiable need for new capital on the part of industries and govern mental units. Practically none of this is available. Before attempting to assess the markets performance in the light of these ultimate tests it is necessary to distinguish between investment and speculation, and their relation to the operations of the market.
2. I n v e s t m e n t
v s.
S p e c u l a t io n
Transactions in the security markets, in general terms, may be divided into two broad classifications: investment and speculation. "Investment implies purchase of securities (or other property) for the purpose of realizing the maxi mum income consistent with safety, marketability and other factors. By "speculation is meant trading in securities for
76
the primary purpose of realizing capital gains i.e., making a profit by a subsequent purchase or sale at a different mar ket price. It cannot be emphasized too strongly that these words are used in this discussion without any moral connotation whatever. The activities of the speculator, if not excessive, may assist the market to perform economically useful func tions, such as furnishing continuity and liquidity. The per son who invests, on the other hand, does not invariably or necessarily help to make the market function to the best interests of our economy as a whole. Furthermore, not every transaction can be readily classi fied as either investment or speculation, nor can every person who buys or sells stocks or bonds be classified as a speculator or an investor. Many securities are purchased by individuals who have made no definite decision as to whether they will keep them for income or sell them for profit. There is thus a borderland between investment and speculation. Obviously in these borderland cases it is absolutely impossible to assign particular trading activities to either of these two classes. These difficulties do not, however, invalidate the usefulness of the classifications. W e do not refuse to use the terms night and day because twice in every 24 hours there come a few minutes when it is impossible to say whether it is night or day. Moreover, if objection is made to any classification that is based on subjective motives, the difficulty is avoided by classifying transactions on the basis of actual performances over a period of time. The investor does not go in and out of the market to take advantage of minor or intermediate price fluctuations. He buys and sells primarily on the basis of his appraisal of the present performance and future pros pects of the companies concerned. The number of his transac tions compared with those of the speculator are relatively
CRITIQUE
OF
SECURITY
MARKETS
77
few. Speculative traders behave very differently. Their atten tion to the records of corporate operation and finance is often relatively slight. Their interest in these matters is confined to the probable effect of corporate performance on the price changes of its securities. Speculators, of course, differ widely in the amount of information and judgment they possess of actual market conditions. Some trade with sufficient knowledge to anticipate correctly; others know relatively nothing about market and business actualities but act on hunches and tips. By shrewdly appraising future develop ments the intelligent and informed speculators undoubtedly aid the market to perform its discounting and evaluating functions, but the ignorant and uninformed traders, who, unfortunately, are most numerous at times of great market activity, undoubtedly hinder the market in the performance of some of its most important functions.
3. T y p e s
of
T r a d in g
and
M a r k e t F u n c t io n s
Having these definitions in mind it may be useful, first, to consider the probable value of each of these two kinds of trading in producing the most economically desirable markets; and second, to make as shrewd a guess as possible as to the relative importance of speculative and investment trading in the organized markets.
a.
the e v a l u a t i o n o f se c u r it ie s
Common observation as well as available statistics raise a serious question as to whether the market has adequately performed its evaluating function at least during the past several years. Sufficient data to reach final statistical conclu sions on this point are not available, but a study of market prices of 50 representative industrial common stocks gives some concrete factual support for these conclusions. As shown in Chart 10 the aggregate market value of these com-
78
QUARTERLY EARNINGS O N COMMON, & COMMON DIVIDENDS F O R 5 0 INDUSTRIAL COMMON STOCKS COMPARED W ITH AGGREGATE MARKET VALUE
CRITIQUE
OF
SECURITY
MARKETS
79
mon stocks rose steadily and with increasing rapidity from about $6 billion in the early part of 1926 to $21 billion at the peak of the bull market in 1929. Aggregate quarterly earnings applicable to these shares which amounted to $169 million in the first quarter of 1926 fluctuated consider ably during the ensuing three years and reached a peak of $327 million in the second quarter of 1929. Quarterly divi dends paid rose from around $106 million in 1926 to ap proximately $166 million in 1929- In other words, while dividends paid on these stocks increased 56 per cent during this period and earnings increased 93 per cent, market prices more than trebled. It is apparent, therefore, that, during this period at least, the market failed signally to evaluate these securities in terms of their real worth as represented by dividends and earnings. Nor did market performance during this period accurately discount future earnings. Although the rise in prices did precede the rise in earnings, the latter was greatly over discounted, and prices failed utterly to discount the drastic decline in earnings which commenced in 1929. Final judgment cannot be rendered on general averages which conceal wide individual differences or on data cov ering so short a period. It is also true, as shown elsewhere in this study, that the stock market in the past has frequently anticipated major cyclical turning points in business. But it is equally true that the market usually overshoots the mark in discounting the extent of advances and declines in business and earnings. If speculation contributed to proper evaluation, one would expect that speculative activity in individual issues or in the market as a whole would result in greater price stability, since earnings do not show violent variations. That this is not true for the market as a whole has been demonstrated above. A statistical analysis of the actual behavior of specific issues subject to varying degrees of speculative activity gives
80
STOCK MARKET CONT ROL
some confirmation to the conclusion that excessive specula tion makes for more rather than less violent fluctuations. Apparently, however, a moderate amount of speculation re sults in less violent fluctuations than the absence of any speculative activity. A comparison of the day-to-day price changes of several specific issues of stock were studied: (1 ) J. I. Case, in which speculation was known to have been extreme; (2 ) Interna tional Harvester Common, in which speculation was only moderate; and (3 ) the common stock of John Deere and Company, which was inactive although no trading in the issue would occur for several days the volume of trading was sufficient to give it a quotation most of the time, yet small enough to indicate the almost complete absence of speculation. The high and low daily deviations from the long-swing price trend of each of these issues were examined for the period of January 4 to March 29, 1932. Other things being equal, investors would prefer that the market price of a stock deviate as little as possible from its trend so that in case of forced liquidation they would be able to obtain an amount very near that which they would receive if they could sell at their leisure. It is often claimed that speculation reduces this deviation and, by so doing, performs a service for the investor. While the maximum deviation above the trend was practically the same for all three issues, the deviation below the trend was twice as great for the excessively speculative stock as for the mod erately speculative and for the non-speculative stock. Assum ing the trend to represent the true worth of each issue, in vestors in J. I. Case, forced to sell on the day of maximum deviation below the trend, would have obtained 28 per cent less than its true worth, while investors in International Harvester and John Deere in the same circumstances would have forfeited but 13.7 per cent and 12.5 per cent, respect
CRITIQUE
OF
SECURITY
MARKETS
81
ively. An investor would have risked a much greater loss in selling the most speculative stock of the three than in selling the inactive or the moderately speculative issue. Indeed it is apparent that the speculator thrives on price fluctuations. Insofar as speculators influence market prices, therefore, it is not surprising that the pressure they exert frequently aggravates rather than stabilizes price fluctuations, particularly as the uninformed outside public rushes into the market at times of great activity. In other words, specu lative forces tend to carry the ups and downs of prices temporarily out of line with values based on earning power. Speculators fall into one of several broad classes. In one class belong those informed and shrewd traders who analyze and study business conditions until they become skilled at forecasting prices. Such traders may now and then make errors but when their number is large the betting odds re main in favor of their collective judgment proving correct. Speculation of this type is a real aid to the market in the fulfillment of its discounting functions. When a speculator correctly anticipates a future increase in investment demand, the stocks which he accumulates are distributed to investors and the market price remains on the new level to which the speculative activities brought it. Under such conditions the profit which the speculator re ceives may be economically justified by the discounting service that he has rendered, and by the fact that he has been willing to assume the risk of buying and holding securities when investors were reluctant to enter the market. In another class belong the corporation officials and direc tors, together with their relatives and friends, who by their access to confidential information are enabled to speculate with little risk of loss to themselves. Without doubt such in siders hold an advantage over others in the matter of predict ing future prices and this advantage would act to increase the
82
discounting ability of the market. For example, one of the directors of a prominent transportation company, while re ceiving $20,000 a year as chairman of its finance committee, was able to "anticipate the necessity of this company pass ing an approaching dividend in sufficient time to unload huge blocks of its stock held by his personal corporation. Largely as the result of this selling and that of an as sociate, Chairman of the Board of the same company, the price of the companys stock dropped from 25 to 11]/$ less than two weeks before the announcement was made that the dividend was passed. Of course, it is impossible to condone such dealings. In another class are the professional traders the floor traders of the stock exchanges, operators, and board room speculators who base their trading largely on the technical position of the market, aiming to profit from small varia tions in price and thereby contributing to price continuity. The majority of speculators, especially in active markets, are the uninformed "outsiders. Their activity partakes more of the nature of guessing the movements of professional manipulators than of discounting the effect of current in dustrial happenings upon future prices. Their susceptibility to tips and rumors makes them dupes of professional pool operators. The purchases and sales of such traders exag gerate the price movements begun by professionals rather than initiate price corrections when current quotations fail to conform with real worth. It is obvious that the bulk of speculative activity is of such a nature that it does not con tribute to price stability and sound evaluation of securities. Speculation, therefore, is frequently a disturbing influence which prevents the market from performing its proper service to investors. The investor, on the other hand, for whom after all the markets are supposed to exist, desires stable prices and bases
CRITIQUE
OF
SECURITY
MARKETS
83
his trading on his best estimate of the present and future earning power of the corporations in whose securities he deals. The more efficient he is, the more likely is the market price of the security in which he trades to correspond to its real worth, and, consequently, the more effectively the mar ket performs its function of evaluation.
b. M ARKETABILITY AN D PRICE C O N T IN U IT Y
Speculation undoubtedly does contribute to marketability and price continuity. In the performance of this function the principal requirement is a large and continuous volume of transactions. For stocks and bonds to be readily marketable at all times there must always be buyers and sellers ready to trade. It makes relatively little difference whether the deal ings are speculative or not as long as they swell the volume of trading. Insofar as the speculators are active on both sides of the market they assist in maintaining a liquid and con tinuous market. The investor, on the other hand, because his transactions are less frequent, might be supposed to con tribute less to the markets liquidity. Two doubts, however, arise at this point. First, under ex isting conditions is not speculation limited to relatively few issues, in many of which there is sufficient investment de mand to provide reasonable continuity? Second, how far do speculative activities, especially those of the uninformed out sider, tend to so accentuate market trends as to precipitate panics in which liquidity disappears? Even if this extreme is never reached it may be that speculative activity results in such violent fluctuations in prices that the ill effects outweigh the usefulness of quick and easy trading facilities. These doubts can be transmuted into certainties, or disposed of altogether, only by factual information by statistical analyses which actually demonstrate causes and effects. Dr. S. S. Huebner aptly defines a continuous market as
84
"one where any security listed may be bought or sold at any time during business hours at comparatively small variations from the current price. To have a continuous market it is necessary that there be bids and offers at small variations from the general market price. The highest bid in an inactive stock, however, may be several points below the price at which the last transaction occurred. In an inactive issue a shareholder has no assurance that he would get anything near the last price quoted were he to offer to sell his holdings at the market. In other words, quotations in inactive issues have only historic significance to shareholders, whereas quo tations in active issues are reliable indicators of the approxi mate price at which the next sale will take place. Obviously, a market quotation may be accepted as a true index of the market value of a security only if it means that additional shares may be sold at or near that price. Whether or not it is true that a continuous market is due to speculation, it is a fact that the issues in which active speculation is known to occur enjoy a more continuous mar ket than do the issues in which speculation is absent. A study of ten active and speculative, and ten inactive and non-speculative stocks during three weeks of November 1933, showed that the spread between closing bid and asked prices of the former averaged from $0.12 to $1.33, while that of the latter averaged from $0.33 to $2.67. Obviously price con tinuity is greater in the active and speculative issues. However, if a continuous market is to be obtained only at the expense of a stable market, then some doubt exists as to whether investors gain more from the former than they lose by the latter. After all, price continuity has reference to minor fluctuations, whereas stability has reference to wider variations in the price of a security. If forced to choose be tween a stable and a continuous market, an investor might be better off for choosing the former.
CRITIQUE
OF
SECURITY
MARKETS
85
C. DIRECTING THE FLO W O F SAVINGS
Finally, do the activities of speculators contribute to the most productive flow of savings into the nations economic activities ? Obviously the investor who is seeking security and stability of income is unwilling to assume the risks involved in financing new and untried enterprises. Without the specu lator, willing to risk large losses in the hope of large profits, therefore, these young enterprises would find it impossible to secure capital. Insofar as this function is performed by the speculator his activities are legitimate and useful. There is less need and justification, however, for specu lative trading in the existing issues of established enterprises. In fact, excessive speculation in such issues creates an arti ficial interest and higher prices for these securities which, in turn, frequently leads to unwise expansion of plant and equipment with funds obtained by sale of new securities to the public. That the excessive speculation which character ized the late 20s not only led to an unnecessary and un justified flow of savings and credit into fixed capital investment, but also resulted in a disproportionate allocation of savings among enterprises and industries is so apparent that it requires no statistical verification. In other words, the rising prices of the bull market were largely responsible for general over-expansion of productive capacity or at any rate for a disproportionate expansion of some industries as compared with others. Our experience during the post-war boom indicates that both the investor and industry itself might have fared as well or better without the services of the speculator. It must be said, however, that even the most intelligent investor using all the facilities for obtaining accurate infor mation about new issues which the Securities Act provides is hardly in a position to be the arbiter of the flow of savings
86
into industry. An intelligent decision demands far more knowledge of the facts than he is able to obtain. Essentially the economic justification for a particular new issue is based upon the relation of plant expansion in the industry to con sumer demand for its products. To weigh this intelligently requires information not only on the plant capacity of the concern in question but also that of other companies in the same industry not to mention that of concerns in industries which may be in competition.
d . THE VOLUM E O F SPECU LATION
Granting a certain degree of usefulness to the informed speculators activities in evaluating securities, providing mar ketability and price continuity, and directing the flow of sav ings into new enterprises, the question arises as to whether such an enormous volume of speculation as occurred in the boom years was really necessary to accomplish these purposes. In 1929, for example, the total number of shares of stock sold on the New York Stock Exchange was 1,124,608,910. The total number of shares listed on the Exchange at the beginning of the year was 757,301,677, so that on the aver age each share of stock was turned over about II/2 times. Even in the less active year of 1928 the rate of turnover of listed shares was as great. But these comparisons do not indicate the real intensity of speculative activity, because the "floating supply, in which trading takes place, is only a small fraction of the total list ings, and since most of the issues were comparatively inactive, speculation was largely confined to the floating supply of relatively few issues. In 1928 the average turnover of 24 market leaders was 4 ; in other words, there were four times as many shares traded as there were outstanding. But the proportion of the shares of these companies which constituted the floating supply is estimated to have been 30 per cent o'f
INVESTMENT HOLDINGS IN RELATION T O FLOATING SUPPLY AND TURNOVER

CRITIQUE OF SECURITY MARKETS
87
Copyright 1934 b y Twentieth Century Fund, Inc.
Chort by Rudolf Modley
C hart
11
88
the whole number. Therefore, those shares which were in volved in the trading were turned over 13 times. This is illustrated in Chart 11. Against this sensational turnover rate in the active stocks may be set the relatively low rates of the less active issues. A calculation covering 24 of such in the same year shows a rate of five one-hundredths or, computed on the basis of the floating supply, one-eightieth as much as the 24 "market leaders. A spectacular example of the extent of speculative activi ties is found in the trading in the common stock of a promi nent manufacturing company. There were 820,000 shares of this stock outstanding in 1928. The records show 6,398,000 shares sold during the year, or 7.8 times as many shares sold as there were shares outstanding. But this tells only part of the story. Some of the 820,000 shares were undoubtedly held by investors who did not sell at all during the year. Each share so held raises the turnover rate of those which were actually traded in. Measured in terms of market values, the trading in stocks on the New York Stock Exchange amounted to about $74 billion in 1928, as compared with a total value for all listed shares as of January 1st of that year of approxi mately $50 billion. Of course, this enormous volume of tradingexcessive as compared with total listings was en tirely out of proportion to the volume of new stock issues floated during the year. Total new issues of stock amounted to less than $4 billion, only part of which was listed on the New York Stock Exchange. Thus "secondary trading amounting to $74 billion was involved in directing the flow of less than $4 billion of new savings into industry. The picture of the markets which these figures create is that of a vast amount of unnecessary activity with a relatively small proportion of the nations securities. All indications
CRITIQUE
OF
SECURITY
MARKETS
89
point to an enormous milling and churning around of a few shares of a few companies mostly purely speculative in character rather than to a broad activity along the entire front of all listed securities. This highly concentrated trading, of course, is not the result of the activities of investors, who buy and sell to obtain the maximum income from the con cerns in whose stock they are dealing, but from the activities of those who go in and out of the market to make profits on minor fluctuations. The reasons why security market prices have not corre sponded more closely to their investment worth, and why the exchanges have developed such an amazing degree of con tinuity and marketability may prove to be the same: specu lative operations dominate the market. Prices may result primarily from the trading of those who seek to obtain a profit from rapid turnover on short-term fluctuations. The same cause which has resulted in the excessive performance of one function of the exchanges that of making a ready market may have prevented the proper evaluation of securi ties and a better allocation of the savings that flow into new issues. The problem of security market improvement, there fore, centers in the volume and nature of speculation.
e. MARGIN TRADING AN D SPECU LATION
This enormous and unnecessary volume of speculative ac tivity is made possible only by trading methods involving the use of credit: margin buying and short selling. Both oper ations are conducted largely with borrowed resources. In margin buying the trader borrows cash to buy securities; in short selling he borrows the securities which he sells. In each case, of course, he is obliged to protect or margin his loan by putting up some of his own cash or securities. Obviously these methods enable the trader to conduct larger operations than would be possible if he were restricted to the use of his
90
own resources. Tho total volume of trading is thereby enor mously increased.
4 . M a r g in B u y i n g
The practice of margin buying has been violently attacked on ethical grounds on the theory that it is not right morally to buy more than one can pay for and that the speculative profit realized from such transactions does not represent any real service to the community. In this survey, however, our purpose has been to apply exclusively economic standards in appraising the practice of buying stocks on margin. On economic grounds it has been contended that margin buying absorbs credit which would otherwise go into productive in dustrial uses and that, by magnifying speculative activity, it hinders the markets in performing their legitimate functions. Speculation is increased by margin transactions in spite of the more rigid requirements recently established by the New York Stock Exchange. Therefore, the arguments set forth above regarding the harmful influence of excessive specula tion on the proper functioning of the markets apply with equal force to margin trading. There are other harmful effects which arise from the very nature of margin trading, apart from its acting as an incentive to speculators.
a. B A N K CREDIT AN D BROKERS LOANS
These harmful effects are disruption of the nations credit mechanismthe interruption of the normal flow of savings into investment, and of bank credit into commerce so that short-term bank credit is improperly drawn into long-term investments, and the volume of bank credit is abnormally inflated. In bull markets bank credit and the resources of corporations and individuals are drawn upon in vast quanti ties to finance stock purchases and are thus put to uses which are of questionable economic soundness. At least a portion of this enormous flow of credit goes into the expansion of the
C R I T I Q U E OF S E C U R I T Y M A R K E T S
91
nations plant equipment at a time and in a manner danger ous to the national economy. A description of the origin and flow of brokers loans is necessary for an understanding of the effects of the use of credit in speculation. Brokers obtain the funds to finance margin purchases partly from their own resources, but mostly through their own borrowing from banks. The banks in turn make these loans on the basis of their own reserves and those of other banks, or they act as agents in lending the funds of others outside the banking system. Prior to November 16, 1931, corporations and individuals made huge advances through the banks to finance security speculation. Since then, how ever, New York Clearing House banks have been forbidden by the Clearing House Association to make these loans for non-bank lenders, and subsequently the practice was forbid den to banks in the Federal Reserve System by the Banking Act of 1933. New York non-member banks, however, are still free to make loans to brokers for their own account and that of other banks without limitation. At the peak of the bull market loans to members of the New York Stock Exchange alone, made to finance security speculation, reached the unprecedented total of about $9 bil lion. Of this huge volume more than $4 billion repre sented the funds of others than banks in somewhat the fol lowing proportion: corporations, 56 per cent; individuals, 20 per cent; investment trusts, 14 per cent and foreign lenders, 10 per cent. With the decline in market activity and the pro hibition against "loans for others the volume of brokers loans has receded. At the end of 1933 the amount outstand ing was $593 million. It cannot, of course, be said, as is sometimes claimed, that this enormous amount of credit was "withdrawn from busi ness in order to be put into the stock market. The total lending-power of the banks of the country is not a fixed sum,
92
but is extremely elastic, depending upon such factors as the amount and kind of bank investment, the proportion of commercial paper eligible for re-discount at the Federal Re serve banks, the proportion of bank notes to checks used in payments by consumers, the amount of gold reserves. These factors are influenced not only by interest rates and market conditions but also by Federal Reserve policy and the policy of foreign central banks. It is not possible to prove, therefore, that business suffered because credit was withdrawn from it for speculative pur poses, but it can easily be shown that the enormous inflation of credit due to the speculative demand for funds had unfor tunate results for the banks themselves, for industry and business. The chief function of commercial banks is to advance short-term funds to finance transactions the termination of which automatically provides the funds for repayment of the bank loan. Brokers loans, in spite of their being nominally "call loans, do not meet this requirement, since the specu lative buyer-borrower, at least in the case of already listed securities, usually sells to another buyer-borrower. The result is that when for any reason individual and corporate lenders withdraw their funds from the market the banks must take over the loans in order to protect the values of securities which they are holding as collateral. And when outside banks withdraw funds the burden as has been proven in every crisismust be taken up as far as possible by the New York banks. In the last analysis, therefore, call loans are neither "liquid in the commercial loan sense, nor "shiftable. The close connection between bank and stock exchange activity through the money market is the worst feature of the Ameri can banking system, and is fortunately not to be found dupli cated in any other banking system in the world. It has been claimed that the expansion of bank credit for
93
speculative uses was justified by the fact that it aided the placing of real capital, or savings, in industry. A large part of the proceeds of brokers loans undoubtedly goes into the purchase of new issues or into the purchase of other old issues. But another portion goes directly into expansion of plant and equipment by those sellers who are corporations or owners of business concerns. And still a third portion goes into the purchase of consumers goods. Chart 12 shows schematically the flow of brokers loans into the hands of the purchasers of securities and disbursed by them in various ways.
b. BROKERS LO ANS AN D P L A N T EXPAN SIO N
The data obtained in this survey indicate that the increased resources arising from brokers loans become available in large part to corporations to finance plant expansion. Be tween January 1, 1927 and October 1, 1929 brokers loans increased $5.3 billion. During this period, however, corpora tions whose stock was listed on the New York Stock Ex change reported that they had received $3-9 billion from their sales of new shares of common stock. While it cannot be proved that all of this $3.9 billion came from the $5.3 billion increase in brokers loans by way of sales to margin purchases, nor that all the proceeds went to plant expansion, this was in all probability one of the chief sources of supply. In other words, insofar as this process did occur the stock exchange became a mechanism for making bank credit avail able to corporations to finance increased capital equipment and plant expansion. This is certainly a questionable proceed ing since it has never been considered sound practice for commercial banks to lend to companies for these purposes directly. It is far worse when they do so indirectly, espe cially when the uninformed judgment of security traders is substituted for the presumably sounder judgment of bank executives in the allocation of the funds. Increasing brokers
94
ORIGIN
AND
F L O W
O F BROKERS' LOANS
95
loans and rising stock prices out of proportion to productive activity and earnings are inflationary in nature and effect. And when the resultant increase in credit is used to finance plant expansion at a time when over-expansion has already taken place the evils of an excessive business boom are still further accentuated and the difficulties are multiplied. Although it is not strictly true that speculation withdrew funds from business there is no doubt that business suffered serious consequences from speculative inflation of values. For one thing it had distorting effects on the direction of productive activity. High interest rates to small concerns and increased raw material prices and services were other penalties paid by business during the upward swing of infla tion. Reduced markets, lowered earnings and bankruptcy came as an aftermath.
5. S h o r t S e l l in g
The second method of margin trading short selling has been even more violently criticized and defended. The volume and intensity of discussion have varied inversely with the business cycle, mounting as prices and business activity declined and gradually subsiding as business improved. Dur ing the past 15 years there have been two periods of wide spread discussion of this subject. The first centered in 1920 and 1921, coincident with the decline in prices at that time and related mainly to short selling in commodities. The second has centered in 1931 and 1932 and has related more to stocks than commodities. The violence of the short selling discussion has been due largely to the absence of concrete data which would demon strate without question the truth or falsity of the various contentions. For example, no adequate record of the volume of short trading is available. The New York Stock Exchange has published in recent years some statistics on the size of
96
the short position at certain specific times. They have not, however, been related to the corresponding long positions at the same periods. Yet it is impossible to judge the effect of short selling in any instance without a knowledge of the margin purchases in the same securities. In this survey, however, available statistics of short opera tions and others hitherto unpublished, have been analyzed in an attempt to discover the effects of short selling upon the fluctuations of security prices and its advantages and dis advantages from the point of view of the markets efficiency. Before summarizing the results, however, some general com ments on the criticism of short selling are in place. One criticism of short selling is that it is not socially useful since it does not involve an exchange of tangible goods. A second criticism is that a short sale may involve the sale of something which may not in fact be in existence since the total sales may exceed the total amount of stock. The opera tion of selling short is, therefore, held to be socially harmful, as it may result in the creation of what is in effect an arti ficial supply. The present study is not concerned with ethical abstrac tions but is limited to a consideration of the economic effects of short selling upon security markets. Short selling, like other practices, has been examined and analyzed exclusively from the point of view of its effects on the economic efficiency of the markets in the interest of the nation as a whole. The economic arguments about short selling center in its effect on the prices of securities. The opponents of short selling claim that (1) it artificially depresses prices over considerable periods of time and par ticularly after substantial declines have already occurred; and (2) it unsettles prices in particular issues and at par ticular times through sudden and excessive selling which is popularly referred to as "bear raiding.
97
In support of short selling on this issue it is usually argued that (1) it provides a two-sided market and thus gives greater assurance that prices will accurately reflect present and future business conditions; and (2) it lends stability to current prices by broadening the market, adding selling volume to check temporary unwarranted advances and com pulsory buying volume to check sudden and unwarranted declines.
a. SHORT SELLING AND SECURITY PRICES
The arguments can be resolved only by an appeal to the facts. In the actual record of experience in the markets:
(1) What is the cumulative influence, if any, of short selling upon the trend of stock prices? (2) What is the cumulative influence, if any, of short selling upon intermediate "swings in stock prices? (3) What is the separate influence, if any, of short selling upon individual issues and during particular periods of time?
The statistical analysis undertaken in this survey has led to the following answers to these questions: ( l) In Relation to Major Trends In its relation to the major cyclical trends of security prices, short selling does not appear in volume until after prices have started downward. Short selling does not, therefore, have any appreciable effect in limiting the extremes to which prices may rise. Its tendency is to accelerate the downward trend of prices during the early and middle phases of the movement and either to check the price trend in the lower phase or accelerate the recovery after prices have turned upward. For example, to have served as a stabilizing influence upon prices, the total short interest should have been larger in the
98
great bull market of 1929, exerting a downward force at that time. Instead, it was relatively small during the summer of 1929 and after a substantial price decline in the fall of that year was still comparatively small. The market value of the total short interest on November 12, 1929 was $89.6 million and on June 26, 1931 it had grown to $212.7 mil lion. As a stabilizing influence, the short interest should have declined through covering purchases as prices moved downward in 1930 and 1931. Instead, it increased in abso lute amount as well as relative to the speculative long in terest. Short selling thus first appeared after prices had started downward and increased in absolute as well as rela tive importance as prices continued downward. Its cumula tive influence, if any, upon the trend in stock prices was, therefore, to induce a larger rather than a smaller downward swing. (2) In Relation to Short Swings The effect of short selling on intermediate swings of prices is less clear. The New York Stock Exchange began publish ing weekly figures of the total short interest in May 1931. At this point a maximum short position of 5,589,700 shares was reported. By September 1932 the total short position was less than 2,000,000 shares and thereafter it remained fairly stable for about six months and then declined to less than 1,000,000 shares at the end of October 1933. It is not possible finally to determine from this small sam ple what influence, if any, short selling and short covering have upon the smaller price cycles. Even with very complete data over a considerable period of time this question would be a difficult one to answer because of other important fac tors operating at the same time. It is possible, however, to question the tendency of trading for short account with refer ence to the course of prices.
99
On this matter there are two schools of thought. One main tains that short positions increase as prices advance, to be covered as they decline, thus tending to have a "cushioning effect upon prices by limiting the extremes to which they otherwise would go. The other school maintains that traders go short only after prices have definitely turned downward to cover at the bottom of the movement or perhaps after prices have begun to advance again, thus tending to increase the extremes of each price swing. According to the first, or "price-resisting theory, short sellers operate against the movement in prices; according to the second, or "price-following theory, they move with the swings in prices. In Chart 13 the total short position in the market is shown in comparison with the stock prices at weekly intervals from June 1931 to October 1933. During June 1931 prices ad vanced, while the short position decreased through covering purchases. Prices began to recede at the end of June, fell steadily during July, recovered slightly in August and then fell sharply and uninterruptedly until the end of September. Prices were then one-third below the high point reached in June. The June decline in prices was followed about two weeks later by a sharp increase in the total short interest, which thereafter remained generally stable at about 4.3 mil lion shares until September 10. While prices were plunging downward during the remainder of September short sellers were covering rapidly and continued to do so until early October, when the total short interest was only half as large as it had been a month earlier. During this period of rapid price decline, therefore, the activities of short sellers had the effect of cushioning or resisting the decline and thereby help ing to stabilize prices. Prices advanced with considerable ir regularity from October 5 to November 10. The total short interest remained about the same from October 10 to October 20, when it again began to increase and continued to increase
100
STOCK MARKET CONTROL Price Index
y \
'"r
'V J
I I
< r /
V
t x u s ,s ' # s <; / s .... k : ? J
/
1' V .*< i
/ /
< )
v*> J 'f e
v> X c '" I CSI o' r>
1 > k
il
>
!S
K&
'iS
1 1
k
1
^___j
j
Q * * **
> 3 }
J9
/
>
* >
>
*>
tM
Millions of Shares Short
CRITIQUE
OF S E C U R I T Y
MARKETS
101
through November 10. For this brief period the "priceresisting theory again applies. After November 10 prices moved consistently downward through December. The short interest continued its increase until early December, after which covering occurred in con siderable volume. For this period the short sellers were "price-followers during the forepart and "price-resisters during the latter. Considering the entire period from October 5 to the close of the year, they resisted the market in the early part, moved with the market during the period in which its movement was most pronounced, and moved against it in covering in late December. On the whole their actions appear to have followed, rather than resisted, prices. Prices advanced a little during the forepart of January 1932, receded during the latter part and the forepart of February and advanced again to March 5. During this period the short interest increased to the forepart of February and covered after that point. Its changes were for the most part of the price-following type. Beginning in March, prices continued downward until late May; they continued low until early July when a substantial advance to September 3 took place. The short interest during this entire period decreased materially through covering pur chases. Its action on the whole was of the price-resisting type, particularly in the forepart of the period when prices were declining to new low levels. After early September prices moved irregularly downward until the end of February 1933, but the total short positions remained virtually unchanged at slightly less than 2,000,000 shares. During the period of substantial price recovery which continued until the end of August the short position was reduced to less than a million shares. In September and Oc tober, although prices fell, the short position was further reduced by a small amount.
102
On the whole the evidence for this period is insufficient to show whether short selling had a stabilizing or an unstabilizing influence on stock prices. During the two periods of most severe price declinein September 1931 and from March to May 1932the covering operations of the short interest were a stabilizing influence. On the other hand, there is little evidence that short sellers cushion the rise in prices by going short before a decline commences. Instead, their activity has the effect of accelerating the downward swing after it begins. (3 ) In Relation to Individual Issues The observations in respect to the effect of short selling on the prices of individual issues were reached on the basis of a statistical study of the action of 14 representative stocks during the period of May 1931 to October 1933. The rela tion between the size of the short interest and the price fluctu ations of each of these was separately analyzed and charted between May 23,1931 and September 1,1932. The changes in the short interest of each were also compared with the corre sponding net changes in price from day to day in the period of September 19, 1931 to September 17, 1932. These com putations were also made for all 14 weeks together on a weekly basis. The latter study showed, for example, that in the case of the 25 largest position changes, 84 per cent of the short sales were made as the price moved down; but in only 40 per cent of the cases were covering purchases made as the price advanced. For the small position changes, the same general relationship held true for the short sales. But among the purchases, in 22 out of 27 instances covering occurred as the price advanced. That this was due to the fact that the purchases were smaller seems doubtful. It may have been due to the trading characteristic of over-staying the market. It is
CRITIQUE
OF
SECURITY
MARKETS
103
much easier to enter the market and acquire an apparent profit than to leave the market with a real profit.
b. STOCK EXCHANGE REGULATION
The rules of exchanges bearing on short selling are few. For the New York Stock Exchange they include at the pres ent time only three regulations aside from a few minor tech nical provisions relating to loan rates and the inter-broker handling of loans. The first of these three reads as follows:
Purchases or sales of securities or offers to purchase or sell secur ities, made for the purpose of upsetting the equilibrium of the mar ket and bringing about a condition of demoralization in which prices will not fairly reflect market values, are forbidden, and any member who makes or assists in making any such purchases or sales or offers to purchase or sell with knowledge of the purpose thereof, or who, with such knowledge, shall be a party to or assist in carrying out any plan or scheme for the making of such purchases or sales or offers to purchase or sell, shall be deemed to be guilty of an act inconsistent with just and equitable principles of trade. (Art. 17, sec. 4 of the Constitution.)
It will be noted from this rule that it applies equally to long as well as short operations and is obviously designed to prevent artificial methods of trade generally. The penalty for being guilty of an act inconsistent with just and equitable principles of trade is suspension or expulsion. The second regulation of importance in force at the pres ent time is in the form of a circular sent out by the Business Conduct Committee of the New York Stock Exchange on October 5, 1931. It reads as follows: To
M em bers of t h e E x c h a n g e :
The Committee on Business Conduct directs that before executing any selling orders, members shall ascertain and notify their floor brokers whether such orders are for long or short account.
104

Members having out-of-town correspondents are directed to transmit this ruling to their correspondents immediately by wire.
Testifying before the Judiciary Committee of the United States House of Representatives, February 24, 1932, Mr. Richard Whitney, President of the Exchange, stated that when this rule of marking all selling orders was made ef fective "at the same time the members were warned of the penalty they would incur if they participated in short sales which tended to depress the market. Mr. Whitney adds, "This rule had two results. First, it permitted the Governors of the Exchange to find out without delay whether a sale which caused a decline in prices represented short stock or the liquidation of long stock. Second, it caused the members of the Exchange to notify their customers that short stock would not be sold at a lower price than the last preceding transaction. It is difficult to determine how effective this memorandum has been in view of its purpose. It represents little more than a pointed application of the rule just quoted from the Constitution unless applied by members in the more rigid form of refusing all executions except when made at the last preceding sale price. If enforced in this rigid form it would naturally restrict the volume and importance of short sales greatly. The third rule of the New York Stock Exchange is in the form of a circular letter to members dated February 18, 1932 (C-4873). The essential provision of the letter reads as follows:
Resolved, that members of the Exchange shall not, on and after April 1, 1932, lend, either to themselves as brokers or to others, securities held on margin for customers unless they shall have obtained separate authorization in writing permitting the lending of such securities.
The force of this rule is simply to call direct attention
CRITIQUE
OF
SECURITY
MARKETS
105
to margin traders for long account that their stock may be used, if permission is granted, for short selling. To what extent it has reduced the supply of loanable stock is not known, though, as a rule, customers have been willing to grant the right to lend their stock. Within the limits of these three rules customers and members are free to sell short any or all listed stocks provided they can be borrowed.
C. THE EFFECTS OF SHORT SELLING
While no final judgment on the actual effects of short selling can be rendered on the basis of the experience of the past few years and the limited data available, it is pos sible to draw tentative conclusions as to the tendency of short selling. In relation to the general cyclical trend of security prices during the long deflationary period following 1929 short selling in large volume did not appear until after the decline had definitely begun. It appears, therefore, that on this important occasion the short interest did not exercise any appreciable restraint on the great rise in prices just preceding the October break. Since it increased in vol ume after the break it tended to accelerate the general down ward trend of prices during 1930 and 1931. Since the total short interest commenced to decline in the last half of that year and continued to grow smaller throughout 1932 and 1933, the covering operations of short sellers may have cush ioned the decline in its later phases and to some extent accelerated the subsequent recovery. In its relation to the intermediate price movements ex tending over successive periods of a few weeks there ap pears to be more ground for the opinion that short selling may have checked the price rallies at certain points. The cushioning tendency of short covering in these intermediate declines is as evident as it was in the case of the major cyclical decline.
106
Since the movements of the markets as a whole reflect the interplay of many complex factors, it is difficult to estab lish a definite causal relationship between short selling and changes in the general price trend. Moreover, while the tendency of short sales is to add weight to the downward trend and to the minor downward swings in prices, judged by the experience of recent years short selling has not been in sufficient volume to warrant the belief that its actual effect on general price movements is at all material. During the past 4 years the short interest probably did not at any time exceed 15 per cent of the posi tions or sales for long speculative account for all stocks. For most of this period the proportion ranged between 5 and 10 per cent. Insofar as trading of itself is a market factor, therefore, much greater importance is to be attached to the positions and trading on the long side of the market. The observation just made was with reference to all stocks considered as a group. While the total volume of short sales was comparatively small, however, it rose to relatively large amounts in particular issues. The exact size of these individ ual short positions, relative to the total speculative interest in each stock, is not known, however, due to the fact that the long speculative interest for individual stocks is not known. It is with reference to particular issues and par ticular points in time that close supervision over short selling is needed. There is no doubt as to the frequent spectacular effects of short selling when used as a manipulative device in operations in specific securities. Short selling is often an important factor in "bear raiding. This implies the sudden flooding of the market with a large volume of selling orders which depress prices to levels at which many stop loss orders are executed, and which force the liquidation of vulnerable brokers loans and bank loans with vanishing margins. The
CRITIQUE
OF S E C U R I T Y
MARKETS
107
cumulative effect of this activity is a rapid decline to arti ficially low price levels at which the short positions are covered. This phase of speculative trading, so frequent in the long history of Wall Street, is discussed in the following section.
6. M a n i p u l a t i o n
in the
S e c u r it y M a r k e t s
Margin buying and short selling are devices which are used in legitimate trading in a free and uncontrolled market. Under such conditions, since margin trading involves the use of credit, its effect is to increase the volume of specula tion beyond what would be possible without the use of borrowed resources. Margin trading, therefore, when it re sults in excessive speculation, is a factor in preventing the market from properly performing its functions. Moreover, when margin buying results in the pyramiding of purchases based on expanded credit, due in turn to increased market prices, this vicious circle produces a market structure ex tremely vulnerable to price reactions. Buying on margin and selling short do not of themselves involve any manipulation of prices. They may or may not result in prices which are less closely related than they other wise would be to investment values. On the other hand, these methods are among the most effective employed by those who attemptby other methodsto make prices to suit their own interests. Margin trading, therefore, has shared in the general public condemnation of manipulation. The term "manipulation is ordinarily understood to mean the deliberate interference with the free play of supply and de mand in the security markets. Usually this term is associated with pool operations designed to raise or depress prices arti ficially. It is true that not all pool operations are undertaken in order to rig the market for the personal gain of individuals or groups. For example, the formation of the Bond Pool
108
early in 1932 was publicly announced as being designed to support the bond market and prevent its further decline. Although this was a manipulative operation its purpose was generally accepted to be in the public interest. Whether or not this kind of operation is economically justified, it implies no condonation of the more common variety of speculative pool.
a. POOL OPERATIONS
Pool operations have been prominently featured and vig orously condemned. In the popular mind pools are the joint activities of several persons or agencies engaged in buying and selling securities. When the number of persons involved is small the ven ture is usually termed a joint account. As used in Wall Street the term joint account means one in which several persons join to purchase and sell securities. The agreement may or may not be in written form. When, however, the condi tions, relations and responsibilities of the participants be come involved and the number engaged in the enterprise exceeds three persons, generally the agreement is committed to writing and is known as a "syndicate agreement. A syndicate, therefore, may be considered as a more elaborate form of the joint account. Underwriting syndicates are formed for the purpose of purchasing and marketing entire new issues of securities. These syndicates ordinarily support the price of these securi ties until the whole issue has been disposed of by the syndi cate. The term is also used to describe a group which agrees to guarantee the sale at a given price of an issue of stocks or convertible bonds first offered to existing stockholders. The ordinary pool, sometimes also termed a syndicate, is formed for the purpose of acquiring either by purchase in the open market or through options a block of securities
CRITIQUE
OF S E C U R I T Y
MARKETS
109
to be sold or "unloaded later at higher prices. In this type the managers may be authorized not only to purchase securi ties but to trade in them as well. In the event the managers are empowered to buy and sell, the syndicate becomes in essence a trading account, differing little from any other trading account, except in financial resources and in the number of persons involved. It is through this type of syndi cate that pools largely operate. Even though, strictly speaking, one person cannot operate a pool there is little in the way of pool manipulation which a single trader cannot also practiceif his cash or credit resources are large enough. Usually individuals have not sufficient resources and several "pool their interests. In this survey the operations of several notorious pools have been described and analyzed in detail. These are: ( l) the famous Radio pool of March 1929; (2) the pool in the stock of American Commercial Alcohol in the sum mer of 1933; and (3) the Fox Film and Fox Theaters pools which operated in the years 1927-1929 inclusive. In each case the facts have been collected and pieced together re garding the participants and the nature of their participa tions, the actual purchases and sales, the profits and the supplementary activities used by the pool operators to further their success. The material on the Radio and Fox pools was obtained from the records of the hearings of the Senate Committee on Banking and Currency. Information on the Alcohol syndicate was made available to the Fund staff by the New York Stock Exchange through data contained in the report made to its auditors from an examination of the books of the brokerage firms through which the pools ac tivities were carried on. The main features of each of these pools are: (1) The Radio Pool was organized in March 1929 and its major operations covered approximately a week. In this
110
time the participants made a profit of probably as much as $5 million. Their aggregate cash deposits were $12.7 million. This feat was accomplished through total transac tions of about 2,500,000 shares of Radio Corporation of America stock. The beneficiaries included about 70 individ uals and agencies whose individual profits ranged from $5,000 to $290,000. (2) The Alcohol Pool operated in the summer of 1933 from May 3rd to the end of July. With cash deposits of $62,500 and credits of $37,500 the profits were approxi mately $300,000through a 54,900 share trading in the common stock of the American Commercial Alcohol Com pany. In this case there were 8 individuals in the pool. (3) The Fox Pools operated in the stock of the Fox Film Corporation and Fox Theaters Corporation common class A stock. One of these, in which the President of the company and several others participated, showed net profits of $1,937,000 in less than 5 months. In this case the partici pants deposited $4,500,000. These are examples of successful pool operations in which the participants were able to establish prices at which they unloaded stock at a profit.
b. ARTIFICIAL MARKET ACTIVITY
Perhaps the chief method of manipulating prices is to create artificial activity in the market in order to attract a public following eager to take over the pools holdings at higher prices. Members of the New York Stock Exchange are forbidden by its rules knowingly to transact "wash salesi.e., sales of securities by the same interests in which no actual pay ment or delivery is contemplated, or "matched orders in which simultaneous buy and sell orders are given to two different brokers by the same interests. But in the case of
CRITIQUE
OF
SECURITY
MARKETS
111
actual pool operations these prohibitions are circumvented, because it is difficult to trace the origin of buying and selling orders. The pool managers, therefore, were making pur chases and sales, many of which were "wash or "matched sales in essence, for the specific purpose of creating an artificial market for the stock, so that the price level might be lifted to artificial heights. On days when these pool transactions were being carried on the total trading of the pool agencies often represented most of, and sometimes more than, the total sales of stock recorded by the ticker. The latter is possible because privately arranged trades, known as "stopped-stock transactions, are not recorded. That the activities of the pools frequently dominate the market in the stocks in which they operate is obvious. A group or even an individual who is responsible for most of the daily purchases and sales in a particular security can unquestionably exercise a material influence on the mar ket. Especially is this true when the group has large finan cial resourcesas did the Radio pool, with cash deposits of over $12,000,000, which could have been used as a margin.
C. COLLUSION BETW EEN POOLS AND SPECIALISTS
The testimony of members of the New York Stock Ex change given before the Senate Committee on Banking and Currency tends to confirm the common knowledge of "the Street that collusion with specialists has been a method of price manipulation used by pools. This practice is almost impossible to prove, but enough evidence has been cited in the survey to establish a reasonable presumption that it exists. The key position of the specialist in the operation of the market is clearly revealed in a special statistical study of original source material included in this survey. This covers
112
a detailed examination of the actual books of 69 floor mem bers in 151 typical active, semi-active and inactive issues, made available for this purpose by those concerned for four periods of one week each in 1933, representing periods of slow and rapid advances and declines of prices. The records show that about one-half of all the transactions in the New York Stock Exchange go through the specialists hands. While the specialist is prevented by Exchange tra ditions from divulging the orders on his book, he himself has at all times a clear picture of the buying and selling orders which would become effective at various price levels. The specialist acts not only as a broker but also can trade on his own accountexcept that he is forbidden to act as broker and dealer in the same transaction. The specialist is expected to make the market in his stock. To enable him to carry out this duty he is permitted to buy or sell for his own account shares of the stock in which he is the specialist. When he acts as a commission broker he is an agent, but when he buys or sells for his own account he acts as principal. It is through his personal transactions that he may influence market prices. It appears that the influence of the purchases and sales of the specialist will vary because of certain conditions pre vailing at the time. In a dull market a comparatively small number of trades, if made on one side of the market, will probably produce as definite a reaction as a larger number in a more active market. The condition of his book will materially affect the influence of his transactions and alter the number of sales required to produce a specific result. That the specialist, by the very nature of his relationship to the market, is in a position whereby his influence may be readily converted into a price factor of major importance, and may even become the price determinant, is scarcely open to question.
CRITIQUE
OF S E C U R I T Y
MARKETS
113
In the Fox stock pools, the specialist actually participated in one of the syndicates. The firm itself made a profit of $42,000 on the pool activities. In addition the managers of the pool paid $10,000 to the firm of the specialists while the pool was in operation, apparently as a direct payment to the specialist for services rendered. The records included in this survey show that the per sonal trading of specialists for their own account bulks large in the day-to-day operations of the New York Stock Ex change. About 15 per cent of all the transactions are of this nature. While this personal trading of the specialist is justified by defenders of the practice as making a con tinuous market, the facts show that his trading constitutes a larger proportion of total transactions in the active stocks, which would have a continuous market without his personal trading, than in the less active stocks. Furthermore, there is serious doubt as to whether the specialists personal activities exert a stabilizing effect on the market. The records of their trading for their own account do not disclose any pronounced tendency to trade either with or against the trend of the market, but they show that the specialists activities are of the in-and-out variety and that their profits and losses are based largely on price changes within each trading session. Moreover, the evidence included in this survey indicates that the trading of the specialist on his own account invites abuses far greater than the advantages of market efficiency which result from the practice. The rules of the New York Stock Exchange now provide that:
N o member acting as a specialist and no partner of such a mem ber and no firm in which such a member is a general or special partner shall, directly or indirectly, be interested in a pool dealing or trading in the stock in which such a member is a specialist.
This regulation is undoubtedly a step in the right direction
114
and will limit collusion of specialists and pool operators. Obviously it does not, however, close the door to the subtler forms of manipulation and to collusion with large individ ual speculators in rigging the market.
d. THE ABUSE OF OPTIONS AND TRADING BY CORPORATION OFFICIALS
A large proportion of pools operate on the basis of op tions. An option, as the term is here used, is a right to purchase a given amount of stock at a definite price within a stated period of time. The amount, the price and the time limits are subject to wide variation. An option agree ment may sometimes involve an arrangement for calls on blocks of varying size on a sliding scale of prices above or below the current market price. Nearly all options used as the basis for pool operations are granted for the purpose of liquidating large blocks of securities which could not be sold in the ordinary way without seriously depressing the price of the issue. Options are derived from various sources and are granted for various reasons. For example, they may be granted by directors or officers or other large individual stockholders who wish to dispose of their holdings; or by banks holding large blocks of stock as collateral on loans which must be liquidated; or by corporations wishing to distribute treasury stock acquired by purchase in the open market, authorized but unissued securities, or stock received as a result of a merger. Such options may be granted to an individual oper ator or, more usually, to a pool. The operator or the pool manipulates the market so as to force the price up to a point which will permit the sale of the securities at a profit. Such an operation, if successful, is, therefore, to the mutual advantage of the parties to the agreement, but this artificial
CRITIQUE
OF S E C U R I T Y
MARKETS
115
price stimulation usually is followed by a more or less vio lent reaction. A special study of options has been made in connection with this survey. The data were obtained from two sources: (1) information furnished by a dozen member firms of the New York Stock Exchange similar to that given to the Senate Banking and Currency Committee in questionnaires submitted by the Committee, and (2) facts prepared espe cially for this study by the New York Stock Exchange from the weekly reports on options received from its members from August 2 to November 15, 1933. (1) The Origin of Options An analysis of the data made available by the brokerage firms shows that options existed in the stocks of 45 com panies in virtually all of which trading accounts, syndicates or pools were involved. The purposes for which these options were granted can only be surmised. In a number of cases the purpose pre sumably was to enable the company to distribute additional stock. In one case in which the company was the grantor of the option it was also a participant in the pool to the extent of 20 per cent, and its president assumed another 10 per cent. While it is true that in some cases the officers or directors may have been acting for the company in granting the op tions, it would scarcely seem necessary from the standpoint of the company for them to have participated in the pool operations, which they did in several cases. It would appear, therefore, that the officers or directors were engaged in pure price manipulation in order to realize a personal profit rather than to facilitate additional company financing. A different group of options, reported to the New York Stock Exchange for the period from August 2 to November
116
15, 1933, involved the issues of 110 companies. Fifty-two options in amounts of less than 10,000 shares existed in the stocks of 37 separate companies. Options in amounts of more than 10,000 shares were reported in the stock of 73 different companies. Stocks of 809 different companies were listed on the New York Stock Exchange as of December 1, 1933. Existing options were, therefore, reported in the stock of approxi mately 13 per cent of all companies whose shares are listed. As this was a dull period in the market this proportion can hardly be considered as representative. In the case of the 73 companies for whose stock options in excess of 10,000 shares were reported, pool operations were either contemplated or possible. The grantors of the options in these cases were as follows:
Grantor Number of Cases
17 20 17 5 3 10 1 73 The issuing company......................................... Officers or directors of issuing company......... Another company............................................. A bank................................................................ A brokerage firm............................................... An individual (neither an officer nor director of issuing company) .................................. No data available............................................... Total.....................................................
The company itself or one or more of its officers or directors granted the options in over 50 per cent of these 73 cases. The purpose of the companies in granting these options was probably to sell additional stock. Although the need for additional capital on the part of the company may have been justified, the procedure for obtaining this capital raises serious questions. This suggests that the public was not inclined to absorb the additional amount of stock at the price offered and that, therefore, high-pressure meth
CRITIQUE
OF
SECURITY
MARKETS
117
ods had to be used to distribute the securities. Irrespective of the purpose for which the option was granted it is ob vious that the price manipulation made possible thereby may result in serious losses to the public. While it is not necessarily true that all options are secretly given, most of them probably are. Indeed, the success of the selling operation is in some measure at least dependent upon secrecy. The options were granted in 17 cases by companies other than the issuing company. On the basis of the data available it is impossible to determine whether the grantor company was either a holding company or an affiliate of some kind of the company in whose stock the option existed. It is im possible, therefore, to state whether the holding company or affiliate was acting in its own behalf or in behalf of the company itself. If the securities were obtained in the course of business by an outside company either in payment for goods delivered or services rendered, probably the granting of the option was sirhply a method used to convert this payment into cash. (2) The Life of Options The length of time for which options are granted also raises some exceedingly important problems. For example, in 7 of the 17 company-granted options the duration was more than a year. One company had granted an option for 25 years, another for 10 years, a third for 7 years. Two of the other options were for periods "over 5 years, one for 3 or 4 years and the last one for 21^ years. These 7 options were granted to brokerage firms in con nection with original or later financing and, therefore, prob ably derived from promotion arrangements. All are still in effect. With one exception they ranged from 50,000 shares to 500,000 shares. It is clear that all of these options might
118
become the basis for pool activities, although they were prob ably not originally granted for that purpose. Moreover, the prices at which these options can be exercised are probably considerably above existing levels. (3) Conclusions On the basis of all data available to us, option pools seem vastly to outnumber all other types. Secondly, it ap pears that officers and directors of corporations not only grant options which become the basis for pool operations, but also participate in the profits of such operations. More over, it appears that the instances where such operations are a matter of company financing are few. In most cases the officers or directors participate for personal rather than company reasons. Since the New York Stock Exchange promulgated its rul ing requiring weekly reports by member firms there has been a decided tendency to grant options to non-members. For instance, a bank may desire to grant an option in order to liquidate a loan it has made, but, not wishing to have that fact known, it may grant the option to an individual not connected with a brokerage house having a member on the New York Stock Exchange. By so doing it makes it more difficult for the Exchange to exert effective control or influ ence over any pool operation based on such an option.
e. PUBLICITY IN MARKET MANIPULATION
One of the most potent means of market manipulation has been shown to be inspired publicity used by manipu lators to increase security prices in order to enhance the profits of their own operations. The records show that dur ing the bull market, newspaper articles and radio speeches, which "touted particular issues, were usually followed by an increase of buying orders and higher prices.
CRITIQUE
OF S E C U R I T Y
MARKETS
119
A study has been included in this survey of the relation of publicity to the operations of the Radio pool, which began active trading on March 12, 1929. Beginning about March 1, the public was bombarded through the press with a bar rage of publicity which certainly could have had no other result than to arouse enthusiasm over the future possibilities of the company and whet the public appetite for the stock. An analysis of the comments by financial and other special writers, appearing in the daily press, presents a picture of a ballyhoo of almost unprecedented proportions. Not a sin gle day went by from March 1st to March 20th, inclusive, when leading and optimistic statements about radio possi bilities did not appear in one or more of the daily news papers of New York City. ( l) Correlation of News with Pool Operations A comparison of material appearing in the financial col umns of leading New York newspapers on the days immedi ately preceding and during the operations of the Radio pool shows a remarkable relation between news calculated to arouse public enthusiasm and the activities of the pool. Of special interest were the comments in a column of the New York Daily News under the anonymous authorship of "Trader. These show that the day-to-day trading advice given to readers of this newspaper corresponded with the obvious interests of the pool. In this instance no direct evidence exists that the pool managers or anyone acting with or for them actually bought and paid for any of the pub licity that either this stock or the corporation and its affairs received at that time. The operations of the Radio pool took place shortly after publication of the annual report of the Radio Corporation of Americaa report which revealed very substantial earn ings and also a continuation of the companys rapid growth,
120
not only in earnings but in size and importance. The Cor poration was quite young. It operated in a field new to human knowledge and about which the human imagination therefore had relatively free play. It had recently announced its decision to "split up its shares. Rumors that a merger with other communications enter prises was being considered, apparently had just enough foundation to give reporters and other financial writers some excuse for keeping the subject ever fresh in the mind of an excited public. As has already been demonstrated, the pool itself, by artificially enlarging the volume of trading, had succeeded in placing Radio stock very much in the spot light before the eyes of customers men and board room habitues. The reporter who in these circumstances spent his day in the financial community of New York City and did not have something excited and exciting to say to his readers about Radio would be rare indeed. These conditions and events may well have made it quite unnecessary, in this case, for the pool managers to take the trouble or incur the expense of any systematic program of "publicity to help their cause. (2) Subsidized "Column Writers In other instances, however, specific proof exists of actual payments to newspaper and publicity men to "tout issues in the interest of manipulationa practice which has un doubtedly been far more common than the relatively few cases which have been exposed to the public gaze. For ex ample, the financial columnist of the News, who was so use ful to the Radio pool, is known to have received over $19,000 between May 3,1929 and March 1, 1930, for boosting other stocks in which he himself was interestedall of which, of course, was unknown at the time. Testimony before the
CRITIQUE
OF S E C U R I T Y
MARKETS
121
Senate Banking Committee revealed the fact that a guaran teed account for the News columnist was carried in a brok erage firm and that profitable transactions were made for him in the stocks which he was touting at the time. The guarantor of the account and his associates were shown to have made profits of over $1,000,000 in these operations. The operations described raise a question as to the au thenticity of much of the publicity appearing in the daily press at the time. How much of the ballyhoo of the time was paid for secretly is difficult to determine. That activities similar to those of "Trader and his "benefactor were not uncommon is shown by the testimony before the Senate Banking Committee in which it was frankly admitted that payments had been made to newspaper writers in the form of options or cash for publicity appearing in their papers. (3) Organized Publicity for Profit An example of the use of organized publicity methods by pool operators was revealed by the testimony, of Mr. David M. Lion, before the Senate Banking Committee. Mr. Lion was retained by various pools to tout their stocks. The usual arrangement involved the granting to Mr. Lion of options in the issues to be touted, thus giving him a direct interest in the price increases which resulted. His activities were extensive. For example, at one time he had over 30 operations under way for which he was furnishing publicity. The purchase price of the stock for which options or calls were given him approximated $6 million during the period of the bull market. His own net profits were estimated by him under oath at half a million dollars. Approximately 250 accounts were handled by him at various times. The calls or options from which he de rived his profits came from individual operators, pool man agers, brokerage houses and even from company officials.
122
In retrospect it seems to have been the general practice, rather than the exception, for brokerage houses to grant these calls or options. A list of the brokerage houses in volved reads almost like the directory of the New York Stock Exchange. It was generally known on the Street that Mr. Lion would furnish publicity either for cash or a call. Obviously he was quite generally employed. Mr. Lion described his own operations as follows, in an swer to questions by Mr. Gray, counsel to the Senate Com mittee:
M r . G r a y : What is your business? M r . L i o n : Financial publicity. S e n a t o r C o u z e n s : H ow did you g o about g iv in g publicity? M r . L i o n : Well, I would canvass the various pool operators to get
work for them.

M r . L i o n : And if I could get an option or a call on some stock I
would use my publication, and I would use the radio, and I would use newspapers, printing facts that were taken out of various financial manuals. S e n a t o r C o u z e n s : Did you pay for this radio and newspaper publicity?
M r . L i o n : Y es. M r . G r a y : In other words, what you did, for the purpose of aid
ing the value of the stock in which you had your call, it being to the interest of both yourself and the pool operator or specialist or trader, or whoever he may have been, that the stock should go up, and your articles were always published for the purpose of inter esting the public in that stock, convincing them, if possible, that it was a stock that had a future and would rise in value.
M r . L i o n : T hat is correct.
Mr. Lion was responsible for the familiar voice of Wil liam J. McMahon, the "economist who used to give radio talks every week on securities under the auspices of the "New York Financial Research Bureau.
CRITIQUE
OF
SECURITY
MARKETS
123
M r . G r a y : When he ended up his talk as a usual thing he referred
to a particular stock and boosted it. That is true, isnt it?

M r . L i o n : Y es, sir. M r . G r a y : And he was a salaried man on your staff for that pur
pose, wasnt he? M r . L i o n : Yes, sir.

M r . G r a y : H ow m uch did you pay him? M r . L i o n : I paid him as h ig h as $250 a w eek.
The prevailing practice of employing secretly financial writers and radio speakers to induce the public to purchase securities which the pool wished to distribute is open to the severest condemnation. It meant usually that profits were obtained by the grossest kind of fraud and misrepresenta tion. The evidence indicates that these practices were en gaged in by many of the brokerage houses of the Street during the years 1928 and 1929. Obviously a large number of purchases were made by the outside public as a result of this paid publicity. Those purchases added to the volume of trading and thereby increased the speculative mania which was sweeping the country. The prevalence of these practices at the present time is impossible to estimate. An attempt has been made, however, in the Securities Act to limit subsidized publicity. Section 17 of the Act provides:
(a) It shall be unlawful for any person in the sale of any secur ities by the use of any means or instruments of transporta tion or communication in interstate commerce or by the use of the mails, directly or indirectly (1) To employ any device, scheme, or artifice to defraud, or (2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
124

(3) to engage in any transactions, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
(b) It shall be unlawful for any person, by the use of any means or instruments of transportation or communication in inter state commerce or by the use of the mail, to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communica tion which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received, directly or indirectly, from an issuer, under writer, or dealer, without fully disclosing the receipt, whether past or prospective, or such consideration and the amount thereof.
. THE USE OF CUSTOMERS M EN
While no concrete illustrations are available to present in this study showing definite payments made by pool man agers to individual customers men, yet oral evidence, given in confidence to the authors during the course of this study, indicates that the practice of paying customers men for "tip ping the stock which the pool wished to distribute has been general. In fact, it is generally understood that a more or less recognized rate of payment had been established by which customers men received an option on one share of stock for each three shares which they were able to persuade their clients to purchase. Obviously, the acceptance of such payment in the form of an option on a block of stock im mediately minimizes the possibility of unbiased advice from a customers man, in regard to a stock in which he has an interest. In an attempt to prevent misrepresentation by customers men the New York Stock Exchange adopted on June 28, 1933, the following regulation:
N o member of the Exchange or firm registered thereon or partner thereof shall take or carry a speculative account or make a specula-
CRITIQUE
OF
SECURITY
MARKETS
125
d v e transaction in w hich any person em ployed by such m em ber or firm, as a security salesm an or as a "customers m an, is directly or indirectly interested. g . THE BANKS AND M ANIPULATION
Evidence was presented before the Senate Committee in dicating that a number of leading banks and their executives actively aided pool operations by the extension of credit in large amounts. It is impossible to determine, however, the extent to which credit facilities were used for this pur pose. This would require an exhaustive survey of all or substantially all pool operations and the credit relationship of the various participants to the banks. It would also in volve a check of loans made by brokers to this same group of participants in the various syndicates. Obviously no such survey has been possible because it would require an almost unlimited use of the subpoena. There is no reason to believe, however, that pool man agers did not avail themselves of credit in the same manner and to the same extent as the mass of our people who used the billions of dollars poured into the stock market during the bull market. Testimony presented before the Senate Committee on Banking and Currency indicates that the ex ecutives of some of the largest banks were engaged during the boom days of 1928 and 1929 in manipulative activities in cooperation with poolswere in fact using the banks funds to "play the market. Furthermore, the evidence pre sented before the Senate Committee indicates that when losses occurred in these unsecured loans, in at least one conspicuous case, the losses were written off by the bank involved. While no concrete evidence has been presented in this survey its authors have reason to believe that pool operators have forced the liquidation of collateral bank loans in their
126
operations. It has been reported that syndicate managers are often secretly advised of the amount of stock they are manip ulating which is held as collateral for outstanding loans and the number of points which the market must move to cause the liquidation of the loans. The pool managers then attempt to force the market price level down the requisite number of points thereby causing a large block of stock to be thrown on the market, thus further reducing the price and aiding the pool managers to accumulate at materially lower levels. This practice has been denied by responsible bank officials. No doubt any executive of any of our leading banks would immediately discharge any employee guilty of furnishing such information to a pool manager, but it is difficult to see how this practice would become known.
Chapter VII
INFORMATION AND ADVISORY SERVICES HE widespread ownership of stocks and bonds in America and the tremendous public interest in the se curity markets have led to the development of a vast and intricate system for supplying information and advice to the investor and speculator. An understanding of how these ad visory and informational agencies function is of special im portance in any survey of the security markets. For the proper evaluation of securities a knowledge of the economic and financial condition of the companies whose securities are traded in is essential. It is also of great im portance that sufficient information about the purchase and sales of securities be available for traders to be able to ap praise the "technical condition of the market. For the main tenance of marketability the maximum information is the most important requirement. For the proper distribution of savings in new securities data about the companies issuing them is the first essential. Information about economic con ditions in the industries concerned, and business conditions as a whole, are of secondary, but none the less essential, importance. The services for informing and advising investors and speculators perform three chief functions: ( l) they give technical information about the activity of the markets, i.e., the number and volume of transactions, the prices at which transactions are made, quotations on unlisted securities and other facts about the trading processes; (2) they supply
127
128
data about individual securities and the earnings, assets, div idends and financial condition of the companies which issue them; and (3) they furnish information on general business conditions and on the economic and political factors affect ing corporate earnings and security prices. Some agencies are exclusively concerned with one or the other of these functions, others with all three. The principal services or agencies providing investors and speculators with information and advice are:
1. The stock and bond tickers, adjuncts of the organized ex changes, which furnish continual information on prices and volume of sales. 2. Official reports of corporations whose securities are bought and sold on the markets. 3. Financial manuals which bring together in annual volumes the official reports of, and other pertinent information regarding, all important corporations in the United States. 4. Advisory and forecasting services which furnish information, interpretation and advice about individual corporations and security issues and general business conditions in the form of periodic mar ket letters and bulletins. 5. Investment counsel firms which furnish investment advice to clients. 6. Brokerage firms which furnish their customers with advice and information. 7. The general and financial press, including the news ticker.
1. T h e St o c k
and
B o n d T ic k e r s
The ticker and the ticker tape have become symbolic of Wall Street and the Exchange. There is nothing else in the world that approaches the American ticker as an instrument for almost instantaneous dissemination of information re garding stock exchange trading. It is the pulse of the mar ket, indicating its strength or its weakness throughout the land. The word ticker usually refers to the stock ticker re
I N F O R M A T I O N A D V I S O R Y SERVICES
129
cording the stock transactions on the New York Stock Ex change. This is by far the most important and until 1919 was the only one. Now, however, there is a separate bond ticker for the New York Stock Exchange. In 1932 there were, in 330 cities of the United States, 5,184 of these Stock Exchange tickers. In addition there are now throughout the country 1,058 Curb tickers reporting stock and bond transac tions on the New York Curb. The ticker is an electrical mechanism by which reports of sales on the floor of the Exchange and other information are printed on an unrolling tape. The quotations on the tape are obtained by reporters stationed all over the floor and recorded on several sending machines, cleverly coordinated so that all these records are printed on one tape, and thence transmitted to the receiving machines. The sending machines in the New York Stock Exchange and the recording tickers in Manhattan below Chambers Street are operated by the New York Quotation Company which is owned by the New York Stock Exchange. All other tickers are operated by the Western Union Telegraph Company which takes the quo tations from the New York Quotation Companys ticker and transmits them over its own system. By means of this service investors and speculators all over the country receive security prices almost simultaneously. Trading can thus be handled just as readily and on the basis of the same information in San Francisco as in New York. The ticker, of course, is invaluable to investors and speculators and is exceedingly useful to banks and financial institutions in checking the collateral value of securities and the adequacy of margins. There is no doubt, however, that the ticker and the translux machines, presenting an illum inated "moving picture of the tape, have contributed a great deal to the development of a stock-market-conscious public congregating in brokerage offices the country over.
130
In view of the proclivity of the typical outside speculator to "take a flyer when the price of stocks is advancing rap idly before his eyes, it is apparent that the stock ticker is much more than a useful means of communication. At times of great public interest in the market the ticker serves as a peculiarly effective form of high pressure advertising stirring speculative fervor with the lure of easy profits. In addition to price quotations the ticker is used to send official notices, dates when certain stocks will be selling exdividend, announcements of new listings with their symbols, of lost and found securities, and of emergency measures (such as were necessary in 1929). It also serves as an alarm clock giving warning just before the close of "delivery time each day. After trading is closed the final bids and offers and the days high and low prices are run off.
2. O f f ic ia l R e p o r t s
of
C o r p o r a t io n s
Except for railroads and operating utilities, corporations in the United States are under no statutory obligations, either Federal or State, to publish periodic financial and operating reports. The only exception to this rule appears to be Massachusetts, where the filing of annual balance sheets is required. By the terms of the Federal Securities Act of 1933, however, every corporation seeking to promote the sale of a new issue of securities through interstate com munications must divulge a wide range of information in its registration statement and in its prospectus, not only about the issue itself, but also about the issuing concern. This law is of such great importance, not only in the field which it covers, but also as a precedent for future legislation of broader scope, that a clear conception of its provisions and effect is a first essential to an understanding of the status of corporate reporting.
131
a.
N EW ISSUESTHE SECURITIES ACT
Under the terms of the Securities Act a "registration statement must be filed with the Federal Trade Commission twenty days before the marketing of any new issue. If the information is insufficient or unsatisfactory the Committee can issue a "stop order suspending the registration. This statement must include, among a list of requirements, the following information, if available:
1. The balance sheet of the issuing company for two years. 2. Earnings statements for three years. 3. Rules of depreciation and depletion. 4. List of persons holding ten per cent of the outstanding stock. 5. Stockholdings of officers, directors, underwriters, etc. 6. Statement of the specific purpose of the issue. 7. Price to the public and to underwriters. 8. List of persons to whom the securities are offered at prices varying from the public price. 9. Commissions and discounts of underwriting. 10. Number of shares covered by options, their terms and names and addresses of all persons allotted more than ten per cent of such options. 11. Terms, vendors and commissions in any contracts in excess of $2,500 not in the ordinary course of doing business, together with the interests in such contracts of the directors or underwriters. 12. Salaries of officers in excess of $25,000.
Fully as important as the data required from issuing cor porations are the penalties provided in the Act. In cases of untrue statements or the omission of material facts in the registration statement the purchaser can maintain a suit at law or equity to recover damages against (1) the issuing company; (2) its principal executive officers and a majority of the directors, all of whom are liable; (3) all accountants and other experts for parts of the statement certified by them; (4) each underwriter. The directors, however, avoid
132
liability if they had reason to and did believe the facts fully and truly stated. The right to sue does not die with the first purchaser but goes with the security to those who subse quently acquire it. Since the Act became effective there has been a dearth of new issues which critics claim has been due to the strin gency of its provisions and particularly to the liability fea tures. As a matter of fact, however, the flood of new financing had already subsided to extremely low levels be fore the Act became effective. The Act will undoubtedly have two major effects upon corporate reporting: ( l) it will prevent many evil prac tices involving fraud and misrepresentation which used to flourish and (2) it will for the first time in American history ensure the publication of reasonably satisfactory informa tion about new securities and the financial condition of the issuing corporations at the time of flotation.
b. N EW ISSUES LISTING REQUIREMENTS
Another important source of information about new is sues, additional amounts of existing securities, and about companies concerned results from the listing requirements of the New York Stock Exchange. The Exchange deserves great credit for the influence it has exerted on corporate accounting and reporting standards through its requirements for listing. The scope and type of this information available for corporations whose issues are listed on the New York Stock Exchange may be classified under two heads: 1. General information relative to the history, conditions and operations of the applying corporations. In this class, data include full information as to the history of the cor poration; of predecessor companies or firms with location and stock issues; conditions leading to new organizations; date and duration of charter; business and special rights or
133
privileges under the charter or by-laws; tabulated list of constituent, subsidiary, owned or controlled companies show ing dates of organization, where incorporated, duration of charter, business, capital stock issues, par value and amount authorized, issued, and owned by the parent company. Full description of the property of the company must also be filed with the Exchange, where it is open to general inspection. Acreage, location, nature, and whether owned, controlled or leased; equipment and character of buildings; list of franchises and full description; timber, fuel or mining rights and water rights; and similar information as to all constituent, subsidiary owned or controlled companies, are all included. 2. Special information concerning the securities to be listed. Schedules concerning the securities themselves reveal the amount of stock authorized, issued, and proposed for listing by different classes; the amounts unissued and options or restrictions on them; full particulars as to preferred stock; purpose of the issue of stock giving amounts issued for securities, contracts, property, and additional property to be acquired; actual use made of the funds obtained from the issue with full description of all securities, property, rights so acquired; par value and dividend rate; voting power of evidences of debt; increases of securities and the authority therefor. It should be remembered that the Stock Exchange listing requirements, as well as the disclosures provided by the Se curities Act, do not involve periodic reports. The required information is supplied only at the time of the new issue. Also not all of the companies whose securities are now listed on the Exchange have made the disclosures now re quired because their issues were listed before the require ments as they exist today were adopted. Furthermore, only a small proportion of the total number of issues traded in
134
are listed on the New York Stock Exchange. Hence the corporate area covered by adequate reports is still relatively small.
C. PERIODIC CORPORATION REPORTS
Most American corporations whose securities are widely held by the public publish balance sheets and income state ments at least once a year. Most of the more important corporations with issues traded in on the New York Stock Exchange publish annual reports in considerable detail, as well as quarterly income statements and statements of cur rent assets and current liabilities. Annual reports are usually accompanied by a statement of an officer of the company interpreting the figures and commenting in a general way on the companys position and future outlook. Taking a broad look at corporation reports in general, the following facts stand out. 1. The publication of these statements is purely voluntary except for the companies covered by the Interstate Com merce Act and by the public utility laws of the States; while in Great Britain all corporations are required by the Com panies Act to keep and make public proper accounts. 2. Only a small proportion of the total number of cor porations publish annual income statements and balance sheets. 3. The reports which are published by American corpora tions show no uniformity or adherence to common stand ards such as prescribed, at least in part, by the laws of Great Britain and Germany. Even the public utility laws of the States do not prescribe uniform reporting standards. 4. As a result of the lack of reporting requirements and standards of accounting in the United States corporation re ports vary widely in content. For example, according to a study made by Laurence H.
135
Sloan, Vice President of Standard Statistics Company, such essentially important figures as those of gross income were not reported in 1927 by 57 per cent of the 545 leading industrial corporations. There is little evidence that this pro portion has increased appreciably since that year. Again a substantial number of important companies do not segre gate operating from other kinds of income. The amount of earned surpluswhich represents the dividend paying power of a companyis often not distinguished from capi tal surplus. Methods of charging depreciation and depletion are not adequately described in most cases. Many concerns do not disclose the nature and method of evaluating inven toriesan essentially important part of assets. Very few corporations give detailed statistics as to the nature of their security investments. 5. American corporations also vary widely in the fre quency of their reports, apart from public utilities which are required by law to publish at least operating figures monthly. Relatively few of the other corporations report oftener than once a year. For example, out of 1,157 companies with stock issues listed on the New York Stock Exchange in November 1933 and these obviously included a large proportion of the leading American concernsas many as 315 published state ments only once a year. 6. The promptness of American companies in making re ports also shows a wide variation. Most of the reports are published within three months after the close of the fiscal year; but the period ranges from two weeks to five months and sometimes longer. 7. The income statements and balance sheets of compan ies which do report may mean anything, or nothing, or be actually misleading, depending on the adequacy of the system of accounting employed and on the competency and honesty
136
of those who keep the records from which the reports are drawn. 8. There is no law, as in Great Britain, which compels companies to submit their accounts to independent, outside audits. 9. The New York Stock Exchange and the American In stitute of Accountants have in cooperation made notable effortsamong the companies whose securities are listed on the Exchangeto raise the standards of corporate reporting as to scope, frequency and underlying accounting practices. Apparently in spite of the improvements resulting from the Securities Act and the more stringent listing requirements of the New York Stock Exchange, the corporate reports available to the multitude of American investors leave much to be desired. (1) The Essentials of Proper Reporting The wide distribution of security ownership in this coun try imposes upon the managers of corporations whose securi ties are publicly held a duty to disclose the operations and general condition of their enterprises as far as feasible and with scrupulous honesty. In spite of this obvious responsi bility those in active control of American corporations have on the whole signally failed to meet their obligations vol untarily. The minimum essentials of adequate reports are briefly:
1. Completeness all the facts essential to the formation of an intelligent judgment of investment values. 2. Frequencyquarterly periods would seem to be the maximum intervals for reports. 3. Promptnessthe figures should be available within a few weeks after the end of each period. 4. Comparabilityuniform methods of accounting and report ing from year to year are essential. 5. Independent auditingthe figures should be checked and vouched for by experts independent of the management.
137
The New York Stock Exchange deserves great credit for the influence it has exerted through its listing requirements on adequate corporate reporting. It should be clearly under stood, however, that the area of American corporate activi ties covered by these efforts is relatively small, including only those companies which have been admitted to list ing since all the requirements have been enforced. Until these requirements have been made into the actual practice of every American concern whose securities enter the mar ket, corporation reporting will be essentially inadequate to the proper functioning of the market.
3. F i n a n c i a l M a n u a l s
Financial manuals are the investors source-books of in formation on the financial condition of important corpora tions and on corporate and governmental bond issues of all kinds. These manuals are virtually indispensable to the in vestor. They bring together in one convenient place all avail able information about any company or issue which the in vestor himself would be unable to obtain without the expense and delay involved in communicating directly with the corporation, the trustees of mortgages, the State of in corporation, the New York Stock Exchange, and possibly other sources of information. This service is provided prima rily by Moodys Publishing Company, the Standard Statistics Company, the Fitch Publishing Company, Poors Publishing Company and the Commercial and Financial Chronicle. An idea of the scope and comprehensiveness of these man uals can be obtained from the following facts concerning the five annual volumes published by Moodys. One volume each is devoted to data on industrial corporations, governmental units, banks and financial institutions, utilities, and railroads. In the aggregate the 15,000 pages of these volumes cover tens of thousands of security issuesa far larger number
138
of course than are listed on organized exchangesrepre senting nearly 17,000 corporations and companies and more than 11,000 governmental units. The space devoted to the various corporate or governmental units varies not only with their importance, but with the amount of information made available by the various organizations issuing securities. The information regarding American Telephone and Telegraph Company and its subsidiaries covers 59 pages, that of the Union Pacific, 35 pages; General Motors, 9 pages and United States Steel, 7 pages. Three hundred and seventy pages are devoted to the issues of the British Empire and Dominions, 76 pages to the United States Government, 150 pages to the New York State issues. It must be remembered that the value of these manuals is limted by the imperfect standards of corporate reporting practice. Supplementary to these annual volumes the publishers is sue periodical sheets or bulletins which keep the informa tion up to date. There are also supplementary publications devoted to the compilation of the more important statistical data designed to show the course of general business. These manuals, with their supplements, print practically all official information available concerning all the more important companies. Of course, long complex documents are ab stracted and the older historic events in the corporations career are summarized appropriately. The manuals them selves include for all important corporations:
1. A history of the enterprise, with substantial detail concern ing its affairs during the past year or two. Usually including sum mary of charter provisions. 2. A list of subsidiaries, if any, which are described in more or less detail following the account of the corporation itself. 3. Territory served, in the case of utilities and railroad com panies, the data furnishing fairly extensive descriptions of the nature of the areas or centers served, together with the more important customers of the company, where appropriate.
139
4. Tangible property. Particularly with the industrial enterprises. Location, description and products of plants. In the case of utilities and railroads miles of lineage, capacity of power plants, etc. 5. Franchises, trackage rights, and the like in the case of utilities and railroad companies. 6. Operating statistics, so far as they are available. 7. Financial statistics, so far as they are available, including, of course, full balance sheets and income accounts of the company itself and, where appropriate, of the consolidated enterprise. Important unconsolidated subsidiary balance sheets and income accounts when available. Comparative figures for a number of previous years are included. 8. Security issues. Full description of each issue of stock out standing, and each class of funded obligation. 9. Dividend and price record of stock. 10. Description of depreciation policy, so far as company makes such information available. 11. Location and address of transfer agents. 12. List of officers and directors.
Correspondingly, detailed information is presented con cerning borrowing political units, such as national govern ments, foreign and domestic, states, municipalities, and counties.
a. SECURITY RATINGS
Another feature of the financial manuals deserving atten tion is the rating of securities. Several publishers undertake to rate stocks as well as bonds, but the work has real im portance only in bonds. The bond ratings of the better or ganizations undertaking this type of service are of great value to investors. In general, the effort by all of the rating agencies is to classify bonds into a number of grades according to the raters judgment of their investment worth. The rating sys tem now used by Moody, which aims to grade securities according to investment worth, is explained as follows:
140
Rating Characteristics of Issue AaaMeet the highest tests in asset value, earning power and stability. Aa Rank well into the high-grade. A Entirely sound obligations of representative companies, but lacking the higher degree of protection obtainable in bonds of Aaa and Aa grades. BaaGenerally make a good showing in the tests, but warrant more discrimination. Ba Always have some characteristics of uncertainty. B Always characterized by speculative features. CaaUsually have a decidedly poor statistical standing and fall short of all tests such as asset value, earning power and stability. Ca Shows marked weakness of one kind or another. C Not to be classed as investments at all.
It is obvious that there cannot be any finality in the rating of a security. The ratings as published ought to be accepted as the carefully derived judgment of organizations whose business it is to collect, compile, digest and study all avail able information about corporations and their securities. They are of genuine service when employed with full rec ognition of their necessary limitations. The ratings cannot be interpreted as advice to buy any given security because market prices are not taken into consideration in such rating. The service offered by these companies is not open to serious criticism in respect to formal accuracy. Naturally statistical and other errors creep in at times, as is almost inevitable in any undertaking where such large masses of detailed information are presented in condensed form. But the standard of accuracy is unquestionably high. Perhaps somewhat more measured praise is their due in certain other respects. It seems reasonable to believe that the manuals and accompanying publications here under consideration could call their readers attention to the defects and pitfalls
141
of corporation reports as they regularly appear in this coun try. At times they undoubtedly do what they can in protect ing the public from the consequences of faulty corporation reports, as witness the numerous footnotes appearing in con nection with financial statements calling attention to sundry facts which the reports of the reporting corporation itself have left to the imagination of their stockholders and the public. Yet this is by no means always the case.
4. A dvisory a n d F orecasting S ervices
The main purpose of advisory and forecasting services is to offer advice to investors and speculators. They differ from the investment counsel in that their suggestions are not spe cifically framed to suit the special needs of any particular investor, but rather concern themselves with predictions as to the course of the markets, appraisals of individual securi ties and groups of securities, and general advice to traders. These services range all the way from advice apparently as carefully and as conservatively prepared as that afforded by the better investment counsel firms, to speculative "tipster sheets. Advisory and forecasting services constitute an important part of the activity of the manual publishers. Many of the investment counsel organizations also publish them. Several of the so-called financial magazines such as the Magazine of W all Street and. the Financial World, de vote the larger part of their space to this type of service. In addition there is a very substantial number of them inde pendently published, several outside of New York. These include several well-known "tipster sheets, several "chart ists and others undertaking to guide those who play the market. At the very outset it must be frankly asserted that in "tipster sheets simple fraud is predominant. One rung above the tipster sheet are those services that specialize in suggesting to their readers how they can, presumably, make
142
money playing the market from day to day, or from week to week. These publications are analogous to the columns printed in some of the sports sections offering advice to those desiring to bet on horse races. The only honest advice that can be given to the individual with savings in small or moderate amounts to conserve is to avoid these tipster sheets as if they were the plague. This leaves the more responsible agencies to be consid ered. There have been two careful, scholarly studies of the effectiveness of these services. One is "An Appraisal of American Business Forecasts, by Professor Garfield V. Cox, of the University of Chicago. The organizations studied were Babson, Brookmire, Moody, Standard Statistics, the Har vard Committee on Economic Research, and the National City Bank of New York. In interpreting his findings, Pro fessor Cox says: "The results obviously do not justify one in placing implicit faith in any given forecast of any service, but they do support the expectation that the services will be right considerably oftener than they will be wrong. The study covered the period from January 1921, to December 1929, and rated or "scored each of the organizations in respect to the definiteness, correctness and adequacy. The scores varied substantially among the six organizations stud ied, the scores for correctness of forecast ranging from 69 per cent to 83 per cent, and averaging 75 per cent. The other study, that of Alfred Cowles, 3rd, is published in Econometrica, Volume 1, No. 3, July 1933. This study is devoted to forecasts of security prices. Sixteen services making regular recommendations concerning individual common stocks for investment were studied. The market forecasts of William Peter Hamilton, then editor of the W all Street Journal, concerning prospective general move ments in prices were carefully analyzed. Twenty-four gen eral financial publications engaged in market forecasting
143
were similarly subjected to detailed statistical study and ap praisal. Mr. Cowles conclusions are as follows:
1. Sixteen financial services, in making some 7,500 recom mendations of individual common stocks for investment during the period from January 1, 1928, to July 1, 1932, compiled an aver age record that was worse than that of the average common stock by 1.43 per cent annually. Statistical tests of the best individual records failed to demonstrate that they exhibited skill, and indi cated that they more probably were results of chance. 2. William Peter Hamilton, editor of the W all Street Journal, publishing forecasts of the stock market based on the Dow Theory over a period of 26 years, from 1904 to 1929, inclusive, achieved a result better than what would ordinarily be regarded as a normal investment return, but poorer than the result of a continuous out right investment in representative common stocks for this period. On 90 occasions he announced changes in the outlook for the market. 45 of these predictions were successful and 45 unsuccessful. 3. Twenty-four financial publications engaged in forecasting the stock market during the 4 y2 years from January 1, 1928, to June 1, 1932, failed as a group by 4 per cent per annum to achieve a result as good as the average of purely random performances. A review of the various statistical tests, applied to the records for this period, of these 24 forecasters, indicates that the most success ful records are little, if any, better than what might be expected to result from pure chance. There is some evidence, on the other hand, to indicate that the least successful records are worse than what could reasonably be attributed to chance.
This is by far the most exhaustive as well as the most careful study of the success of professional stock market forecasting discovered in the course of this investigation. It is indeed about the only careful, comprehensive investigation into that inherently rather difficult subject. It is apparent that the conclusions reached in this study are less favorable to market forecasters than were those of Professor Cox to prophets of changes in business conditions. Clearly no "service can be purchased which will enable
144
a subscriber to make consistent profit trading in the securi ties markets. That advisory services of substantial useful ness to the uninformed investor exist is certainly not yet demonstrated. It is safe to say the majority of such services today much more often hurt than help both the investor and the speculator using them. Numerous "sheets calling them selves advisory services are designed to mislead and make financial victims of subscribers. These, of course, are all facts well known to the seasoned trader, but the continu ance of the vast number of such "services bears depressing witness to the persistence of the popular belief in Santa Claus.
5. I n v e s t m e n t C o u n s e l
Another and an exclusively American medium for advis ing the investor and speculator is the investment counsel or counsellor. The investment counsel is an individual or an organization, or sometimes a department of a brokerage house, bank or other institution, which undertakes for a fee to advise upon or supervise the investment of funds of clients and occasionally actually to manage investment accounts. This profession, which first developed in this country during the post-war decade, came as an offshoot from investment banking, which had been greatly stimu lated by War loans, so that the earliest recruits to this field were investment bankers. Since the stock market break in the fall of 1929 the volume of business handled by in vestment counsel has rapidly grown. The number and types of clients have increased, while the number of those entering the business is increasing still more rapidly. The investment counsel is virtually unknown in Europe. Because of the extensive systems of branch banks selling securities and furnishing investment advice to customers, such institutions have not developed there. In this country
145
security ownership is more widespread than in Europe; con sequently there are large numbers of individuals and insti tutions of relatively small means with invested funds to manage. The rank and file of the people here are security minded, and the experiences of the past few years have caused widespread loss of faith in the security salesmen of the larger financial houses in the larger centers, particularly in New York. Increasing numbers of the smaller unit banks throughout the country for the same reasons are becoming clients of investment counsel. Virtually no statistics are available covering the number of investment counsels, the size of their business, the nature of their holdings or the record of their accomplishment. Well informed estimates or guesses place the sum handled by three or four of the largest companies combined at up ward of a billion dollars, while all investment counsels, which are now believed to number about 3,000 for the coun try as a whole, as compared with about 20 in 1928, are said to handle "several billions. The largest portion of this sum is handled or supervised by a small number of firms, prob ably not more than ten. The sum under each firm in this group, it is estimated by leaders in the field, ranges between 75 and 400 million dollars. A new type of investment counsel, recruited from the brokers, bond salesmen, statisticians, market letter writers whose means of livelihood have been destroyed by the de pression, has recently been entering this field and offers an individual supervisory and management service on accounts much smaller than those which the large investment coun sels are willing to handle. There are also many persons, often wholly unequipped by experience or training for such tasks, who inveigle gullible owners of funds to pay for their advice or to place accounts in their charge. Sometimes they are hardly to be classified as other than tipsters, and
146
they not infrequently conduct speculative operations with clients funds for a percentage of the profits without liability for losses.
a. RATES AND FEES
The rates and fees charged by orthodox investment coun sels vary widely. There is usually a minimum fee ranging from $300 to $1000 for accounts of smallest size and for larger accounts a percentage of the principal is charged. The general average is approximately one-half of one per cent with a gradual decrease in the percentage charged as the amount of principal administered increases. Being relatively young, and having no special legal restric tions, the practices, functions and objectives of investment counsels have not yet reached the stage of standardization or uniformity. Actual practices today consequently cover a wide field, ranging from bona-fide investment advice to the man agement of speculative accounts by counsel, or to the hand ing out of market tips. The relationship between the counsel and the client varies widely among the firms, but two main types seem to exist: (1) the purely advisory, and (2) the discretionary accounts. In the case of the former the counsel has no control over the purchase and sale of securities; in the latter the counsel is given power of attorney to act as the principals agent in giving buy and sell orders. Rarely, however, do these firms accept physical custody of their cli ents securities. This function is often handled in "custodian accounts by trust companies and banks.
b . THE RECORD OF PERFORMANCE
To make any sound evaluation of the activities of invest ment counsels would require far more information than is available at the present time. A study of this subject is lim ited also by the very nature of the business. Whatever the
147
practices and objectives may be, investment counsels are generally agreed that their business is purely personal and confidential. For this reason exact information is practically unobtainable. Several of the investment counsels operating in 1929 with elaborate research organizations frankly admit that at that time they were completely wrong in their advice to clients. Statistics had failed them, resulting in some instances in a loss of more than 60 per cent of the value of the assets in their accounts. However, one large company announced in its circulars that clients "were advised to sell their common stock hold ings prior to the market break of 1929, to reinvest the pro ceeds chiefly in bonds and short term obligations, and to draw on previously established income reserves to supple ment income, where absolutely necessary, during the period of ensuing depression. These clients are in a position today, whenever business conditions warrant, to repurchase, on the average about three times the number of shares of stock which they held in 1929. Other firms, some of which are affiliated with banks and trust companies, claim an equally favorable record, but many of these have come into being after the market break and their experience would not be comparable. The only data bearing on investment counsel operations available are those of five accounts of one firm running back to 1919. They show an exceptionally good performance, as recorded in Roses The Practical Application of Investment Management. The rate of income on market value of prin cipal ranged from a high of 6.62 per cent in 1922 to a low of 4.33 per cent in 1929. Yearly changes in market values ranged from an appreciation of 21.51 per cent in 1928 to a depreciation of 18.67 per cent in 1930. Average annual in come was 5.33 per cent and average annual appreciation
148
6.36 per cent, making a total average annual gross accom plishment of 11.69 per cent. A statistical comparison has been made of this record with those of fire insurance companies, which have no serious legal restrictions in their investment management, and which, moreover, have a long period of investment experi ence. Allowing for the handicap resulting from the neces sity of carrying bank deposits with a low return, this par ticular investment counsel in the five accounts studied did better than the insurance companies. The least successful of these five funds showed a net accomplishment approximately 30 per cent better than the most successful fire insurance company. The only conclusion fully warranted at this time is that the better managed investment counsel organizations, so far as their records are known, have acted with intelligence and the good faith which has often been lacking in those sec tions of the financial district directly interested in the dis tribution of securities, but have naturally been subject to the limitations imposed by the shortcomings of human fore sight and understanding. Their record appears to be as good as the average of those who are ordinarily credited with financial insight.
6. B rokerage H o u se A dvice
As a source of advice to the general public concerning securities the brokerage house in this country has in the past assumed a position of large importance. Not only do these firms, their partners and sundry attaches reach the public directly through personal contacts, market letters, and other written matter widely distributed through the press and by private wire systems, but their indirect influence upon the financial press is very large. The advice and information which brokerage houses give
149
to traders are supplied mostly by customers men, or the "statistician, "security analyst or "economist of the firm. The latter supplies customers with information concerning individual companies or issues. The statistician or economist also frequently prepares market letters and special analyses of individual "situations. He is often the source of opinions sought by both the partners and customers on general eco nomic and financial conditions, and in some instances he functions as a highly important adviser to the investment customers of the firm. In other firms, however, he is hardly more than an information clerk. Another medium through which brokers advise the public is the market letter with which may be classed the "flashes and other more or less informal written statements issued by the brokers, particularly those with large wire systems. The need for economy, however, has greatly reduced the volume of such statements and the Securities Act has made broker age firms adopt a very cautious policy in giving published advice. Another influence directly and effectively tending to curb the former relatively free play in market letter writing is that of the Exchange itself. Since January 1933 the text of these letters and any communication or advertisement con taining forecasts of business in the market must be specifi cally approved and sponsored by a member or partner of the firm before issuance. The result is that these market letters, "flashes and other statements, always tending toward vagueness and meaninglessness, are today extraordi narily devoid of positive recommendations and even of pre dictions of a more general sort. Most of them are practically worthless to the investor not so much because of erroneous or misleading comment or prediction, but because of empti ness.
150

a. DIFFICULTIES OF IMPARTIALITY
While the brokerage house is obviously in a position to know as much about market conditions as any other agency, it labors under serious, and even dangerous, limitations as a purveyor of impartial information and advice. These spring from three sources: 1. In the first place, the income of the broker is derived from two sources: chiefly commissions on transactions ef fected for customers, and secondarily interest charged cus tomers on debit balances. The brokerage house is therefore under an incentive at all times to induce short-term com mitments by its customers, with as much buying and selling as may be, and also to encourage the purchase of securities on credit, which in most cases is the equivalent of encour aging speculative operations on the part of customers. 2. In the second place, the brokerage firm in this country is often also a security merchant in one guise or another. It may be interested in the distribution of blocks of stocks or bonds which it has either purchased in the market or under taken to help sell for other interests. The firm, or one or more of the partners, may be a member of syndicates, pools, joint accounts, or other groups, whose purpose it is either to sell to the general public certain blocks of securities some other individual or corporation wishes to dispose of, or else to conduct what is known as an "operation in the market. The "operation is, of course, invariably designed at one stage or another to dispose of securities to the general public at a profit. 3. In the third place, the average broker is far better equipped to give information about technical market condi tions underlying investment values, if the common impression among careful and shrewd investors can be believed. This general point of view is largely responsible for the typically
151
American habit of appraising security values so largely in terms of short-term market movements. In an ordinary brokerage house it is relatively rare to hear the success of investment policy measured in terms of regularity and as surance of yield. Obviously market prices can be considered accurate measures of investment worth only to the extent that they steadfastly reflect current and prospective earnings.
b. THE ACTIVITIES OF CUSTOMERS MEN
During the mad days of the boom, large scale abuses de veloped in connection with the employment of customers men. It is not necessary to give credence to nearly all the allegations regarding customers men to arrive at the conclu sion that incompetent, irresponsible and at time quite unscru pulous, individuals were employed by brokerage firms in this capacity, and that the practices of many of these employees, with at least the tacit approval of the firm itself, were often highly questionable. A number of brokerage houses during the boom period used unethical methods in procuring busi ness through these often ill-informed, irresponsible cus tomers men. By the end of the new era, customers men and their sundry activities had grown into something of a scandal. The sobering effects of financial reverses, however, gradually brought a realization of the situation on the part both of the general public and of the Exchange authorities. As a result the New York Stock Exchange has voluntarily placed a series of limitations on the activities of these cus tomers men. Each applicant for such a position must now sign a written agreement pledging himself to refrain from sharing in or guaranteeing accounts with customers. Another rule forbids the employment of customers men without ex perience and prohibits them from handling discretionary accounts. The rules now further provide that no member of the Exchange or firm registered thereon or partner thereof
152
shall take or carry a speculative account or make a specula tive transaction in which any person employed by such mem ber or firm, or by another such member or firm, as a security salesman or as "customers man, is directly or indirectly interested. The rules also provide that no customers man shall be employed without prior approval by the Committee on Quotations and Commissions, and that all such customers men shall be employed under a contract providing for at least three months employment and at a salary at least equal to a minimum fixed by the Committee. Payment of expenses incurred by customers men in the entertainment of customers is forbidden, and the employ ment of travelling representatives for the procurement of business in listed securities is forbidden. The employment of clerks in nominal positions for the sake of the business they may bring into the firm is likewise disapproved. All solicita tion of business from customers at their residence is forbid den without written consent by such customers, and no per son is to be permitted to perform the duties of a customers man who is not under contract as such. It is evident that observance of these rules can be expected to eliminate or at the very least mitigate some of the abuses that have arisen out of misuse of customers men. Whether the problem presented in this situation has thus been solved remains for the future to decide.
7. T h e G e n e r a l a n d F in a n c ia l P ress
A flood of information about the security markets and financial and economic developments affecting corporation earnings and security prices is constantly descending upon in vestors and speculators and the general public of the United States through a vast system for gathering and disseminating news. The importance of the press in the operations of the security markets can hardly be over-emphasized. While the
153
extent and nature of this flow of statistics and information cannot be measured or analyzed with any accuracy, an under standing of its general course and direction is essential. The principal agencies for distributing news affecting the security markets are the news tickers, the financial press and the daily newspapers and other general periodicals.
a. NEWS TICKERS
In addition to the stock and bond tickers discussed hereto fore, the news tickers operated by Dow-Jones and the New York News Bureau are perhaps the most important and in fluential purveyors of minute-to-minute news about the mar ket. The Dow-Jones news ticker service, which is owned by the same interests as the W all Street Journal and Barrons operates in 85 cities and has several thousand clients in the United States and Canada. These tickers are machines which print on sheets of paper continually throughout the business day brief flashes of market and financial news, busi ness and corporation reports, items regarding government or international policies, or general news of the type published later at greater length in the W all Street Journal. The New York News Bureau with direct wires to Washington, has a similar service operating in New York City and the metro politan district only. The Western Union news ticker is some what similar, though its information includes sports and general news and is not particularly identified with financial affairs. The financial news ticker services have a position of im portance far greater than the size of their subscription list might indicate. In the first place a very large proportion of the financial news of the day first appears on one or the other or both of these tickers. "Spot news must, so far as the afternoon newspapers are concerned, wait for the ap pearance of editions at set hours. Financial news, and cor
154
poration statements, many of the compilations of business and financial statistics, market prices of many articles of com merce, company developments and most of the important events of the day, unless they occur or are made public very late in the day or are held for "morning paper release by those controlling the information itself, are first broadcast throughout all the leading financial centers of the country by means of these tickers. In the second place, the information and the interpreta tions published in the financial districts by these tickers are promptly further broadcast over the land by brokerage and other firms through their wire systems, which, taken in their entirety, reach practically every city of importance in the United States. In the third place, every leading newspaper, and all the more important press associations, have one or more of these ticker services in their editorial offices at all times. A very large part of the reading matter in the financial departments of the afternoon papers in leading centers is taken more or less verbatim from this source. So far as the afternoon news papers in other cities depend upon the regular news associa tions for their financial news and that is about all that many of them get, the same holds true of them. Even the morning newspapers and the press associations depend to a great ex tent upon the reports of the news tickers in preparing dis patches on financial topics. As disseminators of minute to minute news no very serious criticism can be leveled at these tickers in spite of certain shortcomings resulting from the speed at which they work and the necessity of abbreviation and condensation. The accuracy and fidelity with which they are able to keep the financial world apprised of world-wide developments almost instantaneously is remarkable. These agencies, however, are much more than dissemina tors of minute-to-minute news. They are also market re
155
porters, covering money rates, several of the more important commodities, and of course the securities markets. They likewise undertake to keep their patrons informed as to gen eral business conditions and particularly as to business pros pects. A very considerable amount of space is devoted daily to "write ups of particular corporations, industries and se curities. ( l) Shortcomings of News Tickers In the performance of these latter functions certain serious shortcomings exist. One involves the possible distortion or over-emphasis of news through what is known as "ticker support. Traders, brokers and particularly security dealers say they have "ticker support when they are able with rea sonable frequency to have appear on the leading news tickers items of information, analyses, and prognostications concern ing a company or "situation in which they are interested. Ordinarily these items are hardly spot news of importance, nor are they often objectionable so far as the accuracy of the facts presented are concerned. However, while they are not ordinarily paid for in any direct sense, these items of "ticker support have occasionally been suspected of being related to advertising contracts. Generally speaking, the stock market reviews published by the news tickers do not become conservative until stock prices are declining or showing signs of weakness. Ordinarily the sympathy of the writers is clearly with the speculative trader, and along with him they are obviously interested at all times in seeing prices move upward. Manipulative and other groups trying to force prices upward can be assured of their share of "ticker support. An appearance of substantial ac tivity in an issue accompanied by rising prices, is certain to be promptly reported on the tickers and in such a waywhether by design or not is not here in questionas to attract the
156
attention and arouse the interest of the average man. Realis tic analysis of what is going on in the Street is rarely seen. In their reporting on individual corporations the ticker services seem to rate higher in the public value of their work. They do, of course, give evidence of more faith in the accounting systems of American corporations than the facts warrant, but the closeness with which it is possible for their specialists to tell the public some weeks in advance ap proximately what the earnings of a substantial number of corporations will be for a given period leaves little doubt that they are in close touch with the managements of busi ness enterprises. It is thus not often that the quarterly earn ings of one of the leading corporations in this country catches the market greatly by surprise. This work is to be regarded as a real service to the investment and speculative markets, although of course it does not prevent the private use of ad vance information by those in possession of it, since they can make use of it before it is reported on the news tickers.
b . THE FINANCIAL PRESS
Several daily newspapers of national prominence, of which the W all Street Journal and the Journal of Commerce of New York are the best known, are primarily devoted to finance and business. Apart from these daily publications the strictly financial magazines of national importance are few in number. These few vary greatly as to their content and functions. The Commercial and Financial Chronicle, for ex ample, apart from a few editorial articles of a highly con servative character is primarily a magazine of record. It brings its readers a complete account of the more important events of the week in the field of finance and industry the world overat least so far as they are reported in the daily press. A full quotation service is also included covering all the more important security markets in this country. Latest developments in the field of government and municipal
157
finance are likewise given space in these weekly editions. Finally there are extended and carefully prepared market and business surveys, in which the more important commodities and branches of industry receive analysis. Of a wholly different character are such magazines as the Magazine of W all Street and The Financial W orld which are devoted largely to individual securities and predictions concerning general market and investment trends. Barrons, on the other hand, presents still a different picture. Its weekly issue usually carries a few articles whose subjects are of wide and general interest at the moment, but much the larger portion of the space is devoted to the same sort of company analysis and comment as is to be found in the W all Street Journal and on the Dow-Jones news ticker. The Times Annalist, again, is devoted in large part to the publication of materials already described as making up the content of the Commercial and Financial Chronicle, although on a much less complete scale. This publication compiles its own "in dexes of business and also publishes numerous charts. On the whole the reputable financial periodicals rate rather high in the scale of public usefulnessalthough they too suffer from the gross inadequacies of American corporate reporting. Much information invaluable to the investor is included in these magazines. On the other hand interpreta tions and analyses of general conditions and of individual company situations vary widely. In a few such publications the type of material of this sort at times degenerates into a sort of tipster servicethough so far as ever actually demon stratedwithout the plain fraud characteristic of the usual tipster sheet.
C. THE DAILY NEWSPAPERS
The daily newspaper must be given first rank so far as influence upon the average investor or speculator is con cerned. The majority of the community depends upon the
158
daily press for its day-to-day information concerning finan cial conditions and events. Nor can attention be confined to the financial pages. Ever since the War, and particularly during the past year or two, financial developments and events closely related thereto have more than ever before constituted a very substantial part of the "general news of the day. Often, particularly during recent years, they have been the leading news of the day. Not only have the main sections of the daily press and general magazines given a substantially increased propor tion of space to affairs intimately associated with the secu rity markets, but the special pages devoted to business and finance have developed and expanded prodigiously during the past twenty years. 1. Newspaper Abuses Apart from the all-too-common use of newspaper space by columnists and other writers to further their own specu lative interests in pool operations, which has already been described in Chapter VI, the chief shortcomings of the daily press in supplying information are due to the customs and standards of American journalism in all its fields. By tradition in this country the best "story is that which recounts the most unusual or the most dramatic event. Fur ther, the average American newspaper editor is imbued with the idea that to obtain circulation his newspaper must be "dramatic in the presentation of its reading material. Another traditional requirement of good news and special feature writing for the regular press is that all subject matter in hand be stripped so far as possible of technicalities and complexities. The most dangerous shortcomings of daily newspaper financial information of all kindsgeneral news, special stories, feature columnsare the almost universal domina
159
tion of writers by the speculative point of view. Almost the entire flood of news and comment is written to appeal to the so-called "active trader. Few newspaper writers give evidence of much understanding of the stock market as a place in which the genuine long-term investor may be greatly interested. Through constant and long continued direct contact with the speculatively inclined sections of the financial district, the financial writer is likely to have no other viewpoint so far as the stock market is concerned. Moreover, during the boom period ending in 1929 and at times since that date, the pool managers and the manipulators have more often than not had relatively complete control of the stock mar ket. They became the most active, the most vociferous, and, from the speculative point of view, the best source of in formation about short-term price movements. The existence of pool activity in particular stocks, or rumors of early ac tivity of this sort, still is "important news to the stock market reporter, the more so if he is inclined, as most of them are, to undertake direct or implied predictions. More than one of these writers have been and still are more or less regular speculators on their own account. This daily living in the atmosphere of excited speculative operations, this partial identification of personal interests with that of current speculation, and this constant and rela tively intimate contact with the most speculative elements in the financial community, the large scale trader and the pool manipulator, could hardly fail to leave its impress upon the product of the daily financial writer. The whole country in recent years has obviously been suffering from a sort of stock-gambling mania, and probably is still quite susceptible to the malady. The stock market leader writer is simply one of the victims, but he is also an active carrier of the disease.
160

d. GENERAL PERIODICALS
The weekly and monthly magazines have recently been giving a great deal more space to economic and financial subjects of late years than before the War and they cannot be entirely ignored in any discussion of the press of the country. Several of them with very large circulation now exert a marked influence on public opinion, particularly in respect to broader questions of policy. It is now well recognized that popular interpretations of national policies in the magazines, particularly those that touched the monetary and price situations, not infrequently propounded officially and unofficially, helped lay the basis for the speculative boom of the early summer of 1933. Without such support it would in all probability have been impossible for the usual types of 'ballyhoo emanating from Wall Street to have attained the success it actually achieved. Since, however, the content of these magazines so far as it relates to financial and economic questions is usu ally of such general nature, and so often the expression of individual viewpoints, it is hardly a suitable subject for objective analysis. Suffice it to say that the editors of these publications are naturally more interested in contributions from interesting writers than in products of technically informed contribu tors. Some of these articles are merely entertaining. In others false impressions are created which make possible manipulative movements in the security markets by prepar ing the public mind for propaganda which pools or other groups with selfish designs find it profitable to spread abroad. Of course it is but fair to add that in other instances the net effect of articles is well calculated to make the usual type of manipulation in Wall Street more difficult. Of course, it is not usual for these publications to play any
INFORM A T I O N A D V I S O R Y SERVICES
161
important part wittingly or otherwise in specific manipula tive campaigns in the financial markets. Whatever undesir able influence may be exerted by such periodicals is hardly more than the price that must be paid for our determination to simplify and popularize inherently highly complex and difficult economic and financial questions.
Chapter VIII
C O N C L U S IO N S A N D 1. T h e B a s e L i n e
fo r
R E C O M M E N D A T IO N S 1 t h e R e c o m m e n d a tio n s
E cannot measure abuses, shortcomings and imperfec tions, nor can we suggest changes to bring about im provement, if we have no standard of excellence. The standard appropriate to security markets was defined and analyzed in Chapter II, where it was pointed out that these markets should: 1. Impart to securities sufficient marketability so that under normal conditions they can readily be bought and sold. No system or market can be expected to permit liquidation and
1 The recommendations for reform in the organization and operation of the security markets in the United States represent the opinions, as nearly as they could be reduced to a common denominator, of the group of persons who conducted and assumed responsibility for this survey. This group consists of the senior staff members and authors of the report: Dr. N. R. Danielian, Dr. Paul D. Dickens, Professor Wilford J. Eiteman, Dr. G. Wright Hoffman, Mr. Frederick W . Jones, Professor William H. Steiner; the Director in charge of research, Mr. Alfred L. Bernheim; the Director of the Twentieth Century Fund, Inc., Mr. Evans Clark; and the Economist of this Fund, Dr. J. Frederic Dewhurst. Complete agreement by this number of persons on problems as complex and difficult as those involved in an endeavor to reconstruct our system of security exchanges could scarcely be expected. No one of the above would by himself have formulated the exact program which is outlined in the following pages. Yet all of them have endorsed this program as a whole, and have expressed their belief that if it were adopted and put into practice, a decided improvement would result. It should be noted that Mr. George Soule, one of the contributors, has taken no part in the formulation of recommendations and wishes to remain entirely disasso ciated from them. This fact should not, however, be interpreted as disap proval on his part.
162
CONCLUSIONS RECOMMENDATIONS
163
conversion into cash of all or any considerable proportion of outstanding securities at any one time. 2. Furnish a market through the operations of which securi ties are accurately evaluated in terms of their investment worth. 3. Direct and allocate the flow of savings in accordance with the best interests of investors and of the national econ omy as a whole. All of these major functions, as well as certain minor ones, are now being performed by the security markets, and, from a purely mechanical point of view, performed with a marked degree of efficiency, at least by the more highly organized exchanges. But in our judgment the nation has been paying too high a price for even the most essential services which the security exchanges render. The reasons that have led us to this conclusion, and the facts upon which our reasons are based, have been outlined in the preceding pages. Here it is sufficient to state that the unduly large volume of uncon trolled speculation, coupled with the frequent interference with the free play of supply and demand by manipulative activity, interferes with the performance of the proper functions of security exchanges and also has a serious disrup tive effect on the national economy. The object of our recommendations, therefore, is to in crease the effectiveness of security markets in performing their essential functions, first, by reducing the volume of speculation, and second, by raising the standards of market organization and practice. This, of course, implies recogni tion of the fact that informed speculation in securities, when adequately restricted and controlled, augments the value of security markets; and that, conversely, the elimination or even the unduly rigid restriction of speculative activities would lessen their value. This, then, is the background against which we have fash
164
ioned our recommendations for the organization and practice of security exchanges. Security exchanges render certain eco nomic services which are essential under a capitalistic economy. However, excessive and uncontrolled speculation, especially when accompanied by manipulation, not only makes the price we pay for these services out of proportion to their value, but it also may result in a positive disservice to investors by distorting security values. It follows from this that public policy requires that speculative activities be brought under such control that they will add to and not detract from, the value of the functions which security ex changes are designed to perform; and so that such activities will no longer create credit disturbances and other malad justments throughout our economic structure.
2. S u m m a r y o f R e c o m m e n d a t io n s
The principal recommendations are listed below in sum mary form. They are presented in greater detail and sub jected to analysis and discussion in the section that follows. a. Federal licensing and regulation of security exchanges. b. Federal licensing and regulation of over-the-counter markets. c. Federal incorporation of all corporations engaged in interstate commerce. d. State incorporation laws, establishing the same standard as the Federal law, for corporations engaged exclusively in intra-state commerce. e. Establishment of minimum accounting and reporting standards for corporations. f. Separation of commission business from the business of dealing in securities, and regulation of other aspects of brokerage business. g. Establishment of higher qualifications for customers men.
CONCLUSIONS RECOMMEND ATIONS
165
h. Control of margin buying by limiting speculative credit. i. Control of short selling by limiting its volume in indi vidual issues in any single session. j. Separation of trader and broker functions in respect to specialists. k. Full publicity on all pool activities. 1 . Extension of principles of Securities Act in respect to publication of financial news. m. State licensing of investment counsels. n. Compilation and publication of additional statistical data bearing on security markets.
3. A n a ly sis o f P ro blem s a n d o f R e c o m m e n d a t io n s a. federal r e g u l a t io n o f security ex c h a n g e s
( l) The Problem The ever-recurring demand for governmental regulation of security exchanges in this country has probably never been as loudly and as widely voiced as during the past three or four years. This is easy to understand. Two conditions always stimulate this demand. One is declining stock prices. The other is "exposures of stock market practices. Both these conditions have been fulfilled to a hitherto unparalleled de gree since the end of the speculative orgy of the late twenties. Beyond this rather superficial clamor, however, which waxes and wanes largely in harmony with the increase and decrease of the nations prosperity, there has steadily grown a more substantial, a more permanent, a more reasoned belief in the necessity for some sort of regulation of our security exchanges. The proponents of this belief have become convinced that we may no longer leave to private and unsupervised control an economic institution so heavily charged with public in terest, so intimately tied up with our national and state bank
166
ing systems and so closely intermeshed with the gears that drive the wheels of our industry and commerce. The direction given to the flow of savings through the process of evalu ating securities in the open market is one of the most essen tial economic functions performed in a capitalistic society. To allow the machinery which regulates this vital function to be operated as the private property of a small group of self-interested persons subject to little effective check other than public opinion, creates a preposterous situation which should not be allowed to continue. The people of the coun try have a right to say what services they want their security markets to perform and in what manner they want them performed; and beyond this they have the right to demand the power to enforce compliance. The form which regulation should take is subject to wide divergence of opinion. Incorporation of security exchanges has been suggested. Regulation through the Post Office De partment has been advanced as a method of control. Licens ing of exchanges and brokers is the measure which is prob ably most frequently heard. We do not recommend compulsory incorporation of se curity exchanges because we cannot see that this of itself promises any real improvement in the operation of ex changes. We are, however, not of the opinion that incorpora tion would be a hindrance to effective operation. We do not recommend regulation through control of com munications by the Post Office. This is an indirect attack on the existing abuses and for that reason would not, we believe, prove satisfactory. Furthermore, its effectiveness would de pend upon the use of a force which is dangerously like cen sorship and which for that reason should not be evoked. Licensing under the Federal Government appears to us to offer the most feasible form of regulation, but the system of licensing must not be so rigid as to deprive the exchanges
167
of the incentive to, and responsibility for, self-government, substituting therefor a completely bureaucratic administra tion. On the other hand, a licensing system which stipulates too little, depends too largely upon the judgment and wis dom of the licensing authority and the good will and good faith of the licensee, and for this reason is likely to be unre liable and uncertain. A middle course is suggested, namely a system which pro vides the minimum requirements for a license, leaving it to the licensee to formulate and administer a constitution and body of rules embodying these minima, while extending to the licensing authourity the power of enforcement in the last instance. The fundamentals of a system of this sort are out lined below. (2) Recommendations 1. A Federal Statute should be enacted providing that se curity exchanges be licensed by the Federal Government and be prohibited from operating without such license. 2. The minimum requirements for any license to be issued to a security exchange should be embodied in the Act and not made subject to the discretion of the administrative authority. These minimum requirements are summarized below under the following sections:
f. g. h. i. j. k. n. Brokerage Firm-Customer Relationship Customers* Men Margin Buying Short Selling Specialists Pool Activities Statistical Data
3. The Act should provide for the creation of a Security Markets Authority to administer and enforce its provisions. 4. All employees attached to the office of the Security Mar kets Authority should be subject to the Civil Service laws.
168
5. The Authority should be empowered to issue a license to any security exchange whose constitution and rules em body the specific minimum requirements of the Act and are in conformity with the general purposes thereof. The Act should provide that, once adopted, the constitution and rules of a licensed exchange cannot be altered except with the consent of the Authority. 6. The governing body of each exchange should be charged, in the first instance, with the duty of administration and enforcement of the provisions of the Act. 7. The Authority should be empowered to require any ex change or member thereof to keep its or his books of ac count and other records in such a manner as the Authority may deem advisable; and to inspect said books and records at any time. 8. The Authority should be empowered to investigate fully at any time the operations of any exchange or member thereof. 9. The Authority should be given the power, under suit able safeguards, to revoke a license, levy a fine or impose other penalties upon any exchange or member thereof for violations of the provisions of the Act; or of the administra tive regulations imposed for the purpose of effectuating the Act; or of the provisions of the constitution and rules of the exchange as approved by the Authority.
b. FEDERAL REGULATION OF OVER-THE-COUNTER MARKETS
(1) The Problem The benefits that would accrue as the result of raising the standards of security exchanges might be nullified if the over-the-counter markets were left unregulated and uncon trolled. They are of vast proportions and they would serve as a refuge for any business that might seek to escape the
169
discipline of the exchanges; and the more exacting that dis cipline, the greater the temptation to escape from it. Overthe-counter markets offer facilities that are useful under cer tain conditions, but they should not be permitted to expand beyond their proper sphere and compete with the exchanges for business that, from the point of view of public interest, should be confined to the organized markets. This constitutes the sanction for Federal regulation of over-the-counter deal ers and brokers. To leave the over-the-counter markets out of a regulatory system would be to destroy the effects of. regulating the organized exchanges. (2) Recommendations 1. The Federal Statute outlined in Section "a should pro vide that no person be permitted to do business in securities over the counter unless licensed by the Federal Government. 2. A licensee should be allowed to do business only as an individual, or in partnership with one or more other licensees. This should not apply to bona fide employees of a licensee. 3. Minimum requirements for a license to be issued to an over-the-counter dealer or broker should be embodied in the Act and not made subject to the discretion of the adminis trative authority. They should be similar in principle to those required for a licensed exchange. 4. The Security Markets Authority should be empowered to issue a license upon satisfactory evidence of the applicants experience, character and financial responsibility. 5. The Authority should be empowered to require any licensee to keep his books of account and other records in such a manner as the Authority may deem advisable; and to inspect said books and records at any time. 6. The Authority should be empowered to investigate fully at any time the operations of any licensee. 7. The Authority should be given the power, under suitable
170
safeguards, to revoke a license, levy a fine or impose other penalties upon any licensee for violations of the provisions of the Act, or of the administrative regulations imposed by the Authority for the purpose of effectuating the Act.
C. FEDERAL INCORPORATION ACT
(1) The Problem The existence of 49 separate systems of corporate law opens wide the door to serious abuse. Incorporation in cer tain so-called "liberal states gives almost unlimited oppor tunity to insiders to profit at the expense of the investing public, an opportunity that has often been exploited to the full. Credit is due to the New York Stock Exchange for con tinually raising its listing requirements and thereby offsetting to some extent the laxity of the states. It has not as yet gone far enough, but it has gone further than most of the states themselves. There are, however, weighty objections against placing the burden of regulating corporate practice upon the stock exchanges. Chief among these are the following: Exchanges have no control of the over-the-counter markets. In the absence of such control, too high standards on the part of exchanges might cause many corporations to refrain from applying for listing, or to withdraw their issues from the exchanges. The same type of unwholesome competition would arise among the different exchanges themselves as long as they were permitted to operate on widely varying standards in respect to listing requirements. Additional listings create more business for exchange mem bers. For this reason there is always some danger that ex change listing committees may occasionally be a trifle lax. Securities listed at a time when requirements were less rigorous than they are today, present a difficult problem for exchanges to handle. While the New York Stock Exchange,
171
in particular, has been trying to persuade corporations whose securities are in this category to consent to changes in their original listing contracts, these efforts have not always been successful. It is true that an exchange has the abritrary power to remove from its stock list the securities of a corporation which refuses to meet its suggestions, yet such extreme action would scarcely seem advisable except in most flagrant cases, because it would cause serious hardship to the innocent hold ers of the disbarred securities. On the other hand, it is doubt ful whether a management would ever have the temerity to permit its securities to be stricken from the list rather than accede to a request made publicly by an exchange. In any event the problem of keeping listed corporations in line with the most advanced listing standards cannot be solved in the absence of legal power. There is no assurance of permanency of policy on the part of an association whose actions are not subject to control by authority outside its own membership. A new administration can, potentially at least, always undo the work of a former one. Exchanges have no power to punish violations except to strike securities from the list which, as pointed out, might harm the interests of security holders who had no part in any improper act. The matter of corporate practices is too deeply affected with public interest to be placed under the unregulated and uncontrolled jurisdiction of any private body, no matter how well intentioned. Only through a Federal incorporation act can the present evils be coped with adequately, insofar as corporations en gaged in interstate commerce are concerned. Because of con stitutional hindrances, corporations engaged in strictly intra state business can be reached, according to the best prevailing legal opinion, only through State laws, or, to the extent that
172
their securities are listed on an exchange, through listing re quirements. Through Federal incorporation, supplemented eventually, it is to be hoped, by adequate state legislation, badly needed improvement and standardization of corporate organization and practice, including corporate accounting and reporting, can best be accomplished. Furthermore, objectionable prac tices by corporate directors and officials can be curbed through this kind of legislation with greater apparent hope of success than in any other way. We believe that publicity is the most effective safeguard that can be legally erected to protect the rank and file of security holders against certain kinds of stock market operations by the faithless stewards of the investors savings. (2) Recommendations 1. A Federal Statute should be enacted providing that all corporations engaged in interstate business obtain a charter from the Federal Government, and be prohibited from en gaging in interstate business without such charter; except that corporations below a certain size, to be determined on the basis of total capitalization or number of stockholders, should be exempt from Federal incorporation. 2. The Act should establish minimum standards of cor porate accounting and reporting, as summarized in Sec tion "e. 3. It should establish, insofar as practicable, uniform con ditions in respect to the principles of corporate organization and practice. 4. It should provide that officers and directors be pro hibited from dealing in the securities of their own corpora tion without making prompt and full public disclosure of each such transaction.1 5. It should provide that all options granted or exercised
173
by directors and officers in respect to the securities of their own corporation be likewise publicly reported.1 6. Responsibility for the administration and enforcement of the provisions of the Act should be conferred upon the Federal Trade Commission.
d. STATE INCORPORATION LAWS
( l) The Problem The problem, as already indicated, is that of the regula tion of practices of corporations engaged strictly in intra state business. In this category there is an exceedingly im portant group of utilities. (2) Recommendation 1. The several States should enact legislation providing the same minimum standards for corporations engaged exclusively in intra-state business, as are suggested in sub section "c for corporations engaged in interstate business.
e. CORPORATE ACCOUNTING AND REPORTING
(1) The Problem The official financial reports of corporations constitute by far the most important source of information for the investor. This is especially true of the income account. It is essential that they satisfy as fully as possible the requirements of ac curacy, completeness, frequency, promptness and clarity. Time and time again the investor finds it impossible to make an intelligent decision because he lacks comprehensive, sig1 The possibility of evasion through dummy directors creates a troublesome problem that will have to be faced. In addition, it will probably be necessary at some future date to consider the question of extending control to cover leading stockholders as well as directors. At the outset, however, it would seem advisable not to impose too large a task in a field where no admin istrative technique has yet been developed.
174
nificant, up-to-date, understandable information about a cor poration. We do not believe that rigid standardization of accounting or reporting is at present possible, even within classified groups of corporations. The best minds in the accounting profession, however, seem to be approaching some degree of agreement on many important aspects of accounting pro cedure and on many fundamental principles of accounting science. It is important that further advances in this direction be made because it is only by comparisons between indus tries as well as between companies within an industry that an investor can direct his savings into the most promising channels. (2) Recommendations 1. Every corporation should be required to adhere to the minimum standards and conditions established by the Fed eral Incorporation Act, to disclose the accounting methods it employs, and to declare whether or not their application is consistent from year to year.1 2. Every corporation should be required to observe general accounting principles no less exacting than those now re quired by the New York Stock Exchange, and to report in at least as much detail as now required by the Exchange. 3. Every corporation should be required to employ an inde pendent auditor elected by the stockholders. The auditor should hold the degree of C.P.A., or its equivalent. 4. It should be required to publish promptly annual and quarterly income statements, annual balance sheets and quar terly statements of current assets and liabilities in accordance with the minimum standards to be established by the Act,
1 Compliance from intra-state corporations can be exacted through security exchange listing requirements, which, in turn, can be enforced by the licens ing power of the Security Markets Authority, and through state incorporation laws.
175
and the administrative regulation to be imposed by the Fed eral Trade Commission. Certified copies of the published reports should be filed with the Commission. 5. Every corporation should be required to publish monthly lists of its officers and directors together with the number of shares of each class of its stock standing in the name of each such officer and director as of the last day of the month next preceding publication.2
f. BROKERAGE FIRM-CUSTOMER RELATIONSHIP
(1) The Problem A brokerage firm stands in a four-fold relationship toward its customer. 1. It acts as his broker in the purchase and sale of securi ties and in the borrowing and lending of stocks. 2. It acts as a pledgee, in which capacity it either advances its own capital to finance his margin transactions, or, much more commonly, advances capital borrowed from banks. 3. It is the custodian of his securities and cash. 4. It exercises, to some extent, the function of an invest ment counsel toward him. These relationships imply great responsibilities and obli gations on the part of a brokerage firm. Under these circum stances the customer is entitled to expect the fullest possible protection. He has, however, not had it. Although the lead ing exchanges have erected certain safeguards for the protec tion of the customers of their members, they have not gone far enough in this direction. To the greatest extent possible,
2 The problem of the use of dummies, nominees and other subterfuges will undoubtedly arise and will have to be dealt with after experience suggests the methods. The question of the practicability of requiring the same infor mation from principal stockholders as from directors and officers is of great importance and must be carefully considered in the future. An over-ambitious program at the outset should be avoided.
176
a condition should be created where the conflict of interest between broker and customer is reduced to the minimum. (2) Recommendations 1. No individual or firm doing a commission business in securities should be permitted to act as a dealer in securities; or to trade in securities, either on margin or otherwise, for his or its own account, except in the form of an "error account, which, however, must be liquidated without un necessary delay. 2. Each individual or firm doing a commission business in securities should establish a uniform agreement for all of his or its customers, and should not unfairly discriminate .be tween them in respect to interest charged or credited, pre miums on stock lent on their behalf, or otherwise. The agreement should state that nothing contained therein should be construed to mean that the customer waives any of his legal rights. 3. No individual or brokerage firm should be permitted to carry on his or its books any accounts which do not disclose the full identity of those conducting them.1 4. No transactions in securities should be permitted on Saturdays, either on security exchanges or over the counter.
g . c usto m ers m e n
(1) The Problem The employment of customers men is responsible for grave abuses, which, however, are difficult to eliminate. The compensation and tenure of employment of a cus tomers man inevitably depend, directly or indirectly, upon
1 It is recognized that the person "conducting an account may not be the true owner. It does not, however, seem feasible to require a brokerage firm to conduct an investigation to determine who in fact controls any or all of the accounts on its books. All that can be required from this quarter is the elimination of such cryptic designations as "Account No. 4 7 6 .
177
the amount of business the employee brings to his employer. It follows that he is under constant pressure to find new cus tomers and to persuade his old ones to do a larger and more active business in securities. That a conflict of interest be tween the brokerage firm and the customer is thus likely to arise is to put it mildly. That excessive, and generally unin formed, speculation may be expected is, again, a conservative statement. The more intelligent and far-seeing brokerage firms and customers men realize that their interests and those of their customers coincide in the long run, but this is no guarantee against potential abuse. The statement of the problem is simple but thoroughly effective remedies are not available. The recommendations advanced, while not of momentous import, should ameliorate the conditions to some extent. (2) Recommendations 1. No one should be eligible for the position of customers man unless he is at least 25 years of age and has been em ployed for at least two years in some other capacity by a brokerage firm affiliated with a licensed security exchange. Experience and some degree of maturity should have a re straining influence upon the speculative enthusiasm of a cus tomers man. 2. No customers man should be permitted to handle a customers account on a discretionary basis under any cir cumstances.
h. MARGIN BUYING
(1) The Problem The problem of the control of speculation is essentially the problem of the control of margin buying. It is the use of credit to finance the purchase of securities that makes pos sible such rampant bull markets as that of 1928-29. It is the
178
use of credit that forms the most direct and intimate tie be tween the security markets and banking and business. Security speculation in the absence of credit would assume a vastly different character. We are opposed to measures designed to eliminate margin trading, and our reasons for this, briefly stated, are as fol lows: 1. Speculators would borrow on collateral directly from banks and other financial institutions if they were forbidden to borrow from brokers. This might be advantageous from some points of view but it could scarcely be expected to re duce the volume of speculation materially. 2. If, in an extreme effort to stop speculation on borrov/ed funds, all collateral loans were made illegal, there would be grave danger, in our opinion, that a bootleg loan market of tremendous proportions would come into being. This would aggravate whatever evils now exist in the system of grant ing loans against security collateral and of buying and sell ing securities on margin. 3. Furthermore, if all collateral loans were forbidden, in jury would result to many owners of securities, both indi viduals and institutions, who at times find it necessary or advantageous to make collateral loans for purposes other than speculating in the security markets. Lenders could scarcely be expected to exert effective control over the use borrowers made of the funds advanced to them. 4. It does not seem economically sound or wise to prohibit the purchase of securities on credit as long as credit is per mitted in the purchase of commodities and real estate, and in connection with ordinary business transactions of all kinds, including installment buying by consumers. This statement is made with the full realization that the purchase of securities on margin presents several fundamental differences from transactions involving the use of credit in other fields.
179
5. Corporate financing would be impeded if corporate securities were made ineligible for loans. 6. Above all, perhaps, the elimination of an overwhelming proportion of speculative activity would seriously hamper the important functions of security markets. Instead of seeking to eliminate margin trading, we favor measures to bring it under control and keep it within reason able bounds. Critics of the present system have suggested numerous ways to achieve this result. We have given thought to a wide range of possible recommendations and we discuss them briefly belowboth those we have rejectednot always because we disapprove but often because we believe them im practicableand those we have incorporated in our own pro gram. (2) Recommendations (a) Those Rejected 1. Minimum cash deposit on each brokerage house margin account.1 There is no reason why a cash deposit should be made mandatory as long as the requisite margin is maintained through either cash or security collateral. When the total value of all the securities in an account is used as the base on which the percentage of margin is computed, there is an automatic adjustment between cash and security collateral, and no advantage in the one as against the other. 2. Control through variation of interest rates on debit balances. We do not believe that the interest rate charged on debit balances is, within reasonably wide limits, an effective method of controlling speculation. The relatively high cost of borrowed money is unimportant in bull markets, while in bear markets the cheapness of money can scarcely offer an
1 The figure usually suggested is from $2,000 to $5,000.
180
appreciable inducement to the speculator to make commit ments on the long side when he fears that they may result in capital losses. 3. Prohibition of margin trading in odd lots. This is suggested as one of several devices to keep the speculator of small means out of the stock market. While sympathetic with this objective, we believe that the proposal is of doubtful efficacy. Thus, if the odd-lot trader were for bidden to buy on margin, he would nevertheless continue to speculate, but he would have to trade in fewer stocks or in lower-priced stocks, or in a combination of the two. We fail to see that this would either add to the safety of his capital or contribute to the stability of the market. 4. Prohibition against the purchase on margin of any stock selling at less than a certain figure.1 This is another of the "protective devices, and again there is serious question as to its effect. There may be, and frequently is, less risk attached to the speculative purchase of a given stock when it is at a low price than after it has had a rise. But a rigid price limit would be unsatisfactory in any event since a rise or fall in the general level of the market would change the status of many stocks without any change having taken place in their relative merit as media for speculation. On the other hand, a flexible limit would be difficult to administer and would cause confusion and dissatisfaction. Then too, stocks selling near the limit of eligibility might at times fluctuate slightly above and slightly below, thus being eligible one day and ineligible the next. 5. More careful scrutiny of the financial and moral stand ing of their customers by brokers before granting credit. We endorse this policy but make no recommendations in respect thereto since we do not believe that it can be effectu ated by regulation or legislation. The cure lies in education,
1 Usually placed at between $10 and $20 per share.
181
and the work should be undertaken by security exchanges and associations of brokerage firms. 6. Reduction of trading facilities. One of the most powerful stimuli to stock market gam bling on the part of the outside public is the easy and pleas ant access to the market provided by the stock ticker and the comfortable board room of brokerage houses, especially since recent inventions like the electric board and the translux. The feverish and exciting atmosphere created by these de vices in the board rooms where speculators congregate kindles and magnifies the urge for gambling. In addition, the best advertising medium which the pool operator has at his disposal is the ticker. It whets the appetite of the speculator beyond resistance as it records the pools success in terms of a mounting volume of sales. London and other foreign exchanges get along with a minimum of such luxuries, and seem to perform the legiti mate functions we demand of exchanges, though it must be remembered that there are other and more fundamental dif ferences between the American and foreign security markets. It is probable that the people of this country would be bet ter off if the facilities for speculation were less highly devel oped. We do not, however, see any way of bringing this about by legislation. Again, the remedy lies in education. The investorand the speculator, toomust be taught to appraise securities on the basis of their intrinsic worth against a background of fundamental economic conditions. He must, of course, first, be put in a position where he can make intelligent decisions by being in possession of all relevant information. 7. Reduction of hours of trading. We have weighed the desirability of reducing the daily trading session, in order, by this simple, automatic control, to cut down the volume of speculation. While there is no
182
doubt that the investment demand for securities can be satis fied in a session much shorter than five hours, there is, on the other hand, at least a possibility that curtailment might create a new set of difficulties. Thus when, for one reason or another, speculative enthusiasm was at a high pitch, trading might well be more frenzied in a shorter than in a longer session. Again, a late opening or an early closing of ex changes might stimulate over-the-counter trading before or after exchange hours. While measures regulating the outside markets might prohibit this, it would, we fear, be extremely difficult to prevent an appreciable volume of bootleg trans actions. In view of these uncertainties, we do not recommend that the present five-hour trading session be reduced. We are, however, of the opinion that the two-hour session on Satur days is not needed, and that its elimination can be accom plished without creating any appreciable difficulties of the kind outlined in the preceding paragraph. Indeed, the elimi nation of trading on that day would simplify the task of collecting and compiling the weekly statistical data which elsewhere we recommend should be done by brokerage houses and security exchanges. The establishment of the five-day week would be in har mony with the principles of reconstruction under the New Deal, and in accord, furthermore, with the more funda mental demands of modern business and industry. Its intro duction in the security business has therefore been recom mended in sub-section "f above. (b) Proposed Methods of Control Margin buying can be controlled only by controlling the flow of its lifes bloodcredit. The prevailing system of granting loans and extending credit on the basis of the mar ket value of securities is essentially unsound. Rising prices supply a continuously widening base for speculative credit,
183
and the application of this credit to the further purchases of stocks continues to drive prices upward, thereby making still more credit available. This self-generating and self-perpetu ating margin speculation may continue until a major collapse is precipitated, when the process is reversed. As prices de cline, margins quickly become inadequate and stocks must be sold. This produces further declines and necessitates fur ther forced liquidation. And so it goes until the process has been completed. An increase of margin requirements would only partly remedy this evil. It is true that the larger the percentage of margin required, the smaller the absolute limit of the bor rowing capacity of security owners at any given level of stock prices. The ruling on margins recently adopted by the New York Stock Exchange requiring margins of 50 per cent of debit balances for balances under $5000 and 30 per cent for larger balances is a step in this general direction. But as long as margins are related to market values, pyramiding on rising prices is possible, and necessitous selling of impaired ac counts will occur when prices fall. It is, in our opinion, nec essary to relate the collateral value of stocks primarily to earnings rather than to market prices. On this theory we make the following recommendations: 1. It is tentatively suggested that the maximum loan value of a share of stock should be twice the aggregate net earn ings applicable to that share over the five years next preced ing the date of the loan; providing, however, that this loan value shall in no case exceed 60 per cent of the current market price. This ratio should govern all collateral loans by banks, as well as loans by brokers to their customers. 2. Equitable provisions effectuating the above principle should be established for companies in existence, or securi ties outstanding, for less than five years. 3. It is tentatively suggested that the maximum loan value of a bond or other evidence of indebtedness, should be 80
184
per cent of its market value, or 80 per cent of its face value, or 80 per cent of its call (or redemption) valuewhichever of these three is the lower. 4. The Federal Trade Commission should be charged with the duty of currently computing and publishing the loan value of securities. 5. The provisions outlined in this section should be en forced as to loans to customers by brokers through regula tions established by the exchanges and by the licensing Authority. They should be enforced as to banks through administrative regulations adopted and enforced by the Fed eral Reserve Board and the Deposit Insurance Corporation. 6. The above provisions should not be put into effect until sufficient time has elapsed to permit the establishment of the machinery for the evaluation of securities for collateral pur poses; and to enable the banks to adjust their existing col lateral loans, so that the proposed basis for loan values will not result in losses to the banks or their customers. (c) Expected Results The above-described system of determining the loan values of stocks and bonds would, we believe, have the following salutary results. 1. The volume of bank or other credit created to support security transactions would be held within reasonable limits closely related to earning power, rather than to the price, of securities. 2. The flow of credit into loans on fixed assets would be restricted and the safety of such loans thereby increased since they would be made more nearly similar to self-liquidating commercial loans. 3. Speculation for the rise would not be likely to reach
185
extreme stages because advancing stock prices would not furnish additional credit for the margin buyer. 4. Pyramiding would be virtually impossible except to a very minor extent permitted by a rise in corporate earnings over an extended period of time. 5. Forced liquidation on falling markets would be greatly decreased since margins would at all times be on a very conservative basis, and large declines, in general, would have to take place before the occasion for necessitous selling would arise. 6. The activity of speculators would tend to turn toward the more substantial stocks, as evidenced by consistent earn ing power. 7. Conversely "wild cats, "prospects, "mystery stocks and the like would become less desirable media for specu lation. 8. Both investors and speculators would tend to become "earnings conscious instead of "ticker conscious. 9. There would be a wholesomely conservative influence exerted on investment bankers and underwriters. 10. Subjecting corporate statements to constant analysis of impartial experts would of itself improve the standards of corporate accounting and reporting. (d) Difficulties There are, admittedly, difficulties connected with the es tablishment and operation of the margin system herein rec ommended. A mechanistic basis of determining margins cannot be rigidly applied in practice, and it is not our thought that it should be. What in our opinion is important is the principle of re lating loan values to corporate earnings, instead of to the market value of securities. The details of the procedure must be devised after careful thought and experimentation, and
186
they must allow for a flexible administration. Thus, it may be found necessary to establish different ratios for different classes of stocks, for different industries and even in excep tional cases, for individual companies. Other factors besides earnings may have to be taken into consideration to prevent injustices. There will undoubtedly have to be special provi sions for new corporations, merged or reorganized corpora tions, foreign corporations and other special categories. Then there is a whole series of problems arising out of the matter of determining what the true earnings of a corporation are, a problem which may assume large proportions, especially in the case of oil and mining enterprises. The mere task of building up and then administering the organization required to analyze corporate reports and to determine and publish loan values is formidable indeed. These and still other difficulties, however great, are not insuperable and should not be permitted to stand in the way of the establishment of what to us seems to be the only essentially sound and effective system of coping with the abuses of margin buying of securities which periodically in the past have had such disastrous results.
i. SHORT SELLING
(1) The Problem Our study of short selling has led us to the conclusion that while this practice fails in large measure to perform the useful functions which its proponents claim for it, it also does not in the aggregate cause the havoc to the general price structure with which its opponents charge it. In any discussion of short selling it should always be borne in mind that it is the speculative excesses on the long side which create a condition of the market where short selling can become a disturbing factor. Long buying and
187
short selling are complementary aspects of the same prob lemspeculationand to attempt to solve this problem by an attack on only one of its dual aspects does not promise fruitful results. Yet while it is common to extol those whose activities result in driving prices upward, it is almost univer sal to condemn their speculative counterparts which strive to produce the opposite effect. As we see it no moral question is involved either in long buying or short selling, but only one of utility. To the extent that speculation on either the long or the short side aids the security markets in the performance of their functions, to that extent only should speculation be countenanced. In view of the fact that short selling is relatively unim portant, we do not believe that, as a general technique, it re quires further regulation than now exercised by the New York Stock Exchange. We believe, however, that there is need of more rigorous control in respect to short selling of individual issues at particular points of time, especially where engaged in suddenly and in large amounts. Under such circumstances short selling has a pronounced and de pressing influence upon prices. Our analysis of the net short sales of fourteen securities indicates that when these net short sales become unduly large they invariably cause an abnormal decline in price. (2) Recommendations 1. Exchanges should place restrictions upon the size of short operations in individual issues during a trading ses sion, but, beyond that, short selling as a market technique should not be prohibited. 2. Such restrictions should supplement the present rule prohibiting forms of trading which demoralize the market.1
1 Where in existence; where not, such general rules should be adopted.
188
3. Short sales of unusual size in individual issues within the limits of a single trading session should per se be deemed transactions upsetting market equilibrium and should be prohibited. 4. The minimum margin requirement against short con tracts should be 10 points or 40 per cent of the selling price, whichever is the greater. 5. Exchanges should be required to publish weekly statis tics on the short position of each listed stock, and monthly statistics on the number of shares of each listed stock held by their members and member firms on the "free list. It might be advisable to provide also for additional "calls three or four times a year at irregular intervals without advance notice in order to prevent possible "window dressing.
j. SPECIALISTS
( l) The Problem The system of specialists is attacked on the ground that it gives a preferred position in the market to a group of stock exchange members, through which they benefit at the expense of other members, and particularly at the expense of the investing and speculating public. The advantage to the specialist arises from the fact that he has the "book in a given stock and from this he knows at any moment the market position of that stockthat is to say the bids below the market and the offers above, as well as the stop-loss orders below and above. Since he is permitted to act as a broker and also to trade on his own account,1 his inside information on market position gives him superior bar1 He may not, of course, act as broker and principal in the same trans action, and his trading activities are subject to rules designed to protect the interest of his customers.
189
gaining power over those who trade with him. Furthermore, his interests as a trader are necessarily in fundamental con flict with his duties as a broker, even though in each specific transaction he acts only in the one or the other capacity. Those who defend the system, while conceding that the specialist has an advantage, argue that in return he renders valuable services in maintaining a closer, a more continuous and a more orderly market than could exist without him. By virtue of his function as trader, they maintain, the value of his services as broker are enhanced. The data bearing upon the work of the specialist do not fully support the contention of either the proponents or opponents of our specialist system. That the activities of the specialist on his own account, or the account of his firm, help "make a market is apparent. However, the specialist does the least trading in the relatively inactive stocks, which on the New York Stock Exchangeand doubtless on all exchangesform the great bulk of securities. It is in the inactive stocks that there is the smallest degree of price con tinuity. And so just where the specialist is most needed in his trading capacity, there he is least in evidence. After careful consideration of the evidence bearing upon the work of the specialist, and after consultation with numerous persons of informed opinion, we have reached the conclusion that the services rendered by the specialist are not of sufficient value to warrant the continuation of a condition where a small group of persons is given a preferred position in the market. We believe that the services we look for from a specialist can be more efficiently performed, and at a lower cost, under a different system, such as the one which we shall suggest. In making this statement we do not intend to reflect upon the integrity of the specialist members of the New York
192
times to full information as to the orders in the hands of a specialist.1 5. All transactions of stopped stock should be reported on the tape. If it is felt necessary to identify transactions of this type, a special symbol can be used for that purpose. (3) Effect of Recommendations The recommendations we have suggested would drasti cally change several important aspects of the present organization of security trading on stock exchanges. The separation of the trader from the broker function would certainly not please those members who are now practicing both. It is, however, such an urgently needed reform that the personal welfare of a small number of individuals can not be permitted to stand in the way. It is possible that a considerable number of specialists would not care to con tinue as specializing brokers if prohibited from trading. In that event there would be more stocks to distribute among those who chose this branch of the security business. Taking away the virtual monopoly on information on the market situation would also be unpopular with those who now enjoy it. There is, however, no reason we can see why
1A suggested method for handling orders left with specialists is outlined below. This applies particularly to conditions on the New York Stock Exchange. a. In respect to all relatively inactive stocks which, according to our classifi cation, number about 1,000 out of a total of about 1,300 issues, bids and offers should be filed in cabinets similar to those now used for bond orders and for orders in the present so-called inactive stocks, i.e., those in which the unit of trading is ten shares. b. In respect to the approximately 300 relatively active stocks, the special izing brokers should keep books as heretofore, except that the information in the books should be available to all members who ask for it. Thus for both the active and inactive stocks each person desiring to buy or sell securi ties would be enabled to enter the market on an equal basis with every other in respect to his knowledge of the market position of a particular stock at a particular moment.
193
any group of persons entering the market should be given an advantage over any other when this can be prevented. We believe that our recommendations would tend to re strict the volume of speculation, and this, in our opinion, is another feature that commends them. Perhaps for this reason we would have markets less close than today, though that would probably not be so in the great bulk of inactive stocks which do not enjoy close markets as it is. But even if that were the effect, to whom would it matter? Who benefits most from a close market? The speculator, obvi ously, especially the "in-and-outer. What the investor is primarily interested in is a market that is orderly and sure, a market as free as possible from manipulation. Under those circumstances a market that is somewhat wider than it might otherwise be is of no importance.
k. POOL ACTIVITIES
(1) The Problem Wall Street commonly distinguishes between "legitimate pools and "illegitimate pools, but the validity of this dis tinction is open to question. This, however, need not con cern us here. Whatever regulation and control of pool ac tivity is deemed necessary and advisable must be applied to all pools. It would not be practicable to subject each pool to analysis and to formulate special rules to fit each circum stance. As a matter of fact, any pool which seeks to bring about a change in the price of a security through manipula tion is "illegitimate according to our definition, inasmuch as it thereby lessens the efficiency of an exchange in the performance of those functions which, as we indicated, are the only justification for its existence. No exception can be made for the pools and syndicates organized to support a new issue in the open market until
194
it is absorbed by investors. These, as a rule, are merely mani festations of the fact that the new issue was brought out at a price too high to attract a spontaneous investment demand. The show of strength in the market is intended to tempt the investor to buy at a price which the under writers and distributors know is not likely to be maintained without artificial support, and which will not hold once that support is withdrawn. Thus, for example, a study of bonds offered between the years 1924 and 1932 shows that more than three-fourths broke the offering price within six months. It is maintained that investment bankers could not dis tribute large amounts of new capital issues without resort ing to the practice of "pegging. Perhaps in competition with pegged issues, an issue offered under conditions of a free and natural market would fare badly. If, however, it became an established and recognized custom not to peg any offering, there is no reason to believe that investors and speculators would not buy reasonably priced issues at the offering figure. This is the situation in England and, making due allowance for differences in customs, habits and tem perament, there is no reason to believe that the English system of distributing new securities could not be made to work in this country. It is our conclusion that it is the element of manipulation and the mechanism this brings into play that is bad; not the mere fact that two or more persons combine in a mar ket operation. An individual with sufficient resources can do exactly what a pool does, and do it perhaps even more effec tively because of undivided leadership and responsibility. So can an institution. Conversely, mere joint action is, in the absence of manipulation, not distinguishable from indi vidual action. Therefore, what we must seek to regulate and control are manipulative activities such as are ordinarily
195
practiced by pools, syndicates, joint accounts and the like, but which may be indulged in also by individuals or by institutions.1 We believe, furthermore, that this is more promising of good results than an attempt at outright pro hibition of pool activity. The latter course would be difficult to enforce since evasions through concealment as well as through subterfuges of all sorts would be a comparatively simple matter. The stock exchanges are able to exert some measure of control over pools, but their direct authority extends only over their own members. Non-members can and do run pools and they are, of course, immune from discipline by the exchanges, though the members who execute their orders are subject to discipline. The New York Stock Ex change has repeatedly claimed that its efforts to halt what it regards as illegitimate pool operations have been largely nullified by the fact that outsiders are usually responsible for such unsavory operations. Two observations may be made in respect to this claim. The first is that the Stock Exchange is not interested in stopping pools as such, but only in preventing those activi ties, indulged in by some pools, which it has proscribed, such as wash sales and efforts to demoralize the market. The second observation is that we must take with a grain of salt the assertion of the New York Stock Exchange that it has no control over the activity of non-members. It has, of course, no direct control, but through its member firms it can exert influence over the trading public. Since August 1933, the Exchange has required from each member and member firm a weekly report on all pools, syndicates and joint accounts in listed securities in which they are directly or indirectly interested or of which they have knowledge by
1 W e shall generally speak of "pools, but the term should be understood in its broader implication of a price-manipulating agency, however set up.
196
reason of transactions executed by or through them. It also has required a like report in respect to all options. Literally interpreted, knowledge can be disclaimed when ever a customer does not definitely state his pool or option connection. As a matter of fact, however, the experienced floor membersbrokers, traders and, above all, specialists can almost invariably detect pool operations in a stock, if at all extensive. They can do this even where the outside pool operator divides his orders among a number of brokers. If all instances of suspicious behavior of stocks were promptly reported to the appropriate committee, invesigations of brokerage house accounts and of the records of the Stock Clearing Corporation would in almost every instance reveal the precise nature of the operations that were taking place. We conclude, therefore, that if the New York Stock Exchange, and the other security exchanges, had a real desire to do so, they could detect and control pool ac tivity on the part of outsiders, not as readily, perhaps, as where their own members are concerned, but with appre ciable effectiveness none the less. It seems essential to reduce as much as possible all manipulative activity, and this can best be accomplished, not by a direct attack upon pools as such, but by an attempt to control the weapons and the machinery employed by pools. Most of the measures designed for this purpose have al ready been outlined in this chapter under the various specific heads under which they properly fall and where they have an application beyond their relationship to pool activity. Some of the more significant are repeated below to show their particular significance in relation to pool operations. A pool cannot be successful unless the public comes into the stock in which it is operating. It must find sellers when it wants to buy and buyers when it wants to sell. Perhaps it would be more accurate to say that it must be able to
197
"create these buyers and sellers when it needs them. Though members on the floor generally know at an early stage that there is pool activity, and frequently are able to make money by "riding with the pool, the rank and file of the public speculators and investors does not know until the pool wants it to. The more completely and the more promptly the activities of pools are exposed, the more discouragement is there to pool operations. Probably a very large proportion of pools that would otherwise be instituted would never even attempt to get under way if they were sufficiently well advertised at the right time. They would have too much company at one stage and too little at another. (2) Recommendations 1. Each security exchange should require weekly informa tion from its member firms as to the organization of pools, syndicates and joint accounts, and as to the granting of op tions. There should be severe penalties for failure to report, or for reporting false or misleading information. 2. The information thus received should be promptly re leased by each exchange for publication each week in summary form. 3. Each security exchange should require all its floor mem bers to report promptly to an appropriate committee all activ ity in stocks which indicates the presence of pool operations; and the committee should be obliged to investigate all such reports immediately and to publish its findings promptly. 4. To insure more adequate information, however, we must look to the corporations. For this reason there must be a Federal Incorporation Law, as previously recommended. Charters issued under this law would require, among other things, it will be remembered, that all transactions of offi cers and directors in the securities of their own corporation be promptly reported; and that all options granted by them
198
in their own securities be likewise reported. Our study of pools indicates that a large proportion of pools trade against options, and that a large proportion of the options are granted by officers and directors of the corporation in ques tion; and that these officers and directors also frequently participate in pools. Full publicity on such transactions by directors and officers would do much to force a sense of trusteeship upon those whose actions suggest that they re gard their corporations as their personal property. 5. Pools thrive on secrecy and mystery. Publicity would be the most effective deterrent of manipulative activity. It is also advisable, however, to attack the problem at the other endto squeeze the mystery out of the securities dealt in by any pool which either succeeded in evading publicity, or attempted to operate in spite of it. For this reason we once more recommend a Federal Incorporation Law, this time having in mind its function of regulating corporate accounting and reporting. Prompt, full and accurate finan cial reports by all corporations whose securities are in the hands of the public would further add to the difficulty of pools in attracting a following, and would therefore dis courage their practices.1 6. Pools unquestionably use news and propaganda media to stimulate public interest. Not only the out-and-out tipster sheets, but even the most reputable daily newspapers are made use of by pool managers. We recommend that the flow of financial propaganda be controlled as far as legally possible, and as far as consistent with freedom of the press. The stock exchanges can help by exercising closer super vision over the market letters and circulars of their members.
1 A Federal Incorporation Law would, of course, apply only to the securi ties of corporations engaged in interstate commerce. It would still be neces sary to rely on State laws and on stock exchange regulations in respect to those corporations engaged in strictly intra-state business.
199
The legal department of the States can, perhaps, be more zealous in detecting and prosecuting criminal acts on the part of publications. The reputable newspapers can do much toward raising the standards of financial reporting and the standards of their financial reporters. 7. The trader and broker functions should be separated, especially in respect to specialists. 8. All exchange members, and therefore their customers, should be given access to information as to the market posi tion of a stock as indicated by orders left with the specialist. 9. Brokerage firms should be forbidden to carry any ac counts on their books except in the full names of their true owners. 10. All relevant information on the market, such as short positions and customers debit balances, should be published fully and promptly and in as much detail as possible. We believe that this program in its entirety would go a long way toward effectively reducing the present power and influence of pools. It should be noted that this program en compasses no direct prohibition of pools, syndicates, joint accounts and the granting of options.
1. FINANCIAL NEWS
( l ) The Problem
The investor and the speculator are exposed to a torren tial flow of financial news ranging from the sober reproduc tion of official corporate reports and authentic statistical data, to the publication of the wildest rumors, having little or no foundation in fact. Daily and financial newspapers, weekly and monthly financial magazines, market letters, tipsters sheets and a conglomeration of nondescript pub lications contribute to this flow.
200
Even when honest and well-intentioned, it is doubtful whether, as a whole, these organs of news do more to in form or to misinform their readers when they go beyond reporting and analyzing facts and figures. Often, however, they are not honest but are open to sus picion of willingly lending themselves to the use of stock promoters and manipulators who seek to influence the course of security prices through the use of propaganda. Sometimes a single employee may be corrupted without the knowledge of his superiors. Sometimes the organization itself is cor rupt. Sometimes it is an unwitting dupe of clever machina tions. The worse forms of tipster sheet exist for no other reason than to lure the investor and gambler to their financial ruin. Brokers market letters are issued in most in stances for the purely selfish purpose of exciting speculative fervor. The investigation into stock market practices which was conducted by the Senate Committee on Banking and Currency revealed instances of unblushing corruption of financial reporters. That such things go on is common knowledge in Wall Street. Our own study of pool operations shows that pool activity is frequently carried on behind a barrage of news and propaganda. This does not mean that there is necessarily corruption in every instance, or even in most. But it indicates, in any event, that pool managers and specula tive operators have access to the press and contrive in one way or another to turn its columns to their purposes. When important daily and financial newspapers are thus used it is particularly unfortunate and damaging, because these news papers carry a large measure of prestige and influence and are presumably independent in their news columns. The brokers letters and the tipster sheets bear the stamp of self-interest on their mastheads, and the investor who is beguiled by them has largely himself to blame. Neverthe
201
less, their output should be controlled in whatever way possible. To suggest reasonable, practicable and lawful remedies for the abuses on the part of newspapers and other news agen cies is a nearly hopeless task. Fundamentally, it is a matter of educating the investor and speculator in security analysis and the interpretation of economic data, and weaning him from the influence of rumor and propaganda. It is also a matter of raising the ethical standards and the professional skill of the publishers and disseminators of news. These objectives cannot be closely approached by legislation or regulation. We are, therefore, prepared to make only three general recommendations. (2) Recommendations 1. The Securities Act of 1933 should, as far as possible, be strengthened and broadened in respect to those of its provisions which bear on the publication of news matter about corporations. 2. The several states should show a greater zeal than they have in some instances in uncovering and prosecuting fraud ulent practices on the part of purveyors of news. The Martin Act in New York State, for example, might be more effec tively applied than it has been. 3. Stock exchanges should make fuller use of their power to discipline members and member firms for issuing mis leading advertisements, circulars and market letters. Copies of all such matter published by a broker for distribution among his customers or the public in general should be sub mitted to stock exchange authorities prior to publication; and copies of all such matter as is actually published and dis tributed should be kept on file at a stock exchange for a period of no less than five years.
202
(3) Suggestions to Newspaper Publishers Not as a recommendationbecause the subject lies outside our fieldbut merely by way of suggestion, we urge the daily press to endeavor to serve the investor more adequately and to take rigorous steps to prevent its columns from being so edited as to stimulate reckless speculation on the part of those whose interests would be better served if they refrained from so doing. We suggest, further, that newspaper pub lishers should require all their employees who are engaged in writing the reports of speculative markets, or who, directly or indirectly, are in a position to influence the formulation of such reports, to desist from speculative operations in the stock market.
m . INVESTMENT COUNSEL
(1) The Problem There is unquestionably a useful field for the investment counsel. There are, however, two striking abuses connected with the profession. One is that it has been debauched by an influx of incompetent persons whose only qualification seems to be a record of unsuccessful experience as customers men, brokers or speculators. The other is that the disinterestedness of some investment counsel is open to serious question. We refer, of course, to those who directly or indirectly are en gaged in the underwriting, distribution, purchase or sale of securities. We believe that anyone who entrusts his investment prob lems to an investment counsel is entitled to protection against both these abuses. He should be assured that his financial adviser is possessed of at least certain minimum qualifications and, in addition, that he is free from all entanglements that might divide his loyalties.
203
(2) Recommendations 1. No individual should be permitted by the several states to practice as an investment counsel without a degree of Certified Investment Counsel, and a license to be awarded after proper examination by suitable state authorities. 2. No individual should be granted, or permitted to re tain, a license to practice as an investment counsel for pay who is in the business of underwriting, distributing, buying or selling securities either as a broker or principal; or who is in the employ of, or is in any way affiliated with, or is a stockholder or partner in, any organization engaged in any manner whatever in such activities. 3. No licensed investment counsel should be permitted to employ, or to retain in his employment, any one in any way connected with any activity named or implied in paragraph 2, above; or to associate himself as a partner, joint stockholder, or otherwise with any such disqualified person.
n . STATISTICAL DATA
(1) The Problem Our study has revealed that there is little factual infor mation about security markets, security owners, security speculation, as well as about such fundamental questions as the volume of savings in the investment channels of various kinds. Even of the little there is, all is not currently made public and is therefore not readily accessible. Growing appreciation of the importance of statistical in formation has brought forth over the years an ever-increasing quantity of data illuminating more or less brightly almost every phase of our economic life. Why have security ex changes been largely overlooked in view of this trend and in view of the deep and widespread influences which the activities of these exchanges exert?
204
The most plausible answer to this question is that the stock exchanges have been traditionally resentful of all de mands for information from "outsiders, and fearful that such information would lead to governmental control. As a result they have kept the blinds closed as tightly as possible against the searchlight of publicity, especially when the ac tivities of their members are concerned. There are signs that this resistent attitude has been gradually subsiding, but prog ress is still not as rapid as we might wish. Whether or not our answer is correct, the fact is that there is little information about security exchanges available, while, on the other hand, much is needed. It is our belief that a step of far-reaching significance would be taken by organiz ing the compilation and publication of statistical series relat ing to various important aspects of the market. Some of these would be prepared by the stock exchanges; others by other agencies. The several series suggested below, while not all-inclusive, would supply much information of value to industry, the investor and the government. They would, be sides, serve as at least partial correctives of the abuses in herent in the security markets. (2) Recommendations We recommend the periodic publication of the following data: 1. Total customers debit balances of all member firms by security exchangesmonthly. 2. Combined short position of brokerage house customers by individual stocksby security exchangesweekly. 3. Number of shares of each stock held by brokerage firms on the "free list (i.e., "the floating supply) by security exchangesmonthly as of last day. 4. Number of accounts (not eliminating duplication) of all member firmsby security exchangesmonthly, as of last day
205
a. With debit balances b. With credit balances against short positions c. With free credit balances (i.e., not against short posi tions) d. Total. 5. Combined member firms balance sheetby security ex changesmonthly. 6. Purchases and sales of officers and directors in respect to securities of their own corporationby Federal Trade Commissioncurrently. 7. Options granted or exercised by officers and directors in respect to securities of their own corporationby Federal Trade Commissioncurrently. 8. Number of dividend receiversby Bureau of Internal Revenueannually, by income groups.1 9. Number of receivers of interest on funded securities by Bureau of Internal Revenueannually by income groups.1 10. Number reporting capital gains and capital losses from security transactionsby Bureau of Internal Revenue annually by income groups.1
4. Scope o f R e c o m m e n d a t io n s
Our program, it should be borne in mind, has for its main objective the control of speculation for the purpose of pro tecting the banking structure and the commerce of the United States. We have sought to indicate the methods by which this result can be brought about. The most important planks in our platform are Federal licensing of security exchanges and of over-the-counter dealers, on the basis of stipulated mini mum requirements; a Federal Incorporation Act embodying
1 Consideration should be given to the advisability of extending the require ment of filing an annual income tax return to all income receivers, and of imposing a filing fee of 25 or 50 cents. Exceedingly valuable information on the distribution of income would thereby be obtained.
206
minimum standards of corporate practices and of the prac tices of corporate officials; the establishment of an earnings standard as the basis for collateral loans on stocks; the sepa ration between dealers in securities and commission brokers, with no one permitted to exercise both functions; the collec tion and publication of comprehensive statistics on all important phases of stock market operations. The details of our plan are limited to what seems necessary for the sake of clarity. Recommendations concerning the minutiae of the technique of trading have largely been avoided. It was not the purpose of the survey to draw the exact blueprints for a reconstructed system of security ex changes, but rather to sketch the broad outlines of the struc ture that is needed. The preparation of the blueprints is the task of technical experts working through the Congress and through the security exchanges themselves. The program should be regarded as a "working hypothe sis. All the findings of the investigation indicate that this program is sound and practicable and that it will bring about the desired results, if intelligently effectuated, as an inte grated whole, and if honestly, efficiently and wisely admin istered thereafter. Nevertheless, each recommendation must pass the test of time and trial before it is finally accepted as sound. That some modification and revision will be found necessary is inevitable in any plan which seeks to make fun damental changes in a mechanism as sensitive, as highly organized and as complicated as is our system of security exchanges.
5. E ffe c t o f R e c o m m e n d a t io n s o n Se c urity B u sin e ss a. im m ed ia te effec ts
The immediate effects of a substantial reduction in the volume of speculative transactions in securities would doubt
207
less be unfavorable to the immediate interests of investment bankers, brokers, stock exchange members, and their em ployees. Subsidiary businesses, such as the engraving of stock certificates and the work of transfer agents and registrars, would also be adversely affected. From top to bottom, the security business would offer fewer employment opportuni ties. Stock exchange seats would decline in value. The New York Stock Exchange would probably not be able to support its present membership "in the manner to which it is accus tomed. In general, the business would undergo a process of partial deflationpainful to all those dependent upon it. This aspect of the results of a program to reduce specula tion must be faced. There is no use attempting to conceal the fact that our vast and long-established institution of security exchanges cannot be overhauled and reconstructed without causing some stresses, strains and hardships in the process. That we are prepared to recommend such a program, fully aware of these consequences, is the strongest possible evi dence of our conviction that it is essential for the national welfare to squeeze a sizeable proportion of speculation out of the security markets. The pecuniary interests of a rela tively small group of persons cannot be allowed to stand in the way of changes which will benefit the much larger group of savers and investors and of corporate borrowers. The existence of an active and continuous market under the present system of security exchanges is one of the bless ings we are asked to treasure and preserve. But the point is seldom made that it is the speculator and not the investor who reaps the lions share of whatever benefits arise from activity in trading and continuity in prices. To the speculator especially to the short term, in-and-out speculatorthey are of overwhelming importance. To the genuine investor, excessive activity and perfect continuity are less important
208
than close conformity to real value. He wants them only if their cost is not too high. Under our program, the speculator would have to operate in a less active, less continuous and less mercurial market. If he wished to persist as a speculator he would have to adapt himself to changed conditions, and to the extent that he were successful he would contribute something of value to the security markets which would justify his speculative activi ties. We do not want markets for the benefit of speculators, but speculators for the benefit of markets.
b. LONG-TIME EFFECTS
Once the transition period has been passed and the neces sary adjustments have been made, the security business should, we believe, rest on a firmer and more reliable foun dation than it ever has before. The type of market and the form of organization which we envisage as the outcome of our program should ultimately produce results which would be beneficial to those in the security business. If confidence in the integrity of the security markets were built up, if there were a justifiable belief that security mar kets actually were "free and open, that all buyers and sellers met on substantially equal terms, that the outsider was not victimized by the insider, that pool activities did not distort investment values, that brokers could be relied upon to give undivided loyalty toward their customers, that reckless specu lation would not occur, only to bring disastrous collapse if, in short, a new atmosphere of this sort could be created, the response would be a greater investment interest in secu rities and a consequent improvement in all phases of the security business. In the long run the brokerage business will be on a sounder basis if the attitude of the American people toward it changes from hostility to approval. But before such a change in the
209
publics attitude can be expected, the brokers and the ex changes must offer assurance that they will so conduct their business as to make a substantial contribution to the economic welfare of the nation at a cost which is not excessive. Oppo sition to legislation reasonably and intelligently designed to reduce the volume of speculation would doubtless be inter preted as a declaration of adherence to a policy of selfinterest and neglect of the public welfare.
TH E EN D

Stock Market Control

Încărcat de

Informații document

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Stock Market Control

Încărcat de

Drepturi de autor:

Formate disponibile

STOCK MARKET CONTROL

TWENTIETH CENTURY FUND, INC.

Edward A. Filene, President

Newton D. Baker Bruce Bliven Henry S. Dennison

John H. Fahey James G. McDonald Roscoe Pound

Evans Clark, Director

11 WEST 42ND STREET NEW YORK CITY