Bypassing Wall Street


                                               The Traffic Cops on Wall Street


Plenty of government departments have been set up to police Wall Street.  The problem is that they operate like the old protection racket—“We’ll let you get away with doing wrong—and chase away your competitors—if you pay us off.”  For elected officials, the payoff is campaign contributions and other favors.  For government employees, it is the offer of high-paying jobs after they’ve put in their time in “public service.”

President Andrew Jackson complained in 1833 that a banking corporation “had been actively engaged in attempting to influence the elections of the public officers by means of its money” and asked “whether the people of the United States are to govern through representatives chosen by their unbiased suffrages or whether the money and power of a great corporation are to be secretly exerted to influence their judgment and control their decisions.”  []

President Woodrow Wilson described the problem:  “We have been dreading all along the time when the combined power of high finance will be greater than the power of government. . . . If the government is to tell big business men how to run their business, then don’t you see that big business men have to get closer to the government than even they are now?  Don’t you see that they must capture the government, in order not to be restrained too much by it?  Must capture the government?  They have already captured it. . . .  Nevertheless, it is an intolerable thing that the government of the republic should have got so far out of the hands of the people; should have been captured by interests which are special and not general.  In the train of this capture follow the troops of scandals, wrongs, indecencies with which our politics swarm."  [Woodrow Wilson, The New Freedom: A Call for the Emancipation of the Generous Energies of a People, BiblioBazaar, 2007, pages 102, 23] 

President Franklin Roosevelt put it most colorfully:  "For out of this modern civilization economic royalists carved new dynasties. New kingdoms were built upon concentration of control over material things. Through new uses of corporations, banks and securities, new machinery of industry and agriculture, of labor and capital—all undreamed of by the fathers—the whole structure of modern life was impressed into this royal service.  There was no place among this royalty for our many thousands of small business men and merchants who sought to make a worthy use of the American system of initiative and profit. They were no more free than the worker or the farmer."  []  

George Stigler, a Nobel Prize Laureate in economics, built a career on the study of this “capture theory” of economic regulation.  His central thesis is that “as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.” [George Stigler, The Theory of Economic Regulation,   University of Chicago, The Rand Corporation, 1971, p. 3.  See, also, George J. Stigler, “The Theory of Economic Regulation,” The Bell Journal of Economics and Management Science, 1971,]  At the level of the individual elected or appointed official:  "Nearly everyone in government has 'clients' to protect or advance, sponsors who often helped put them there."  [William Greider, Who Will Tell the People: The Betrayal of American Democracy, Simon & Schuster, 1992, page 66.  ON page 258:  "If one asks, for instance, why the Democratic party never did anything during the 1980s to confront the various abuses and instabilities unfolding in the financial system, a power analysis of the party establishment might provide the answer. . . . The nation's leading banks and brokerages have assembled a formidable team of Democrats to protect them from hostile legislation [listing the names]." ]  The regulated industry "owns" its regulatory agency, while industry members and lobbyists "own" the individual regulators and legislators.


Part of a protection racket, or capture theory, is for everyone involved to deny what is really going on and to have a consistent cover story.  That cover story needs to say that what’s happening is a legitimate activity, one that we all need; that it’s true there have been some rogue participants but we’re taking care of them.  Simon Johnson and James Dwak call this "cultural capital: the spread and ultimate victory of the idea that a large, sophisticated financial sector is good for America."  [13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, page 90]  Matt Lauer, on the Today television show for April Fools’ Day, 2010, asked Treasury Secretary Timothy Geithner, former president of the Federal Reserve Bank of New York, about policing Wall Street.  Geithner acknowledged that the recent past “was a crazy way to run a financial system” but that Wall Street was needed for “taking the savings of Americans and using those savings to finance growing businesses.”  This is the myth of capital formation, the cover story for protecting Wall Street’s monopoly for trading in securities.  The truth is that only a very tiny percentage of Wall Street’s activities move money from individual savings into growing businesses.


Wall Street should be a place where ethics prevails.  Its people are trusted with moving huge amounts of money in complex, secretive transactions.  It would seem that the most honest and fair individuals and firms would also be the most successful.   It doesn’t work that way.  Whatever ethical standards may have become a person’s character seem to be shed by the time they are in a Wall Street career, like a snake wiggling out of its skin.  What replaces those discarded ethics are rules.  Instead of guidance from within, life becomes governed by external stop lights, flashing go, stop and proceed with caution.  The question before action is not, “Is this right?”  It has become, first, “What’s in it for me?” Then, “Is this permitted?” and, if not, “Will I get caught?” 


Government Enables and Enforces Wall Street’s Monopoly 


From the beginning of securities regulation, it has not been about safeguarding the public.  Emphasis has always been placed on protecting the financial intermediaries from competition.  “A statute of Edward I, in 1285, authorized the Court of Aldermen to license brokers in the City of London, and there are records of a number of prosecutions against unlicensed brokers before the year 1300.”  [Louis Loss, Joel Seligman, Troy Paredes, Securities Regulation, Aspen Publishers, supplemented annually, Volume 1 of an 11 volume set, “Background of the SEC Statutes.”]  The English government established and enforced standards for licensed brokers, just as the English and United States governments do today.  A 1697 English statute set penalties for unlicensed trading in securities.  It also established fixed commission rates and required every transaction to be recorded.  Our Securities and Exchange Commission is still in that role, except that most fixed commissions haven’t been enforced since 1975.


Also just like today, the government in England was called upon to do something about a financial crisis three centuries ago.  Shares of the South Sea Company, which had been granted a monopoly on trading with South America, had risen from £128 at the beginning of 1720 to over £1,000 in July of that year and were back down to £125 by December.  Directors of the Company had sold £5 million of its stock at the top.  The government response was called the Bubble Act of 1720 and it was directed at preventing imitators of the South Sea Company’s business.  The only real sanction was that brokers trading in the imitator companies could lose their license and pay treble damages.  This mismatch between the wrong and the remedy foreshadowed how governments would deal with later collapses, including the 2008 credit crisis.


In the same year we created the United States, insider trading by a broker caused the first “panic” and the first government reaction.  Securities traders and their agents had been meeting in a Wall Street coffee house to conduct the “open outcry” auctions that still take place on trading floors.  After the panic, New York State passed a law prohibiting “public stock auctions.”  The Wall Street coffee house regulars took that law as an invitation to create a monopoly.  They gathered under a buttonwood tree on Wall Street and agreed to a members-only market, escaping the prohibition on “public” auctions.  In their one-sentence agreement, they fixed a minimum commission for all members and agreed to give each other “preference.”   Neither this monopoly nor the price-fixing was disturbed by the government for nearly 200 years.  In fact, Congress placed the police powers of the SEC behind enforcement of rules made by members of the stock exchanges and the brokers’ trade association.   


The United States government has a particular conflict when it comes to reining in Wall Street.  Throughout our country’s history, the federal government has often found that it absolutely needed Wall Street to raise money for its own purposes.  The War of 1812, the Mexican War and the Civil War were largely financed through the connections of investment bankers to wealthy Europeans and Americans.  In 1894, President Grover Cleveland failed at selling Treasury bonds in Europe.  He then went to the leading investment banker of the time, J.P. Morgan, who sold the bonds and later issues as well.


When the government was unable to stop the Panic of 1907, Treasury Secretary George Cortelyou traveled to New York to ask Morgan to lead a rescue of Wall Street brokers.  After Cortelyou got the Treasury to deposit $25 million in New York banks, and John D. Rockefeller committed another $10 million, Morgan pressured the banks to lend $25 million to “cash-strapped stockbrokers, who have been unable to borrow and are facing ruin.”  Morgan bailed out New York City by placing $30 million of its bonds and even persuaded the city’s clergy to preach sermons calling for calmness and confidence. [Federal Reserve Bank of Boston, Panic of 1907,

The government has protected Wall Street’s monopoly by requiring anyone in the business of selling securities to be licensed by Wall Street’s own trade association, first the Investment Bankers Association, then the National Association of Securities Dealers and now the Financial Industry Regulatory Authority.  Attempts by other segments of the financial industry to muscle in on investment bankers have been stopped by the government.  Back in 1900, life insurance companies posed a serious threat to the underwriting business of investment bankers.  With the large capital they built to pay insurance claims, they could buy and resell new issues of securities.  The New York legislature appointed the Armstrong Commission in 1905.  Acting on the committee’s recommendation, the New York legislature prohibited life insurance companies from underwriting securities.  By 1907, twenty states had banned the practice and a major source of competition was quashed.  A similar encroachment by commercial banks was eliminated by the Banking Act of 1933.  Charles Evans Hughes, the committee’s chief counsel went on to become New York Governor, Republican candidate for President against Woodrow Wilson, Secretary of State, Chief Justice of the Supreme Court and founder of a Wall Street law firm.


The Federal Reserve Subsidizes Wall Street


When J.P. Morgan died in 1913, Congress replaced him by creating the Federal Reserve Board and its regional banks.  The Fed operates as a fourth branch of government, owned by its members, which now include Wall Street investment banks.  Its powers are immense, affecting the economic lives of everyone on the planet.  The law has given Wall Street the power of the U.S. government over the supply of dollars and the cost of money.  Its basic purpose is to do what J.P. Morgan did—save the Wall Street monopoly from itself.  [William Grieder, Secrets of the Temple: How the Federal Reserve Runs the Country, Simon & Schuster, 1989]


Wall Street justifies its existence as being necessary to transform customers’ available cash into loans and securities, which provide money to businesses and governments.  Like any other intermediary, it needs to have a profitable spread between the cost of the money it acquires and the return on the money it provides.  That spread is not always available in the open market.  That’s where the Federal Reserve comes in.  The Fed has a bottomless supply of money and it has the power to set whatever interest rate it wants.  So all it has to do is make that money available to its member banks, at a price that allows the banks to make a profit, which they can do simply by lending the money back to the federal government, through purchasing Treasury securities. 


This recycling of taxpayer money, with Wall Street siphoning off its percentage, has immense consequences for the rest of us.  By keeping short-term interest rates artificially low, and Fed borrowings plentiful, banks don’t need to pay individuals higher rates to get their money.  That’s nice for the banks, but what about all the individuals who rely on interest income from insured bank deposits for their rent and groceries?  "When they say the economy, they mean—the Fed means its constituency: the banks. And the banks’ product is debt. And that’s what they’re trying to produce."  [Michael Hudson, Amy Goodman and Juan Gonzalez, “Fed Creates Hundreds of Billions Out of Thin Air:  Have We Launched an Economic War on the of the World?,”, radio interview transcription at]    Wall Street's customers are big businesses and Federal Reserve policy is implemented to make big businesses increase their bank borrowings and bond issues, while minimizing their default rate.  It doesn't seem to matter if the Fed's actions ignore, or harm small business.  [Scott Shane, "QE2 Will do Little to Help Small Business," Bloomberg Businessweek, November 30, 2010,


The only member of the Fed’s Open Market Committee who currently dissents from keeping interest rates even lower than inflation levels is Thomas Hoenig, president of the Kansas City Federal Reserve Bank, who says:  “I really don’t think we should be guaranteeing Wall Street a margin by guaranteeing them a zero or near zero interest rate environment. . . . [T]he saver in America is in a sense subsidizing the borrower in America. . . . We need a more normal set of circumstances so we can have an extended recovery and a more stable economy in the long run.”  [Quoted in “The Weekend Interview” by Mary Anastasia O’Grady, The Wall Street Journal, May 15-16, 2010, page A13]

The States and the Supreme Court Fashion Corporations to Serve Wall Street


For a prospective investor, becoming a partner in a business is a major, potentially life-changing decision.  Even a small investment as a partner has the effect of putting all of one’s eggs into a single basket.  The new partner’s entire property and future income could be taken away if the partnership went under.  Then there is the issue of management.  In a general partnership, all partners have equal votes, no matter how active they are in management.  There is no weighting for how large or small their investment may be.  Finally, ownership interests in partnerships are hard to sell.  Without some special agreement, anyone buying a partnership interest can’t become a partner without the consent of all the other partners.  Because of the unlimited liability feature, no one in their right mind would become a partner in a business without a thorough investigation of the other partners.


To meet these weaknesses in partnership investing, the corporation evolved from the charters that had been granted by kings and queens “to pursue their dreams of imperial expansion.”  It “brought together the three big ideas behind the modern company: that it could be an ‘artificial person,’ with the same ability to do business as a real person; that it could issue tradable shares to any number of investors; and that those investors could have limited liability (so they could lose only the money they had committed to the firm).”  [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, pages xvi, xvii]


It was the use of corporations that made Wall Street possible.  Well into the 1800s, most American businesses, even large ones, were conducted as partnerships.  Raising money to finance partnerships was a very personal matter.  Bringing in a new partner meant letting someone else become part of top management, since each partner must approve any serious business decision.  It also meant that all the partners had their entire personal wealth open to being taken away by creditors of the partnership.  One big mistake in judgment by a single partner could bankrupt every one of the partners. 


Selling a partnership interest could be nearly impossible, since the buyer had to be accepted by the other partners and the new partner could be blindsided by personal liability for what the partnership may have done in the past.  This meant there was little room for a Wall Street intermediary in selecting and approving a new partner.  By contrast, corporate shareowners have no personal liability—they can only lose the amount they paid for their shares.  Those shares are freely tradable and corporate managers don’t much care who owns shares in the corporation. 


Wall Street makes most of its profit from trading in corporate securities. It collects commissions for finding buyers for newly issued shares and makes far more by operating a trading market for the shares.  Even greater profits have come from manufacturing and trading in derivative instruments based upon corporate securities.  Wall Street had a great interest in having corporations be the entity of choice for all business ventures. 


The federal government has mostly stayed away from chartering corporations, leaving that prerogative to the states after James Madison, at the Constitutional Convention, tried to include chartering corporations in the powers of the federal government.  At first, state governments had serious public policy standards for granting a business the right to operate as a corporation.  In exchange for letting investors escape personal liability, and giving them free transferability of their investments, the states granted corporate charters only for specific business purposes.  The initial charters would expire in a few years and would not be renewed if the conditions had been ignored.


Corporations are still created by state governments today, except for a few special industries that need federal charters.  Competition among the states for incorporation revenues led to what has been called “chartermongering,” a “race to the bottom” in permissiveness for corporate management.  [Thom Hartman, Unequal Protection: The Rise of Corporate Dominance and the Theft of Human Rights, Berrett-Koehler Publishers, Inc. 2002, page 134]  The first corporate charters were limited to a specific purpose, for a term of just a few years, and could be revoked if management stepped outside the granted authority.  By the early 1900s, some state legislatures could still terminate corporations for failing to comply with their responsibilities.  After a few more years of lobbying state legislatures, a corporation could engage in “any lawful business” and for a perpetual term.  [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page 46]  Delaware has chartered more corporations by far than any other state and a fourth of its total tax revenues come from corporate licensing fees.  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2008, page 30; Richard L. Grossman and Frank T. Adams, Citizenship and the charter of corporations, The Apex Press, Council on International and Public Affairs, 1993,; research by Jane Anne Morris, summarized by Thom Hartman, Unequal Protection: The Rise of Corporate Dominance and the Theft of Human Rights, Berrett-Koehler Publishers, Inc., 2002, pages 75-76]


While state governments were accommodating Wall Street by removing restrictions on the use of corporations, the United States Supreme Court kept defining corporate powers and protections to be more and more like those of human citizens, beginning with the Dartmouth College case in 1819 [] through to the Citizens United case in 2010. []  Corporations still don’t have the rights to vote, hold office or bear arms.  However, in several ways, corporations have greater rights than those of individuals: they can live and accumulate property forever, while their owners’ liability to outsiders is limited to the amount they have actually paid into the corporation for their shareownership—usually a tiny fraction of the earnings that have been retained in the corporation.  And they don't get executed or put in prison for crimes.


These parallel government actions, by the state legislatures and U.S. Supreme Court, gave Wall Street the feedstock it needed to become America’s largest industry.  The Supreme Court said a corporation had nearly all the rights and powers of a partnership or individual, plus a few more.  The states said a corporation could be in any lawful business and stay alive forever.  The courts and legislatures carefully protected shareholders from any responsibility beyond the money they used to buy their shares.  The government had handed Wall Street the essential tools for operating a stock market and expanding into markets for derivative securities based upon corporate shares.


The “Watered Stock” Red Herring


In the years just before and just after 1900, Wall Street built its basic meal ticket by consolidating thousands of businesses into a few large corporations.  In addition to the fees generated by effecting the mergers and placing securities, trading commissions came as markets were created for millions of shares of common stock issued in the consolidated corporations.  From the perspective of most Americans, the result was the disappearance of competitors in several industries.  Their elected representatives responded to the voter uproar with an attack on monopolies, like the Steel Trust, the Sugar Trust and the Money Trust.  The focus of alarm was on efforts to pass and enforce antitrust laws.  Only later would attention turn to the role of Wall Street in arranging the monopolizations and issuing the securities to carry them out.


The tool that Wall Street used in creating the giant corporations was the ability to grossly overpay for the businesses being merged.  New Jersey had led the way in loosening standards for corporate charters, so that a corporation could issue shares to acquire other businesses.  The amount of new shares paid to the sellers could be set without any limits.  This led to what was called “overcapitalization,” or “watering the stock.”  It also created millions of shares for trading, usually on the New York Stock Exchange.  “Overcapitalization allowed promoters to issue enough shares to induce the industrialists to sell their plants into the giant combinations and to pay themselves huge fees.  It was also how they created the modern stock market.”  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 58]   


Many of the businesses incorporated in the boom years after the Civil War had become owned by the children and grandchildren of their founders.  These later generations were often happy to exchange their shareownership for spending money and financial security.  Since Wall Street brokers had exclusive access to the stock trading markets, they were paid for selling shares in the new holding companies exchanged for the inherited businesses.  Buyers in the new holding company weren’t concerned with paying for watered stock.  They were counting on the gain from owning a monopoly business. 


The practice of watering the stock is said to have been brought to Wall Street by Daniel Drew, who had been a cattle drover before he took up corporate finance.  He would feed his cattle salt as he drove them to the market, not letting them drink until just before he arrived.  They weighed in freshly bloated with water and sold for more than they would have otherwise been worth.  He carried the same technique over to issuing stock in amounts well over the value of the business.  Government and the media set up watered stock as the evil that came from the corporate consolidations, one “that proved, in the end, to be a red herring that diverted them from their main task in the long struggle to regulate competition and protect consumers from monopolies. . . . While reformers’ attention was diverted, overcapitalization during the merger wave created the modern stock market. . . . The problem of overcapitalization is a key to the triumph of finance over industry and to the shape that regulatory efforts to control giant corporations took.”  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, pages 59, 60]


The first big government investigation of investment banking came from the Industrial Commission, appointed by President McKinley and active from 1898 to 1902.  It looked at the practice of combining several businesses into a new corporation and selling its securities to the public.  The Commission found that the price to the public was far greater than the value of the assets, referring to it as “watered stock.”  No action was taken.  The government’s reaction to Wall Street’s drive to merge entire industries into one big corporation continued to focus on overcapitalization—the issuance of more shares in the new corporate giants than could be matched to the value of the businesses acquired.  This was seen as leading to monopolies, as competitors were absorbed into the dominant corporations in each industry.  Congress saw the culprit as the state incorporation laws that had been changed to permit overcapitalization and, as a result, the solution proposed was to preempt the state laws by requiring federal corporate chartering of every business operating beyond a single state.  One federal incorporation bill was passed unanimously by the House of Representatives in 1903 but failed to get through the Senate.


No one at the time seemed to realize that Wall Street was building a new industry, one which would create, buy and sell securities.  A century later, revenues in the securities industry would far surpass railroads and most manufacturing.  At the time, however, the government saw only antitrust and overcapitalization issues.  Today, we accept that the market price of a company’s shares will have little relationship to the value of the property it uses in the business.  Unfortunately, we also still accept that Wall Street is the monopoly for raising and investing money.


The foundation for Wall Street’s new industry, the stock market, had been vastly expanded by the issuance of common stock by the giant corporations, as they soaked up thousands of competing businesses in major industries.  The price of stocks doubled from 1904 to 1906.  Then came the Panic of 1907, which many blamed on the Money Trust, “a loosely bound small group of banks and investment banks that controlled the money supply and the New York Stock Exchange.”  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 219] 


Government Left Wall Street Unconstrained Until the New Deal


President Theodore Roosevelt was the big trustbuster of the early 1900s and there was much talk about “the Money Trust.”  However, when his administration was unable to stop the Panic of 1907, he turned to J.P. Morgan, who used his position as the Godfather of Wall Street to restore financial order.  When the Federal Reserve System was established in 1913, the publicity said it “was designed to remove some of Wall Street’s power.”  [Robert Sobel, Inside Wall Street: Continuity and Change in the Financial District, W. W. Norton & Company, 1977, page 202]  Nevertheless, the first president of the Federal Reserve Bank of New York was J.P. Morgan’s son-in-law.


In response to the Panic of 1907, the House Banking and Currency Committee established a subcommittee to investigate the concentration of money and credit.  Called the “Money Trust Investigation,” it is also known as the Pujo Committee, after its chairman, Congressman Arsene P. Pujo.  The Committee focused on the underwriting syndicate, why it seemed to always include the same investment bankers and why the managing underwriters never tried to take business from another firm’s client.  A witness in charge of one of the top firms said that they prefer “to deal with our friends rather than people we do not know,” while another said “we make alliances for the occasion.  We have no standing alliances.” [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 145]  Nevertheless, the Committee’s majority found “an established and well-defined identity and community of interest between a few leaders of finance . . . which has resulted in great and rapidly growing concentration of the control of money and credit in the hands of these few men.”  [Money Trust Investigation: Report, 129, 133-35, quoted in Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 151]  The Committee’s chief counsel, Samuel Untermyer, later wrote:  “It is not healthful or desirable that a few banking houses should monopolize the prestige and profit of acting as intermediaries between those who need capital . . . and the investors who are able to supply it.  The need should be supplied by a public market for securities.”  [Samuel Untermyer, “Speculation on the Stock Exchanges and Public Regulation of the Exchanges,” The American Economic Review, V, supplement (March 1915, pages 224- 68, quoted in Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, pages 153, 154].


No legislation came from the Money Trust Investigation.  After the Committee’s report in 1913, Congress “struggled with ways to curb speculation, especially futures trading, margin buying, short selling and wash sales that by general consensus had turned the nation’s securities markets into gambling dens.”  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 227]  After intense lobbying, Congress did nothing to deal with the problems in the Pujo Committee report.  In 1919, bills began to be introduced in Congress to regulate the sale of new securities, including preparation and filing of offering materials with the federal government.  All of these efforts were defeated and no serious attempt to restrain Wall Street was to be made until 1933.

The Money Trust Investigation Report dropped its earlier recommendation to have the Interstate Commerce Commission regulate securities issues.  It did, however, recommend that commercial banks be prohibited from underwriting and selling securities.  (Congress waited another two decades to take this action.)  Reaction to the growth of banks had enough political clout to get the McFadden Act passed in 1927.  It prohibited banks from opening branches outside of their home state.  This early demonstration of Congressional involvement in investment banking practices set a pattern that continues through today:  Use public hearings to vent public outrage, issue a report that excoriates bad behavior, then do nothing or just pass laws that don’t do much except strengthen the investment banking monopoly.  If it is necessary to create a regulatory agency, keep its funding so low that it can’t accomplish much and becomes a tool of the regulated industry. 


The “Roaring 20s” were just that for Wall Street.  Liberty Bonds had been marketed with great success in World War I, opening up the middle class to exchanging money for paper investments.  What Wall Street did was to divert the new investors away from putting their money into securities issued by governments or real businesses and into securities manufactured on Wall Street.  Before the 1930s, the only federal law applying to investment banking was the postal fraud law, which had criminal penalties for swindlers using the mail.  [For a description of this period on Wall Street, see John Brooks, Once in Golconda: A True Drama of Wall Street 1920-1928, E.P. Hutton, 1969]


There were more calls for regulation after World War I.  The Capital Issues Committee had been reviewing all new issues of securities over $100,000, to protect the success of the Victory Loan program.  It recommended that the Federal Trade Commission police the sale of securities.  After the War, it unanimously called for supervision of new issues, fearing that the millions of Americans who had been introduced to investing in securities would be exploited.  Congress introduced several bills in response to the Committee’s report, but none became law.  A series of other bills for regulating securities issues were defeated in the 1920s.


The states all had some regulation of the securities issued by corporations chartered in their state, but they had no authority over securities sold to their residents by businesses incorporated elsewhere.  By 1903, states had begun requiring prospectuses to be filed for offerings made in their states.  In 1911, Kansas passed the first licensing system for persons selling securities and required registration of securities issues and a permit to be issued before sales could begin.  Its banking commissioner, J.N. Dolley, called for protection against promoters who "would sell building lots in the blue sky,” giving the “blue sky” nickname to state securities laws.  Most other states followed and the new laws were upheld by the U. S. Supreme Court in 1917. [Hall v. Geiger-Jones Co., 242 U.S. 539 (1917)].


Regulation brings trade associations and, in 1912, the Investment Bankers Association of America was created out of the American Bankers Association.  It proposed its own model state blue sky law, but only Maine adopted it.  The IBA was more successful in lobbying for the defeat of several bills introduced in Congress.  One would have applied the principles of the Pure Food and Drug Act to the securities business.  Another would have authorized the Justice Department to prosecute security dealers for mail fraud.  Early drafts of the Securities Act of 1933 placed its administration with the Post Office Department.  The final law was to be under Federal Trade Commission jurisdiction but that was changed when the Securities and Exchange Commission was created in 1934.


The Great Depression, the New Deal and a Wall Street Strike of Capital


For more than 100 years, our political leaders have pointed to the concentration of power in Wall Street and the painful consequences.  As early as the 1890s, a popular orator would rail against “a government of Wall Street, by Wall Street and for Wall Street.”  [Mary Ellen Lease, quoted in Charles Derber, Corporation Nation: How Corporations are Taking Over Our Lives and What we Can Do About It, St. Martin’s Press, 1998]  One of the early critics of Wall Street was Louis Brandeis.  After he was appointed to the U.S. Supreme Court in 1916, he could not participate directly in the efforts to reform the securities business.  However, “he kept in touch with the New Dealers through an elaborate network of former students and disciples.  Through them, his ideas reached FDR and his advisers, who referred to him as ‘Isaiah.’”  [Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 232]


Some of the strongest language indicting Wall Street came in the opening paragraphs of Franklin D. Roosevelt’s inaugural address on March 4, 1933:  “Practices of the unscrupulous moneylenders stand indicted in the court of public opinion, rejected by the hearts and minds of men. . . . They know only the rules of a generation of self-seekers.  They have no vision, and when there is no vision the people perish.”


The remedy, FDR said, was “strict supervision of all banking and credits and investments, so that there will be an end to speculation with other people’s money . . ..”  [John T. Woolley and Gerhard Peters, The American Presidency Project. Santa Barbara, CA: University of California]  Just two months later, Roosevelt signed into law the Securities Act of 1933, which had the Federal Trade Commission regulate the sale of new securities.  In June came the Banking Act of 1933 (called the Glass-Steagall Act, after its authors), which prevented commercial banks from also underwriting securities.  The next year brought the Securities Exchange Act of 1934, requiring registration of securities brokers, dealers and exchanges, as well as regulating their practices.  It also established the Securities and Exchange Commission to administer all of the federal securities laws, taking over from the Federal Trade Commission.


The Crash of 1929 had been followed by a continuing decline in share prices for the next two and a half years.  By 1932, common stock prices were only ten percent of their 1929 level.  A near-disappearance of underwritten new issues reflected the lack of interest in buying corporate shares.  Nearly half the Investment Bankers Association membership went out of business by 1933.  The Crash also brought Congressional hearings and legislation, including the

•  Securities Act of 1933, requiring registration and prospectus standards for new issues of securities, 

•  Banking Act of 1933, forbidding commercial banks from also being investment banks,

•  Securities Exchange Act of 1934, regulating brokers and trading markets, and requiring public reporting by businesses with traded securities,

•  Trust Indenture Act of 1939, requiring registration and investor protection tools for bonds,

•  Investment Advisors Act of 1940, providing very light regulation of money managers and other persons selling investment advice, and

•  Investment Company Act of 1940, regulating mutual funds.


The big victory for investment bankers came from the Banking Act, which forced deposit-taking banks to choose either the business of accepting deposits and making loans or the business of buying and selling securities.  The Banking Act also created the Federal Deposit Insurance Corporation, which put the full faith and credit of the United States Government behind consumer-size bank accounts.  That guarantee of deposits was hard for a bank to pass up in a time when bank failures had wiped out the life savings of so many.  Nearly all of the banks chose to give up underwriting, brokering and dealing in securities, sometimes splitting themselves into two separate businesses.


 By 1970, one of the firms that had chosen the securities business described itself this way:  “Morgan Stanley is an organization which specializes in basic investment banking services—the raising of debt and equity capital in the domestic and international markets and such closely related activities as general financial advisory services, mergers and acquisitions, and brokerage services for institutions and corporations.” [Morgan Stanley 1970, a book published by the firm.]  Wall Street investment bankers had been restored to their monopoly franchise, free of the competition from commercial banks that had plagued them during the 1920s.


Investment bankers and securities brokers won another major legislative battle in 1938.  Roosevelt had gotten the National Recovery Act through Congress in 1933.  It called upon all industries to adopt codes of fair competition, which could then be enforced by the federal government.   The Investment Bankers Association, as the only national trade association in the securities industry, drew up a code, which was adopted by President Roosevelt in 1933.  When the NRA was declared unconstitutional in 1935, the code continued under the Investment Bankers Conference, Inc., with the blessing of the SEC.  Faced with the threat of direct government regulation, investment bankers supported the 1938 Maloney Act, with the result that the Investment Bankers Conference became the National Association of Securities Dealers, Inc. and no one could engage in business as a securities broker or dealer except through membership.  The NASD has since become the Financial Industry Regulatory Authority.  The SEC has delegated to FINRA its power to license and regulate brokers and dealers in securities.  What had started as a trade association of private investment banking businesses is now a “self regulatory organization,” with rules that can be enforced just like a federal government agency.  Members of its Board of Governors are representatives of Wall Street firms and of the “public”—which includes several retired Wall Street executives. 


During the 1930s, the federal government itself got into competition with investment bankers.  The Reconstruction Finance Corporation was started in 1932, under President Hoover, for making loans to businesses which served the national interest.  Some of the New Dealers pushed for even greater government involvement in financing business.  They blamed the renewed economic decline in 1937 on a “strike of capital” by Wall Street against government reforms.  “Throughout the 1930s the RFC was the world’s largest corporation because of the vast amount of money it distributed to industries in need.  When war broke out, it became the natural organization to coordinate the war effort through industry. . . . The great inroads made by the RFC in helping finance the war effort were making investment bankers nervous.  They were feeling the heat created by the RFC, which was only responding to their own lack of enthusiasm in the first place.”  [Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 265]  Congress voted to abolish the RFC in 1953.


In financing the second World War, the role of the Treasury in earlier wars was taken over by the Federal Reserve Board, which acted as a managing underwriter.  Each of the Federal Reserve Banks coordinated bond sales within its district.  No commissions, fees or expenses were paid to the securities industry.  The government also took steps to assure the supply of funds that individuals would invest in bonds.  President Roosevelt asked consumers to restrain their borrowing and spending, while War bonds were heavily marketed as a contribution to the war effort.  Very important was the way the Federal Reserve kept interest rates stable. War usually brings inflation and high interest rates, a real deterrent to bond investors.  The Fed stood ready to buy or sell Treasury bills, the shortest term debt, at a three-eights of one percent yield.  This kept long-term bonds at about 2.5 percent for the entire War.   


President Truman, who held a bias against Wall Street, asked the Federal Reserve to continue its financing efforts through the Korean War, saying “my approach to all these financial questions was . . . to keep the financial capital of the United States in Washington.  This is where it belongs—but to keep it there is not always an easy task.”  [From Truman’s Memoirs, quoted in Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 269]


The SEC is Set Up to Police (Protect) Wall Street


According to its website, “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  []  Experience shows that its actual mission is to protect Wall Street’s monopoly and to settle turf disputes among Wall Street insiders. 


The real reason for setting up the SEC as a new agency to regulate the securities industry may have been to bring responsibility for law enforcement into the hands of people who would be more receptive to the needs of the industry being regulated.  The Federal Trade Commission is charged with enforcing antitrust and other unfair competition.  According to its website, “When the FTC was created in 1914, its purpose was to prevent unfair methods of competition in commerce as part of the battle to ‘bust the trusts.’ Over the years, Congress passed additional laws giving the agency greater authority to police anticompetitive practices.”  [


Bringing the “Money Trust” under FTC supervision had been included in proposed Congressional legislation since the 1920s, but the Investment Bankers Association had successfully lobbied against any of the bills becoming law.  The Great Crash in 1929 made it likely that Congress would finally do something about regulating securities issues.  Rather than try to stop the momentum entirely, investment bankers directed their efforts toward getting laws that would work for their benefit. 


The Securities Act of 1933, governing the sale of newly issued securities, put enforcement in the hand of the FTC.  The next year, in the Securities Exchange Act of 1934, investment bankers got Congress to take that away and to set up the SEC as a single industry police to monitor the securities business.  The result was that Wall Street was effectively exempted from hundreds of years of the common law against fraudulent practices.  The SEC became the exclusive federal agency to police securities transactions.  Joseph P. Kennedy, a major contributor to Roosevelt’s presidential campaign, was appointed the first SEC Chairman and lasted a year.  He came to the job from many years of making millions in stock speculations and turned out to be a moderate, soothing both Wall Street’s anger at government interference and the New Dealers desire to make Wall Street pay for its sins.  Kennedy did shape the SEC as the protector of established investment bankers by forcing “marginal brokers” to close.  [Charles R. Geist, Wall Street: A History, Oxford University Press, 1997, page 236]

The SEC’s stated mission “is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  []  In practice, the SEC protects Wall Street’s monopoly over the buying and selling of securities.  Wall Street pays multi-million dollar fines and moves on, like parking tickets for a drug dealer.  It has been written about the SEC:  “Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors.”  [Michael Lewis and David Einhorn, “The End of the Financial World as We Know It, The New York Times, January 3, 2009,]  When Congress made a show of protecting investors, after the 2008 market collapse, the "investor advocate" and "investor advisory" authorities were placed within the SEC, not as independent agencies.  [Dodd-Frank Wall Street Reform and Consumer Protection Act, sections 915 and 911,]  In the 21 years that the SEC has been able to make whistleblower awards for insider-trading cases, it had paid out only $160,000 before a  $1 million payout in 2010.  [Jesse Westbrook, "Whistleblowers Get a Raise," Bloomberg Businessweek, August 2-8, 2010, page 31]

Single-industry regulation can be a bonanza for its members.  Cozy relationships can be developed among regulatory officials and corporate officers, lawyers and lobbyists.  The “revolving door” can open to encourage employees to move from public to private jobs and from private to policy level government positions.  People working on both sides understand each other and the unwritten rules.  Congress is careful to preserve the SEC's exclusive jurisdiction over Wall Street, while also taking care to underfund the SEC, so it can't take its job too seriously.  This pattern carried over when Congress appointed and funded the Financial
Crisis Inquiry Commission, which issued its report in January 2011.  [].  Lynn Turner, former SEC Chief Accountant, observed that Congress “never gave it enough money to do its job, not unlike how Congress has treated many of the regulators. It didn't hire the attorneys and accountants trained as investigators as Pecora [the New Deal commission] did. Some of its top staff were seconded from the Fed which as the report notes, was one of the biggest reasons for the crisis. Its top and initial head of staff left long before the project was done as did other staff frustrated by the superficial work of the Commission.”  []


Just one example of the payoffs for Wall Street from having the SEC as its single-industry regulator:  The economist John Maynard Keynes proposed a tax on stock transactions, to deter investors from short-term trading.  The subject has been revisited many times since, particularly as computer-generated program trading has come to dominate stock exchange volume.  Wall Street is, of course, adamantly opposed to the idea and it has never gotten any support from the SEC:  “The explanation lies partly in the history of the Commission, which has been one of seeking accommodation with Wall Street, no confrontation, and partly in its staffing.” [Louis Lowenstein, What’s Wrong With Wall Street, Addison-Wesley Publishing Company, Inc., 1988, page 85]


Contrary to its statutory duty "to protect investors," the SEC has actually protected the incumbent CEOs and directors from investors.  Shareowners who want to propose candidates for the board of directors have had to pay all the costs to prepare their own proxy statements and to distribute them, solicit responses, receive votes, etc.  Shareowner groups have long asked the SEC to let their nominees be included in the company’s proxy statement, without getting any action.  Opposition had been consistent and powerful from CEO organizations like the U.S. Chamber of Commerce and the Business Roundtable.  In August 2010, forced by Congress in its financial reform law, the SEC finally let that happen—but only if the proposing shareowners hold at least 3% of all the shares.   [Kara Scannell, “Investors Set to Win New Rights on Proxies,” The Wall Street Journal, August 5, 2010, page B1]  The result is a loss for CEOs but also a loss for individual investors.  The winner is Wall Street's buy side, the private equity takeover firms and the hedge funds, who can buy 3% of a company and nominate their own directors.  As Harvard professor, corporate director and former CEO put it:  "These changes are likely to empower short-term money movers such as hedge funds at the expense of long-term owners--and pressure management to focus on the short term, which is the exact opposite of what's needed."  [Bill George, "Executive Pay: Rebuilding Trust in an Era of of Rage," Bloomberg Businessweek, September 13-19, 2010, page 56]  A former SEC commissioner claims that "unions and cause-driven, minority shareholders . . . would use it to advance their own labor, social and environmental agendas instead of the corporation's goal of maximizing long-term shareholder wealth."  [Paul Atkins, "The SEC's Sop to Unions," The Wall Street Journal, August 27, 2010, page A15]


(As lawyer for a meat trade association, I ran across a model for dealing with the threat of FTC supervision, in how the “Meat Trust” had responded to an antitrust decree and an FTC proposal that part of its industry be taken over by the government.  The Packers and Stockyards Act was passed in 1921, with the stated intent to prohibit unfair and deceptive practices, manipulating prices, creating a monopoly, etc.   [Title 7 U.S.C. §§ 181-229b,]  However, it placed exclusive enforcement with the Department of Agriculture, making it clear that “The Federal Trade Commission shall have no power or jurisdiction over any matter which by this chapter is made subject to the jurisdiction of the Secretary” of Agriculture, with limited exceptions.  [Title 7 United States Code §227,]  The legislative history disclosed that the Act had been drafted and lobbied by lawyers for the “Big 5” meat businesses.  The previous year, the FTC had forced the Big 5 into a consent decree, after an investigation ordered by President Wilson.  The real purpose of the Packers and Stockyards Act was to take away antitrust enforcement from the FTC and lodge it with the far friendlier Department of Agriculture, where it is today. There has been minimal funding and no serious enforcement of the Packers and Stockyards Act since it was enacted.)

There are at least three big advantages to being regulated by an agency that is supposed to oversee only one industry.  One is control over the funding process.  If the agency is becoming too difficult, industry lobbyists can persuade the administration and Congress to “cut off their water” until they behave.  This recently occurred when the SEC Chairman was Arthur Levitt, who had been head of a securities firm and president of the American Stock Exchange.  When he took his job too literally, key senators proposed drastic cuts in the SEC budget.  The history of the SEC, beginning with its first Chairman, Joseph P. Kennedy, was one of under funding.  For many years, the SEC has collected far more in fees and fines paid by the industry than it has received from Congress for its operations.  The SEC staff went from 1,700 in 1940 to 770 in 1954, “and all but a handful of them were clerks, typists, political appointees, rejects from other agencies, time servers, and ambitious young men who hoped to use their employment as a means whereby they could land more worthwhile positions in the financial district.”  [Robert Sobel, Inside Wall Street: Continuity and Change in the Financial District, W. W. Norton & Company, 1977, page 172]   Only a few federal financial industry regulators are subject to Congressional appropriations.  Most operate on fees and other income they collect.   Paul Kanjorski, Chair of the Financial Institutions Subcommittee had said that self-funding is in line with a major goal of the legislation to change the culture and climate of the SEC.
However, Senator Richard Shelby said that keeping the SEC subject to Congressional appropriations "
ensures the SEC has the funding it needs while still ensuring it be accountable to Congress."  [ The committee reconciling house and senate versions took self-funding out Dodd-Frank Wall Street Reform and Consumer Protection Act.   [ ]  Instead, section 991(e) allows the SEC to put not more than $50 million a year from its registration fees into a reserve fund, and accumulate not more than $100 million.  The Commission can draw on this fund for its functions, but it has to give notice of the date, amount and purpose to Congress.  Wall Street lobbyists can still get Congress to punish the SEC by cutting its funding, if it takes enforcement too seriously. 

Another advantage to being regulated by a single-industry agency is how people in the regulated industry can gain access to regulatory officials, without competition from other industries knocking on their door.  Industry members can stay well within codes of ethics and still develop close relationships at all levels of the agency.  SEC Commissioners and senior staff members are invited to speak at industry gatherings.  They visit with top industry personalities at social gatherings, office visits and telephone conversations.  All of this can be explained by a need for the regulators to understand issues in the regulated industry.  Nevertheless, there is no comparable access on behalf of the people who are supposed to be protected from bad practices, the investors and issuers of securities. 

Related to access is the third advantage of single-industry regulation.  That is the effective “revolving door” practice, where the regulated industry hires from the regulatory agency, and the agency hires from regulated firms, and also from their lawyers and accountants.  Apologists for the practice argue that the agency can recruit higher quality applicants because they know that a few years experience will land them a lucrative position in the regulated industry, or the law, accounting and consulting firms that service the industry.  They also say that regulation is more effective when staff in the industry and its service firms understand the workings of the regulatory agency.


There may be individuals who can completely separate their allegiance to the agency’s mission from their own career goals.  (I knew one law firm senior partner who told his associates to always make a “soft” job offer when dealing with a regulator on an important matter.  Several of these offers eventually resulted in the firm hiring the former regulators.  My own telephone conversations with SEC lawyers often got around to a question from them like, “How’s the job market in San Francisco?”)  “It’s not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.”  [Michael Lewis and David Einhorn, “The End of the Financial World as We Know It, The New York Times, January 3, 2009,]  In a June 2010 letter from the Senate Finance Committee to the SEC, asking its Inspector General to review the revolving door, Senator Charles Grassley said:  “We need to ensure that SEC officials are more focused on regulation and enforcement than on getting their next job in the industry they are supposed to oversee.”  [Tom McGinty, “SEC ‘Revolving Door’ Under Review,” The Wall Street Journal, June 16, 2010, page C1]


A very public example of how the SEC protects Wall Street occurred in a court case, brought on behalf of persons who purchased technology IPOs in the bubble years just before 2000.  As described in the first paragraph of the U.S. Supreme Court’s opinion:  “The buyers claim that the underwriters unlawfully agreed with one another that they would not sell shares of a popular new issue to a buyer unless that buyer committed (1) to buy additional shares of that security later at escalating prices (a practice called ‘laddering’), (2) to pay unusually high commissions on subsequent security purchases from the underwriters, or (3) to purchase from the underwriters other less desirable securities (a practice called ‘tying’).” [Credit Suisse Securities v. Billing, 551 U.S. 264 (2007),]


The SEC came into the case on the side of Wall Street and against the investors, arguing that regulation of the securities industry was its exclusive turf and the courts should stay off it.  The U.S. District Court agreed with the SEC and ruled in favor of the defendant investment bankers, but that was reversed by the Second Circuit Court of Appeal.  [426 F.3d 130 (2005).  That Court, located in New York, is the most knowledgeable and experienced in matters of finance.]  The U.S. Supreme Court later reversed the Second Circuit, agreeing with the District Court that enforcing the antitrust laws would disrupt the capital markets and that the SEC had the expert authority to regulate the securities industry. 


Part of protecting Wall Street’s monopoly is to enforce its code of conduct for people allowed to be included in the monopoly.  In 1933, the National Industrial Recovery Act permitted self-regulatory industry groups to adopt codes of fair practice enforceable by the federal courts. As the only national trade association for the securities industry, the Investment Bankers Association prepared a “Code of Fair Competition for Investment Bankers” that was approved by a presidential executive order in March 1934. The Supreme Court declared the NIRA unconstitutional in May 1935 but, with the assistance of the SEC, the investment banking industry continued “voluntary compliance” with the Code.  The IBA reorganized itself into the National Association of Securities Dealers and became the SEC’s self-regulatory organization for securities broker-dealers. 


The NASD’s “Rules of Fair Practice” included (and still include) a ban on discounting the price or commission on underwritten securities sales.   The Rules preserved Wall Street’s very strict limits for how new issues are sold, so that the big investment banks have the advantage over retail brokerage firms and their middle class customers.  Before the date sales become final, underwriters may solicit “indications of interest” only through oral communications. They can’t use any mass marketing such as newspaper, radio or television advertising. The result is that marketing is directed to institutions and wealthy investors.   


When Joseph Kennedy’s son became President in 1960, a series of gross scandals at the American Stock Exchange brought attention to the adequacy of SEC regulation.  The new president asked for a Special Study of the Securities Market, and the first part was finished in April 1963.  On November 19, 1963, the “salad oil scandal” hit the news as the largest securities fraud of its kind, involving borrowings on fictitious commodities.  It took down two brokerage firms and caused huge losses at 20 banks and several trading firms.  As Wall Street prepared for the SEC to seek the broader powers recommended by the Special Study, President Kennedy was assassinated and the moment for renewed enforcement was past.  Nothing much of any substance has happened since. A 2010 Minority Report of the House Committee on Oversight and Government Reform lists recent problems with the SEC and recommends several remedies.  Nothing is in the Report about the SEC protecting Wall Street's monopoly, the revolving door in hiring or the influence of Wall Street with Congress.  []


How All Three Government Branches Protect Wall Street From Investors


All three branches of the federal government ostensibly have a role in protecting individual investors from unfair practices in the securities industry.  The history has been, however, that they actually protect Wall Street from disappointed investors.  The game is to appear responsive to the complaints of voters, while really enabling Wall Street to continue cheating. 


One example of looking responsive but doing nothing was revealed in the Lehman Brothers bankruptcy report by Anton R. Valukas, for which his law firm billed over $38 million:  “In mid-March 2008, after the Bear Stearns near collapse, teams of Government monitors from the Securities and Exchange Commission (‘SEC’) and the Federal Reserve Bank of New York (‘FRBNY’) were dispatched to and took up residence at Lehman, to monitor Lehman’s financial condition with particular focus on liquidity.”

[, page 8]  According to a commentary on the report, witnesses said “that the government didn’t raise significant objections or direct Lehman to take corrective action.”  [Paul M. Barrett, “Cold Case: Lessons from the Lehman Autopsy,” Bloomberg BusinessWeek, April 5, 2010, page 22] Six months later, Lehman’s bankruptcy triggered the Panic of 2008 and the Great Recession.




A recent case illustrates how all three government branches contribute to keeping investors from recovering losses caused by Wall Street fraud.   For its part, Congress made it unlawful to use any manipulative or deceptive device in the purchase or sale of a security.  But it added, “in contravention of” SEC rules.  [Securities Exchange Act of 1934, section 10(b),]  In legislative doublespeak, that means that the general rules for going after fraud could no longer be used against securities fraud perpetrators. 


After Congress had adopted section 10(b) of the Securities Exchange Act, granting Wall Street immunity from the general fraud laws, it was up to the SEC to make and enforce the rules under 10(b).  The SEC’s Rule 10b-5(a) [] makes it unlawful “to employ any device, scheme, or artifice to defraud.”  This seems to cover all kinds of cheating.  But the SEC doesn’t do much to catch and prosecute perpetrators of securities fraud.  In fairness, it is a very small agency by federal government standards, demonstrating another Congressional ploy of holding down funding for agencies that could interfere with business-as-usual.


If the SEC won’t bring criminal or civil action, can the injured persons seek a remedy in court?  A big question for Wall Street was whether disappointed investors could sue investment bankers who set up the transactions that were found to violate section 10(b). 

That question came before the U.S. Supreme Court in 2008, in a case that didn’t actually name a Wall Street firm.  [Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. , 128 S.Ct. 761 (2008),,]  But its importance to them, as well as their customers, is shown by the “friends of the court” briefs, which are allowed when the decision in a case may become a rule affecting others not a party to the case.  They make it clear that the Stoneridge decision would settle the issue between investors and investment bankers.  Briefs on the side of institutional investors included the American Association of Retired Persons, the Consumer Federation, the Council of Institutional Investors, many state and local pension funds, and a majority of the states and the North American Securities Administrators Association.  For the defendants, briefs included those for the American Bankers Association, the Securities Industry and Financial Markets Association, Merrill Lynch, the New York Stock Exchange and the NASDAQ. [


The real subject in Stoneridge, never mentioned by the Court, was Enron.  Several institutional investors had sued Enron, which was bankrupt and couldn’t pay any judgment.  They also sued Enron’s Wall Street bankers alleging that they structured contrived financial transactions to falsify Enron’s financial statements, sold new Enron securities with falsified financial statements and recommended Enron’s stock through false analyst reports.  After the trial court ruled that the plaintiffs could go to trial, some of the investment bankers settled, including Citicorp for $2 billion, J.P. Morgan Chase for $2.2 billion and CIBC for $2.4 billion.  Other defendants appealed the decision.  The investors had won the trial, but the federal circuit court reversed the decision and said that the Enron case could not include the investment bankers as defendants.  Two other circuit courts, in other securities fraud cases, had decided the same issue, coming down on opposite sides.  That created a conflict that only the Supreme Court could resolve.  The high court chose to accept the Stoneridge Investment Partners case to review the issue, rather than the Enron cases.  Stoneridge did not even involve investment bankers. 


Stoneridge Investors had lost money on its shares in Charter Communications, Inc., a cable TV operator.  Charter had purchased cable set top boxes from Scientific-Atlanta, Inc. and Motorola, Inc.  Charter arranged to overpay $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter, at inflated prices.  The companies backdated documents to make it appear the transactions were unrelated.  Stoneridge sued the vendors for having participated in the fraud.


The Supreme Court decided, on a five to three vote, that the two set box vendors could not be liable to the investors.  Since the investors did not know of the vendors’ involvement in the fraud, the court said they could not have relied upon the vendors having been honest.  The majority acknowledged that general fraud law would have held the vendors liable.  But it ruled that Congress did not want that result in securities fraud cases.  The investors had also claimed that the vendors had “aided and abetted” the fraud, which Congress had also made unlawful.  But the majority held that Congress intended “that this class of defendants should be pursued by the SEC and not by private litigants.”  Since the SEC only pursues a small fraction of securities frauds, any aiders and abettors were off the hook.


The big effect of the Stoneridge decision was on investment bankers, lawyers and consultants who were claimed to have invented fraudulent schemes and guided companies in carrying them out, like those in the Enron cases.  The court’s majority acknowledged that it had been appropriate to consider “the practical consequences” of its decision.  One of these practical consequences was the frivolous lawsuit argument, that “the potential for uncertainty and disruption in a lawsuit allows plaintiffs with weak claims to extort settlements from innocent companies.”  Referring to the friend of the court brief by NASDAQ, the opinion added that holding responsible the undisclosed participants in a fraudulent scheme “may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.”  The judicial branch of our government decided it was better to let defrauded investors take their losses than to risk putting Wall Street at a competitive disadvantage to their counterparts in other countries.


The executive branch of government found it politic to be on both sides of the case.  The SEC’s role in the Stoneridge lower court proceedings was on the side of the investors, reflecting the growing political weight of Wall Street’s “buy side,” the institutional money managers.  However, before the Supreme Court, the United States was represented by the Solicitor General, who is part of the Department of Justice.   The United States brief was filed in favor of the defendants and against the investor plaintiffs, reportedly on directions from the White House. [Thomas Brom, “Scheme Liability Lives!” California Lawyer, July, 2008, page 14.] 


The cleverest bit of politics in the Stoneridge case was maneuvering it to come to the Supreme Court before the Enron litigation or other case where financial intermediaries and their lawyers were active in creating the fraud.  On the legal issues, the Stoneridge case will likely excuse them all, just as if they had been before the Court themselves.  It must have been easier to hold the justices together in the Stoneridge case, where vendors were asked to “do me a little favor,” than in the massive Enron financial manipulation scheme, where investment bankers, lawyers and accountants were alleged to be deep into the design and execution of the fraud. Former Senator Arlen Spector and others tried to modify the Stoneridge ruling in the Dodd-Frank securites reform law.  It would have permitted aiding and abetting exposure for those who “advise on or assist in structuring securities transactions and who have actual knowledge of securities fraud.”  [Bruce Carton, "Changes in Securities Enforcement Thanks to Dodd-Frank," Securities Docket, August 4, 2010,]


Congress Sets Up Another Casino for Derivatives Games


We have heard much about “derivatives” and their role in the Panic of 2008 and the “Flash Crash” of May 6, 2010.  These instruments are designed to bet on price changes in some physical commodity or security.  The derivatives markets are akin to off-track betting parlors for gambling on horse races.


The federal government started regulating derivatives in 1921, with the Futures Trading Act and adopted the Commodity Exchange Act in 1936.  Congress created the Commodities Futures Trading Commission in 1974, when most futures trades were bets on the future prices of agriculture commodities, like wheat, corn and pork bellies.  The commodities futures market accommodated a symbiotic relationship between speculators, who wanted to bet on their ability to predict farm price movements, and the farmers and processors, who wanted to protect themselves by hedging against the risk of those price movements.  The CFTC has promoted vastly expanded speculation in futures and options, far beyond farm products, into oil, securities, currencies and many other markers for placing bets. 

The CFTC initially set limits on speculative trading but, in 1992, it carved out exemptions from these limits for derivatives based on futures. Wall Street began coming up with derivatives-on-derivatives and marketed them to hedge funds and other speculators.  To get around the limits on speculation, Wall Street lobbied itself into being exempt.  “‘When the CFTC granted the 1991 hedging exemption to J. Aron (a division of Goldman Sachs), it signaled a major shift that has since allowed investors to accumulate enormous positions for purely speculative purposes,’" said Rep. Bart Stupak (D-Mich.) Now, he added, “‘legitimate businesses that hedge and take physical delivery of oil are being trampled by the speculators who are in the market purely to make profit.’"  [David Cho, “A Few Speculators Dominate Vast Market for Oil Trading,” Washington Post, August 21, 2008, page A01.]

In 1999, the President's Working Group on Financial Markets recommended that "derivatives should be exempted from federal regulation."  [, reported in Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, pageSimon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, page 136]  The Commodities Futures Modernization Act of 2000 delivered many exemptions and exclusions from regulation for derivatives and for classes of investors/speculators.  It opened an unregulated betting parlor for individuals and businesses with assets of at least $10 million and employee benefit funds of at least $5 million—the prime buy market for Wall Street investment bankers.  The exempt bets include “hybrid instruments” and “swap transactions” sold to “eligible participants.”  This helped bring pensions funds and other institutions into the market, mostly through “index” securities tied to a basket of futures markets.  Reflecting particularly clever Wall Street lobbying, the exemptions were not only from regulation by the CFTC but also from SEC rules.  The law formally allowed investors to trade energy commodities on private electronic platforms outside the purview of regulators. Critics have called this piece of legislation the "Enron loophole," saying Enron played a role in crafting it.  [see law firm summaries of the Act by Cravath, Swaine and Moore,, by Glen S. Arden of Jones Day,  and by Dean Kloner, an associate with Stroock & Stroock & Lavan,]

The role of Congress as Wall Street’s traffic cop was highly visible during the Summer of 2008, around the issue of speculation in the market for securities derived from oil futures.  Several Congressional Committees held hearings, including one May 20, before the Senate Committee on Homeland Security & Governmental Affairs, called "Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation?"  The relentless news coverage came from the relationship between trading in these derivatives and prices at the gas pump.  The lobbying and public relations were a competition between the airlines, with their website,, and Wall Street firms.  “A strong lobbying effort by Wall Street banks, the trading industry and market operators may successfully head off proposals for tougher federal controls on oil futures trading.”  [Ian Talley, “Oil-Futures Players Resist Controls,” The Wall Street Journal, July 11, 2008,]


One hedge fund manager testified that these institutional speculators keep rolling over their positions, they “never sell,” and that, “Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.”

[Committee on Homeland Security and Governmental Affairs, testimony of Michael W. Masters, managing member of Masters Capital Management, LLC []


This continuous buy demand creates an unreal market.  The money used for speculation could have gone to productive uses, like financing new and expanding businesses, or buying securities to fund infrastructure repair.  The diversion into futures securities is like individuals deciding to spend their discretionary income on buying for their stamp collection, except that the speculators are causing harm and bringing unnecessary risk to us all.  [A contrary view was presented by Hilary Till, Research Associate of the EDHEC-Risk Institute, in Nice, France, in her paper, “Has There Been Excessive Speculation in the US Oil Futures Markets? What Can We (Carefully) Conclude from New CFTC Data?” She found that there “has been no evidence of excessive speculation in the US oil futures markets over the last three-and-a-half years, and notably during the oil price spikes in 2008.”]


The Secretary of the Treasury and other politicians continue to explain gas prices as a result of supply and demand, especially supply, saying things like:  “If only we could drill for more oil, then we could supply the demand and the price would stabilize.”  The media similarly offers explanations based upon the supply of physical oil output.  Reporters look at what happened in the oil futures market today and then look to an event that interrupted the supply—sabotage in Nigeria, refineries shut down for maintenance, etc.  A relatively few in the mainstream media, like Moira Herbst and David Cho, were willing to report on the Congressional testimony that a major cause was Wall Street’s new derivative products being sold to institutional money managers. 


Under pressure from members of Congress, the Commodity Futures Trading Commission looked at records of oil futures traders on the New York Mercantile Exchange, or NYMEX.  It found “that financial firms speculating for their clients or for themselves account for about 81 percent of the oil contracts on NYMEX, a far bigger share than had previously been stated by the agency. . . . The biggest players on the commodity exchanges often operate as ‘swap dealers’ who primarily invest on behalf of hedge funds, wealthy individuals and pension funds, allowing these investors to enjoy returns without having to buy an actual contract for oil or other goods. . . To build up the vast holdings this practice entails, some swap dealers have maneuvered behind the scenes, exploiting their political influence and gaps in oversight to gain exemptions from regulatory limits and permission to set up new, unregulated markets. Many big traders are active not only on NYMEX but also on private and overseas markets beyond the CFTC's purview. . . . Using swap dealers as middlemen, investment funds have poured into the commodity markets, raising their holdings to $260 billion this year [2008] from $13 billion in 2003. During that same period, the price of crude oil rose unabated every year.  CFTC data show that at the end of July [2008], just four swap dealers held one-third of all NYMEX oil contracts that bet prices would increase.”  [David Cho, “A Few Speculators Dominate Vast Market for Oil Trading,” Washington Post, August 21, 2008, page A01.  See, also, Ann Davis, “’Speculator’ in Oil Market is Key Player in Real Sector,” The Wall Street Journal, August 20, 2008, page C1 and Ann Davis, “Data Raise Questions on Role of Speculators,” The Wall Street Journal, August 15, 2008, page D1]

“Trading by swaps dealers—the big Wall Street banks involved in energy trading—on behalf of financial investors and commodity companies, along with noncommercial traders such as hedge funds, accounts for an estimated 70% of trading in U.S. markets, up from about 57% three years ago, according to the CFTC.” [Siobhan Hughes, “Bill Targets Speculation Over Energy,” The Wall Street Journal, June 27, 2008]  A hedge fund manager testified that:  “This so-called swaps loophole exempts investment banks like Goldman Sachs and Merrill Lynch from reporting requirements and limits on trading positions that are required of other investors. The loophole allows pension funds to enter into a swap agreement with an investment bank, which can then trade unlimited numbers of the contracts in futures markets. . . the top five users of swap agreements are investment banks, four of which dominate swap dealing in commodities and commodities futures: Bank of America, Citigroup, JPMorgan Chase, HSBC North America Holdings, and Wachovia.”  [Moira Herbst, “Are Pension Funds Fueling High Oil?  A Senate hearing weighs charges that speculation by big investors and sovereign wealth funds is behind the rise in commodities and energy prices,” Business Week, May 21, 2008,  Ms. Herbst reports that the California Public Employees Retirement System invested about $1.1 billion in commodities swaps contracts.  She also mentions that: “In only five years, from 2003 to 2008, investment in index funds tied to commodities has grown twentyfold, from $13 billion to $260 billion.”

Oil got the most attention, when gasoline jumped to $4 a gallon.  But the derivative products that Wall Street created apply to foods like wheat, corn, beef, and pork, as well as minerals, like palladium and platinum, used in manufacturing consumer products.  The result from speculation is a huge and constant increase in the demand for futures contracts by institutions with very deep pockets.  Like the market for oil futures, the resulting higher prices for food futures have led to increases in the price of the actual commodity to consumers.  In the United States, high food prices are uncomfortable.  But in many other nations, price increases have meant that millions go without.


Even in the midst of the post-2008 turmoil over derivatives, while financial regulatory reform is often Topic A in politics, the CFTC goes on expanding the betting parlor offerings.  One Wall Street firm lobbied the CFTC to allow trading in the expected box office receipts for movies.  [Michael Cieply and Joseph Plambeck, Hollywood Tries to Block Market for Movie Bets, The New York Times, April 7, 2010,]  The Commission unanimously approved the concept in April 2010.  []


A major source of harm to us all comes from the way the betting parlor for derivatives is linked with the trading markets for “real” securities, the shares and bonds representing ownership and debt of operating businesses.  Wall Street’s big players place bets in both the derivatives markets, regulated by the CFTC, and the stock markets, regulated by the SEC.  The arbitrage games are vastly multiplied by exploiting price differentials among the various markets for stocks and the derivatives instruments based on stocks.  Add to this complexity all the intricate software development that the “quants” have built for Wall Street.  It was that “program trading” or “portfolio insurance” that brought about the Crash on October 19, 1987.  The size of the problem in 2010 was more than 30 times what it had been then.  “In 1987, about 600 million shares were traded on Black Monday. On May 6, 19.5 billion shares were exchanged in 66 million trades.”  [Zachary A. Goldfarb, “SEC proposes rules to prevent another ‘flash crash’,” Washington Post, May 19, 2010,]  “The slide in futures caused stocks to fall, leading to even more selling of futures.  The link shows that in times of stress, these two key parts of the market—stocks and futures—can have a dangerous self-reinforcing effect that can turn a garden variety selloff into an explosive crash.”  [Scott Patterson, “How the ‘Flash Crash’ Echoed Black Monday,” The Wall Street Journal, May 19, 2010, page C1]


Arbitrage games among the trading markets for stocks and their derivatives have become especially difficult to police as the number of markets have multiplied and become individual profit centers.  What were once a few nonprofit exchange services, dominated by the New York Stock Exchange, have now become many trading platforms, all operated by for-profit publicly-traded companies.  “Now the U.S. stock market is actually a network of 50 different venues connected by an electronic system of published quotes and sale prices.”  Most of the trading is arbitrage, buying in one market for derivatives or real securities and selling in another.  Government oversight, such as it is, serves only to keep the players within the rules of the games, with no attention to the economic purpose of encouraging investment in productive businesses.  As a result, “the market is now dominated by quick-draw traders who have no intrinsic interest in the fate of companies or industries. Instead, these former mathematicians and computer scientists see securities as a cascade of abstract data.”  [Nina Mehta, Lynn Thomasson and Paul M. Barrett, with Jeff Kearns, Whitney Kisling, Peter Coy, “The Machines That Ate the Market,” Bloomberg Businessweek, May 20, 2010,]


Since Congress gave Wall Street the derivatives betting parlor, its agencies have aided in building the complex rules that make it possible for the cleverest gamesters to play the odds with their computer programs and algorithms.  Twelve days after the May 6, 2010 Flash Crash, the SEC and the CFTC issued a joint preliminary report, which suggested six “working hypotheses and findings.”  One of those was the “possible linkage between the precipitous decline in the prices of stock index products . . ., on the one hand, and simultaneous and subsequent waves of selling in individual securities, on the other, and the extent to which activity in the one market may have led the others;” while another hypothesis was “disparate trading conventions among various exchanges . . ..”

The SEC’s preliminary report of the May 6, 2010 Flash Crash sounds like a sudden revelation of a fact that has been known for at least 14 years.  Congressman Edward J. Markey held hearings in 1994 before the subcommittee on telecommunications and finance.  At those hearings, Charles A. Bowsher, head of the Government Accounting Office, testified that:  “The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole. . . . In some cases intervention has and could result in a financial bailout paid for or guaranteed by taxpayers.”  That was the very script for what happened in the Flash Crash of 2010.  Congressman Markey’s bill for regulating derivatives failed to pass, after Alan Greenspan, then Chairman of the Federal Reserve Board, reassured the committee that: “Risks in financial markets, including derivatives markets, are being regulated by private parties. . . . There is nothing involved in federal regulation per se which makes it superior to market regulation.”  Greenspan did warn that: “The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence.”  He went on to call that possibility “extremely remote,” adding that “risk is part of life.” [Peter S. Goodman, “The Reckoning: Taking a Hard Look at the Greenspan Legacy,” The New York Times, October 9, 2008,  Peter Goodman also tells the story of Brooksley Born’s effort to shed light on derivatives, beginning in 1997 when she was Chairman of the Commodities Futures Trading Commission and crossed swords with Alan Greenspan, Robert Rubin, Larry Summers and others.]


Congress Cancels Out State Regulation of Wall Street


State law enforcement officers have often been a real nuisance to Wall Street.  Every state, the District of Columbia and each of the Territories has a set of laws, regulations and rules governing the sale of securities and the intermediaries who sell them.  These “Blue Sky Laws” were adopted nearly 100 years ago and each state has required some form of filing and clearance before securities could be offered to its residents.  The state regulators are closer to the people, with the consequence that their officials may see political hay in pursuing complaints about Wall Street abuses.  For a national business, like the big banks and brokers, it is a real hassle having to deal with 50 different sets of attorneys general, secretaries of state, securities commissions and other law enforcement agencies.  Wall Street has found it far preferable to have only one government agency, a federal one that it can influence and shape with political contributions, lobbying and the revolving door of staff exchanges.  The answer for Wall Street was to lobby Congress to wipe out state laws, using the constitutional doctrine of federal preemption to eliminate state regulation of all the securities offerings that are Wall Street’s bread and butter. 


A big victory for investment bankers came with the National Securities Improvement Act of 1996.  Congress left the securities industry free to sell shares throughout the U.S. without meeting any state standards for disclosures or for the merits of the offering. According to the SEC, the law has “provisions that realign the regulatory partnership between federal and state securities regulators . . .  to preempt state blue sky registration and review of specified securities and offerings.”  []  

The “specified securities” exempted from state review are basically all of the ones that are sold by Wall Street, leaving the states to regulate securities sales made directly by small businesses and the securities sold in ways that bypass Wall Street.  The exemptions from state regulation are called "covered securities" and they include securities issued by  companies listed on the New York, American and Nasdaq Stock Market exchanges.  The law’s drafters carefully meshed it with rules of the exchanges.  For instance, the definition of covered securities includes those “approved for listing” on an exchange.  That’s to cover initial public offerings, where the shares won’t be listed until after the IPO is completed.  Could a company get approved for listing if it planned to do a direct public offering, bypassing Wall Street by selling the shares itself?  No, that door is closed.  The exchange rules will approve shares for listing only if they are to be offered in a “firm commitment” underwritten offering, through a registered securities broker-dealer.  Could the company get a broker-dealer to do a firm commitment for part of the offering and let the company sell the rest directly?  No, that is against the uniform requirement that a firm commitment underwriting must include all the shares being offered.  That means that the exemption from state filings cannot be used in a direct public offering, or a “best efforts” offering which uses securities brokers as agents.  By this Improvement Act gambit, the investment bankers not only got rid of obstacles to their own way of doing business; they strengthened a big competitive advantage over alternative ways of marketing securities.

The Improvement Act also gave immunity from state filings to mutual funds, and the brokers who sell them.  The definition of exempt “covered securities” was even extended to private placements of securities.  The SEC had exempted from its own registration requirements any sale made to “accredited investors” and “sophisticated purchasers,” without any limit on the dollar amount of securities sold.  []  This Rule 506 had become extremely popular with brokers who sold securities to institutional money managers and millionaires.  But state securities administrators were still requiring filings and reviews before they would clear the offering for sale to people living in their state.  Prospectuses were reviewed for the adequacy of disclosure.  Many states also passed upon the merits of the offering, requiring the investment proposition to be “fair, just and equitable.”  As a favor to Wall Street, Congress simply put Rule 506 offerings into the category of “covered securities,” untouchable by state regulation.  The most that the states can now do is call for a notice filing.  They are powerless to stop it or require modification before selling efforts begin.  They have to wait until a fraud has actually taken place and try to prove it in court.


Left out of the escape from state regulation were all of the offerings in which Wall Street has no interest:  securities listed on regional exchanges or the NASDAQ Small Cap market, and securities sold under Securities Act Rules 504, which is limited to sales of $1 million in a year, [] or Rule 505, for sales up to $5 million in a year.  []  Also left under state filing requirements were the Regulation A exemption for offerings of up to $5 million a year, which must also be reviewed by the SEC but are not subject to filing SEC reports and complying with the Sarbanes-Oxley Act.


The result of the National Securities Markets Improvement Act was to give Wall Street investment bankers, and their investor customers, a free pass to sell securities throughout the United States without state surveillance.  At the same time, it left the burden of state regulation on the backs of small business, independent securities brokers and the more than ninety percent of us who are not millionaires.  Anyone raising money from middle class individuals needs to go through all the hurdles of state registration of the offering.  In addition, they must find a way to comply with state licensing requirements for anyone selling a security.


Once in a great while, there has been an occasional burst of concern for small business expressed by politicians and regulators.  Sometimes, useful action is taken.  The last pro-small business cycle was in the early 1980s and a major result was the creation of a separate category for “small business issuers.”  They were corporations with annual revenues of not more than $25 million, or corporations with their publicly-traded shares valued at less than that amount.  The SEC created a separate Integrated Disclosure System for Small Business Issuers, with substantially less burdensome requirements for SEC filings.  That was all taken away in 2007, with the SEC’s regulation, ironically entitled “Smaller Reporting Company Regulatory Relief and Simplification.”  [Release Nos. 33-8876; 34-56994; 39-2451; File No. S7-15-07,]  Small businesses today are the majority of members in the U.S. Chamber of Commerce, the National Federation of Independent Business and the National Association of Manufacturers, which lobbied for the $700 billion Wall Street bailout but "lose interest when the money is going to community banks and small businesses." [Frank Knapp Jr., president of the South Carolina Small Business Chamber of Commerce, quoted by Mark Drajem, Laura Keeley and David Henry in "NO Lobbying Help for the Little Guys," Bloomberg Businessweek, August 2-8, 2010, page 33]   


The federal-preemption-of-state-law ploy was also used to protect Wall Street’s mortgage lending operations in the U.S. Supreme Court case, Cuomo v. The Clearing House Association, LLC, [, 2009].  The Office of the Comptroller of the Currency and The Clearing House Association, a trade group of national banks, each filed a lawsuit to enjoin an investigation by New York’s Attorney General, on the grounds that the state was preempted by the National Bank Act and the Comptroller’s regulations.  The decision followed the Supreme Court’s 2007 decision in Watters v. Wachovia Bank, N.A., [], in which the Court held that a national bank’s mortgage business is not subject to state licensing, reporting, or supervisory visits, that “federal control shields national banking from unduly burdensome and duplicative state regulation.” 


Congress joined the Supreme Court in protecting Wall Street from state regulation.  After the House passed the “Wall Street Reform and Consumer Protection Act of 2009,” the bill went to the Senate, which passed its “Restoring American Financial Stability Act of 2010.”  The different title in the Senate, leaving out any reference to Wall Street reform or to consumer protection, reflects the differences in the bill itself.  For instance, several U.S. Senators proposed an amendment to the take away the ability of states to enforce their laws against multistate banks.  Instead, the states could enforce any standards that might be adopted by the Federal Reserve Board’s new agency.  As the amendment’s sponsor, Senator Tom Carper posted on his website, “The compromise we passed today would preserve our national banking system while also giving state attorneys general the authority to enforce new rules issued by the consumer protection bureau.  This was a hard-fought but fair compromise that will give businesses certainty and provide an extra set of cops on the beat to help make sure that consumers aren't handed a raw deal."  []  The contrary view:  “This is an overt attempt to take cops off the beat and allow banks to get away with outright abuses.”  [Zach Carter, “Tom Carper is Attacking Consumers and Defending Wall Street,” Campaign for America’s Future, May 12, 2010,  See Stacy Mitchell, “Five Reasons the Carper Amendment Must be Defeated,” The Huffington Post, May 27, 2010,


When Wall Street began to go after home loans as a vast source of securities business, it got Congress to take a series of steps to get the states out of its way.  One of the earliest  was included in the Depository Institutions Deregulation and Monetary Control Act of 1980.  All of the states have long had usury laws, making it a crime to charge more than a certain rate of interest.  Of course, these laws exempted banks and most other institutionalized lenders.  But state usury laws would have crimped the style for securitizing home loans, especially those made by nonbank mortgage originators for Wall Street to package as mortgage securities.  State usury laws only affected interest rates higher than those charged on home loans.  So, if Wall Street had been willing to stay within the standards used by established mortgage lenders, it would not have been necessary to get rid of state usury law limits.  But the profit was seen to be in subprime lending, where much higher interest rates could be charged to borrowers who couldn’t qualify for the usual channels.  Congress obliged Wall Street’s lobbyists and preempted state usury laws.


Congress also helped Wall Street develop its mortgage securities business with the Alternative Mortgage Transactions Parity Act of 1982  State and federal laws and regulations had limited mortgage loans to those with a fixed-rate and with interest and principal to be paid in monthly installments over a period of up to 30 years.  This new law opened the door to loans with adjustable rates, payments of interest only and creatures like the “option-ARM,” where the loan amount can get larger.  [Jon Birger, “How Congress Helped Create the Subprime Mess,” Fortune Magazine, January 2008,]  Getting rid of usury limits and fixed-rate loans was a bit like granting terrorists unrestricted access to all the instructions and ingredients for chemical, biological and nuclear weapons of mass destruction.  Along with the Secondary Mortgage Market Enhancement Act of 1984. Congress had opened the door to a series of “structured products,” like the synthetic collateralized debt obligations, about which the SEC’s enforcement chief, Robert Khuzami said:  “The product was new and complex, but the deception and conflicts are old and simple.”  [Gregory Zuckerman, Susanne Craig and Serena Ng, “U.S. Charges Goldman Sachs With Fraud,” The Wall Street Journal, April 17-18, 2010, page A4.  See Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, pages 72-73 ]


It’s hard to match the federal government’s jealousy over state regulation with the conclusions of the U.S. Treasury’s recommendations on financial regulatory reform:  “The financial crisis was triggered by a breakdown in credit underwriting standards in subprime and other residential mortgage markets. That breakdown was enabled by lax or nonexistent regulation of nonbank mortgage originators and brokers. But the breakdown also reflected a broad relaxation in market discipline on the credit quality of loans that

originators intended to distribute to investors through securitizations rather than hold in their own loan portfolios.”  [Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation, Department of the Treasury, 2009, page 44] Treasury’s recommendations are all about more agencies and powers for the federal government. 


The Courts and Prosecutors Choose to Let Wall Street Run Loose


After all the Congressional investigations and New Deal laws, there was one last government attack on the investment banking cartel.  This time, it was through the executive and judicial branches, although it began in Congress, with the Temporary National Economic Committee in 1938—which was defunded in 1941.  Known as the “Monopoly Committee,” [Charles R. Geist, Wall Street: A History, Oxford University Press, 1997, page 258] it produced tens of thousands of pages of testimony and many monographs of its conclusions.  The Committee found extreme concentration of underwritten securities issues in a few Wall Street investment bankers, close relationships between investment bankers and their biggest clients and very little effort to finance small business. 


In 1944, while Franklin Roosevelt was still president, the U.S. Department of Justice used the Committee’s work to begin a major investigation of the way Wall Street conducted underwritten public offerings of stocks and bonds.  The result was U.S. v. Morgan, et al., in which the 17 major investment bankers were charged with violating the  Sherman Antitrust Act, enacted in 1890 to break up monopolies.  The complaint said the defendants were members of “a combination, conspiracy and agreement to restrain and monopolize the securities business of the United States.”  [United States v. Morgan, 118 F. Supp. 621, 628, 1953] 


Harry Truman had become president on Roosevelt’s death in April 1945 and the Justice Department filed criminal conspiracy charges in July that year.  This enabled the government to use grand jury subpoenas to gather evidence, although it chose not to proceed with a criminal case.  The civil action was filed in 1947 and assigned to U.S. District Court Judge Harold Medina, who had been appointed by Truman the same year.  [Charles R. Geist, Wall Street: A History, Oxford University Press, 1997, page 269] 

The trial began in 1950 and it was 1953 before the government completed putting on its case. 


A year into the trial, the government dropped its charges that the investment bankers refused to act as commissioned sales agents instead of underwriters, that they neglected to assist small companies in need of capital and that they concentrated on selling to large institutional investors instead of individuals.  (It is my personal experience, from 1960 through today, that each of these three charges is still true.  However, I can understand how difficult they would be to prove.  As a friend once said, when I described how these practices worked without any written or oral agreement or acknowledgement that it was happening, “They don’t have to talk about it.  It’s in their mother’s milk.”


When the government began putting on evidence, there were three practices left to sustain the monopoly charge.  One was that they didn’t poach on each others’ clients.  If an investment banking firm had managed an underwriting for a particular business, the rest of the firms would not try to have that business pick them for the next offering.  Second was that the positions in an underwriting syndicate for a particular issuer would remain the same for that company’s future issues.  Those positions were reflected in the “tombstone” announcements of a completed offering, where the managing underwriter was at the top of the pyramid and the other firms participating were on descending lines.  Third was the use of reciprocity in selecting members of an underwriting syndicate.  If investment banker A was given a $10 million allotment in an underwriting managed by investment banker B, then banker A could be expected to include banker B for a similar amount in an underwriting it managed.


Most of us outside the securities industry might consider these practices not to be worth such a massive legal battle.  But there was a fourth theory: price fixing.  That theory was based on the standardized Underwriting Agreement, Agreement Among Underwriters and Selling Agreement, in the forms that have been used since the 1920s.  They require every firm in the offering to sell at one offering price and to receive the same commission.  The managing underwriter is also authorized to buy and sell securities in the aftermarket and to keep the trading price from dropping below the offering price.  The SEC and the Department of Justice were on opposite sides of the price-fixing charge.  Judge Medina agreed with the SEC that the agreements were not unlawful.  But the Department of Justice claimed the agreements were clear violations of the Sherman Antitrust Act.  Judge Medina decided that Congress and the SEC would never have permitted anything illegal.  “The real point is that all those who worked together on the formulation of this most significant and beneficial legislation went about their task of integrating into the statutory pattern the current modes of bringing out new security issues then in common use by investment bankers generally, with complete assurance that no violation of the Sherman Act was even remotely involved.”   [118 F. Supp.621, 697]


The Department of Justice tried the case for over two years, without calling a single witness, except the ones used to introduce documents.  Printed materials were over 100,000 pages and included materials from each of the government investigations, beginning with the 1905 Armstrong Committee.  At Judge Medina’s urging, the government finally added two witnesses.  One was Robert R. Young, a former stock speculator who had successfully sold short in 1929.  [His biography, by Joseph Borkin, is titled Robert R. Young, The Populist of Wall Street, Harper and Row, 1969]  When Young completed his testimony, Medina was so annoyed with his behavior that he refused to shake hands with him.  [Remark by Judge Medina to Vincent Carosso, September 2, 1966, Carosso, Investment Banking in America, page 491, note 123.]  Young committed suicide five years later.  [The Handbook of Texas Online,]


The other government witness was Harold L. Stuart, whom a defense attorney referred to as the “dean of investment bankers.”  Judge Medina said that Stuart was someone “upon whose testimony I could rely with confidence.” [Vincent Carosso, Investment Banking in America, Harvard University Press, page 491, note 126]  However, the government’s lawyers only questioned Stuart perfunctorily, in what Medina said was “a most tremendous waste of time.”  [New York Times March 8, 1952, quoted in Vincent Carosso, Investment Banking in America, Harvard University Press, page 492.]  On cross-examination, Stuart demolished the government’s case, denying each element of the charges of conspiracy.  


After the government put on its evidence, and before the defense had begun its part of the trial, Judge Medina dismissed all of the charges.  He took the unusual step of dismissing “on the merits” and “with prejudice.”  That meant that the government could not file a new complaint on the same allegations.  The 200-page opinion can be read as a “once-and-for-all” defense of investment banking, intended to put an end to the long series of Congressional investigations and political hay made from attacks on Wall Street.  The Justice Department, under President Eisenhower, chose not to appeal the decision. According to Vincent Carosso, the historian of investment banking, the trial “shattered the old myth of a Wall Street money monopoly.”  However, Carosso also wrote that “investment banking in the 1960s was as highly concentrated as it had been sixty years earlier.  In some respects it was even more so.” [Vincent Carosso, Investment Banking in America: A History, Harvard University Press, pages 495, 505]


When the Attorney General decided not to appeal U.S. v. Morgan, Wall Street was off the hook.  In the half century since, no branch of the federal government has tried to go after the investment banking oligopoly.  The subject has come up whenever a merger was proposed of major investment bankers.  In 1979, the Antitrust Division of the Justice Department asked the Harvard Business School to analyze the competitive effect of a proposed merger on the investment banking industry.  This led to the book, Competition in the Investment Banking Industry [Samuel L. Hayes III, A. Michael Spence and David Van Praag Marks, Harvard University Press, 1983]  The authors concluded that there “was a tendency toward increased concentration in investment banking.” [page 78]  In an interview, the lead author, Samuel L. Hayes, III, said:  “We don’t see the prospect for an upheaval . . ..”  There are “substantial barriers to entry for intermediaries who would like to offer investment banking services.”  [Pensions and Investment Age, June 13, 1983, page 34.]  The message from academia to the Justice Department:  Hands Off Wall Street, Business as Usual.  [Charles Ferguson, interviewed about his documentary film, "Inside Job," described the "triangular relationship" of "People going between having positions in universities as economists and being in industry and being in government, and often being paid by industry while they are in academia and while they are writing papers and making speeches about what policy should be toward the industry they're being paid by."  Emily Wilson, "Inside Job: Film Brings Us Face to Face with the People Who Nearly Destroyed Our Economy," Independent Media Institute, 2010,]


Why did the federal government start the antitrust case?  Why did it drop so many of the charges before the trial began?  Why did the government have to be forced to put on witnesses, why did it choose only two witnesses and why were they ones which defeated the government’s case instead of making it?  When Judge Medina dismissed the complaint and said the government could not file another one, why did the government not appeal?  These are political questions, not legal strategy.  A political theory advanced by Robert Sobel for why the case was started is that, wanting to “revive the New Deal spirit after the war, the Truman Administration had warmed over that issue which had served F.D.R. so well in 1932-34.”  [Robert Sobel, Inside Wall Street: Continuity and Change in the Financial District, W. W. Norton & Company, 1977, page 205]  That may have been true when the case was started in 1947, with Truman headed for his narrow reelection victory the next year.  But Eisenhower was elected in 1952, two years before Medina’s decision came down.  What was the intention when the case was not appealed?  One argument is that the objective was what actually happened.  Wall Street came back to life and the government kept its hands off.  By 1961, there were more than a thousand initial public offerings in a year.  The underwriting syndicate and all the ritual of investment banking was back, without the slightest objection from government.  It was as if the great antitrust case had signaled, “The coast is clear; you can all come out again to play.”  The permissiveness toward Wall Street's monopoly has been part of the general lack of enforcement of federal antimonopolly laws since 1980.  [Barry Lynn, Cornered: The New Monopoly Capitalism and the Economics of Destruction, John Wiley & Sons, Inc., 2010]


While the government has looked the other way at Wall Street’s monopoly practices, a private action was brought on behalf of persons who purchased technology IPOs in the bubble years just before 2000.  According to Justice Breyer’s opinion for the Court:  “A group of buyers of newly issued securities have filed an antitrust lawsuit against underwriting firms that market and distribute those issues. The buyers claim that the underwriters unlawfully agreed with one another that they would not sell shares of a popular new issue to a buyer unless that buyer committed (1) to buy additional shares of that security later at escalating prices (a practice called “laddering”), (2) to pay unusually high commissions on subsequent security purchases from the underwriters, or (3) to purchase from the underwriters other less desirable securities (a practice called “tying”). 

The question before us is whether there is a “ ‘plain repugnancy’ ” between these antitrust claims and the federal securities law. [citations]  We conclude that there is. Consequently we must interpret the securities laws as implicitly precluding the application of the antitrust laws to the conduct alleged in this case.”

[Credit Suisse Securities v. Billing, ,, 2007] 


The SEC came into the case on the side of Wall Street and against the investors, arguing that regulation of the securities industry was its exclusive turf and the courts should stay off it.  The U.S. District Court agreed with the SEC and ruled in favor of the defendant investment bankers, but that was reversed by the Second District Court of Appeal.  That Court, located in New York, is the most knowledgeable and experienced in matters of finance.  The U.S. Supreme Court later reversed the Second Circuit, holding that enforcing the antitrust laws would disrupt the capital markets and that the SEC had the expert authority to regulate the securities markets. 


The technology bubble IPO was among the few cases brought by disappointed investors that made it through the courts after 1995.  Private securities litigation had become a nuisance to Wall Street and its corporate clients, so they got Congress to make it far more difficult for plaintiffs to bring class actions.  Abuses by some plaintiffs’ lawyers gave them plenty of talking points for their successful lobbying.  The law that Wall Street received from Congress reads like a long series of hurdles and barriers that disappointed investors must navigate before a case can actually get to trial or settlement.  [United States Code, Title 15, chapter 2B, section 78u-4,]


The “Regulatory Gap” for Investment Bankers Proves Self-Regulation Doesn’t Work


Congress controls the Securities and Exchange Commission through its annual budget.  The lobbying pressure from Wall Street has always been to keep the SEC on a tight leash—give it enough money to keep up the appearance of firm regulation but not enough to interfere with Wall Street’s profitability.  The SEC’s response has been to privatize many of its responsibilities, taking the cost off its books and leaving the SEC Commissioners and staff in an “oversight” role.  The SEC refers to these outsourcing contractors as “Self-Regulatory Organizations” or “SROs,” despite the obvious oxymoron in the term.  What the SEC seems to mean is that no government regulation is necessary because Wall Street will behave for its own long-term benefit; enlightened self-interest will eliminate the excesses that nearly led to eventual collapse of the whole system. 


The most prominent SROs are the securities exchanges.  They must be registered with the SEC, which reviews changes in their rules and oversees their enforcement.  From 1792, when the New York Stock Exchange was first chartered, all exchanges had been nonprofit membership organizations.  Each broker-dealer member had one vote to elect a board of directors, which hired the management.  The mission was clear.  It was to help the members trade securities listed on the exchange, in the most profitable manner that complied with the rules of the exchange.  That structure and psychology changed when the exchanges converted to for-profit corporations and had their own initial public offerings.  Shares were owned by anyone who was willing to pay the price.  The mission was now different.  Like any other business with publicly-traded shares, management was supposed to make money for its shareowners.  What happens to self-regulation when ownership is in the hands of nonmembers and the exchange is supposed to make money for these nonmembers?  What is the effect of competition among for-profit exchanges to attract and keep listings?  How will exchanges respond to the Alternative Trading Systems and Dark Pools that aren’t limited by SEC oversight? [Hans Christiansen and Alissa Koldertsova, Organization for Economic Co-operation and Development, “The Role of Stock Exchanges in Corporate Governance,” Financial Market Trends, Vol. 2009, No. 1, Pgs. 191-220, ]


The self-regulatory functions for the securities industry have been outsourced to the Financial Industry Regulatory Authority, created in July 2007 through the consolidation of the National Association of Securities Dealers and the member regulation, enforcement and arbitration functions of the New York Stock Exchange,  FINRA oversees nearly 4,750 brokerage firms, about 167,000 branch offices and approximately 633,000 registered securities representatives.  The basic purpose is to protect Wall Street’s monopoly from nonmember competition and from so-called rogue brokers who break the rules and make the industry look bad. 

One self-regulatory program was the Consolidated Supervised Entities Program, set up in 2004 and referred to as the CSE.  It was intended to address a big gap in financial regulation—the large Wall Street investment banking corporations.  Because they don’t take in deposits, they were not under the Federal Reserve Board, the FDIC, the Controller of the Currency or state bank regulators.  While their brokerage subsidiaries were subject to FINRA rules, their major business, and biggest risks, were from the buying and selling they did for their own profit, and the huge borrowings they took on to leverage their trading.  Under the CSE, these unsupervised giants could voluntarily submit to regulation.  The SEC ended the program, after its Inspector General strongly criticized the Commission's CSE supervision of Bear Stearns, which collapsed in March 2008.  [  See critique of the program by the minority of the House Committee on Oversight and Government Reform, May 18, 2010, pages 8-11,]  As Scott Patterson describes it, "in a move that would come to haunt not just the agency but the entire economy, the SEC outsourced oversight of the nation's largest financial firms to the banks' quants."  [Scott Patterson, The Quants, Crown Business, 2010, page 201] 

A few days after the failure of Lehman Brothers, leading to the Panic of September 16, 2008, the SEC abandoned the CES program as a failure.  Here is what Chairman Christopher Cox said in an unusually candid acknowledgement:  "The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.

According to the SEC news release:  “Because of the lack of explicit statutory authority for the Commission to require these investment bank holding companies to report their capital, maintain liquidity, or submit to leverage requirements, the Commission in 2004 created a voluntary program, the Consolidated Supervised Entities program, in an effort to fill this regulatory gap. 

“As I have reported to the Congress multiple times in recent months, the CSE program was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.

“The Inspector General of the SEC today released a report on the CSE program's supervision of Bear Stearns, and that report validates and echoes the concerns I have expressed to Congress. The report's major findings are ultimately derivative of the lack of specific legal authority for the SEC or any other agency to act as the regulator of these large investment bank holding companies.

“As we learned from the CSE experience, it is critical that Congress ensure there are no similar major gaps in our regulatory framework. Unfortunately, as I reported to Congress this week, a massive hole remains: the approximately $60 trillion credit default swap (CDS) market, which is regulated by no agency of government. Neither the SEC nor any regulator has authority even to require minimum disclosure. I urge Congress to take swift action to address this."

Private Securities Cases Become Their Own Scam


Serious political reformers are aware that government agencies are not enough to protect us.  They realize that laws are not always enforced.  Sometimes the lack of detection and  prosecution is because the agencies are starved through token funding by Congress.  The agencies may end up being staffed by persons more sympathetic to the industry regulated than to the public.  The “revolving door” may influence individuals who work for a regulator, while expecting to go to a job with a regulated business, or vice versa.  Or a regulatory agency may just atrophy in bureaucratic red tape.


Foreseeing this frustration, lawmakers have often created “private rights of action,” inviting persons harmed to start their own court proceeding.  An extra inducement may be the possible award of triple the amount of actual damages, reimbursement of legal expenses or the promise that lawyers can attract follow-on clients for more cases. 

In the federal securities laws, these private rights of action have led to a more or less permanent class of securities plaintiffs’ law firms.  Wall Street has successfully lobbied Congress into erecting barriers to shareowner class actions, while some prominent class action lawyers have been punished for paying plaintiffs to bring lawsuits. 


The private action remedy, if it is at all effective, is likely to be a case of way too little, way too late.  For instance, a class-action lawsuit was brought against dozens of investment banks and brokerage firms for the unlawful games used to inflate prices of IPO aftermarket in the late 1990s.  Losses were claimed in the many billions.  It was ten years before the case was settled and the amount was a relatively token of $586 million.  Of that, the six lead plaintiffs’ law firms were expected to take a third and also put in for reimbursement of $56 million for their expenses.  [Nathan Koppel, “Tech-Firm Holders Settle Suit Over IPOs,” The Wall Street Journal, April 7, 2009, page C3]  A federal appeals court had ruled that there wasn’t a clear chain of causation between the underwriters’ actions and the investors’ losses, so the case could not be conducted as a class action.  The proportionately minor settlement amount “was a big victory for investment bankers,” according to Professor Jay Ritter, the principal authority on IPO practices.  [Randall Smith and Chad Bray, “IPO-Abuses Lawsuit is Finally Settled,” The Wall Street Journal, October 7, 2009, page C1]


The federal securities laws enacted in the 1930s specifically include the right to bring private lawsuits to recover investment losses.  [Securities Act of 1933, sections 11, 12 and 18,; Securities Exchange Act of 1934, sections 18 and 20,]  The U.S. Supreme Court has said that the words of the law and regulations “implied” a private right to sue in cases based on section 10(b), which makes it unlawful to use any manipulative or deceptive device in the purchase or sale of a security.  [Superintendent of Insurance of New York v. Bankers Life and Casualty Co., 404 U.S. 6, at 13, note 9, 1971]


Private enforcement of the federal securities laws has become a game played by class action securities litigators and insurance companies.  Corporate directors and officers are routinely indemnified by the corporation from any liability to securities owners and the corporations also buy directors’ and officers’ liability insurance to cover what they might have to pay on the indemnities.  The dollar limits of that insurance become the treasure chests for the litigators, who will get a big percentage in fees and their expenses.


By the 1990s, Wall Street got Congress to override a presidential veto of the Private Securities Litigation Reform Act of 1995.  That law watered down the ability to bring a class action on behalf of securities holders.  [Securities Act of 1933, section 27,; Securities Exchange Act of 1934, sections 21D and 21E, and  For a summary description, see the law firm memorandum by Pillsbury Winthrop Shaw Pittman LLP at


After the “Reform Act,” shareowner class actions are more difficult and costly, but they are still a trick game, in which the corporations and their insurers settle cases by paying a few institutional investors and their lawyers, with the  money for the settlement and  the large insurance premiums coming out of the corporate net worth that belongs to all shareowners.  As U.S. District Court Judge Jed S. Rakoff said, when rejecting the proposed settlement over Bank of America’s claimed failure to disclose Merrill Lynch bonuses, “shareholders who were the victims of the bank’s alleged misconduct [would] now pay the penalty for that misconduct.” [Michael Orey, “Do Shareholder Class Actions Make Sense?,” Business Week, September 28, 2009, page 66] The officers and directors, who caused or permitted the claimed wrongdoing, pay nothing and come out blameless, because the settlement agreements typically declare that no one admits or denies any wrongdoing. 


Securities class actions are either dismissed or settled; they rarely ever get through an actual trial. The settlement amount is usually right around the insurance policy limits and  negotiations get more complex when the primary insurer is backed up by other policies. [Professors Tom Baker, University of Pennsylvania Law School, and Sean Griffith, Fordham Law School, “How The Merits Matter: Directors' And Officers' Insurance And Securities Settlements,” University of Pennsylvania Law Review, Volume 157, No. 3, Page 755,]   Insurance polices have a "dishonesty exclusion," which lets insurers escape payment if a court finds fraud or willful violation of the securities laws.  Settlements before a court finding are made without admitting dishonesty, to collect on the insurance, "a huge incentive to settle even the most spurious claim."  [Pamela A. MacLean, California Lawyer, July 2010, page 32, reviewing Circle of Greed: The Spectacular Rise and Fall of the Lawyer Who Brought Corporate America to its Knees, by Patrick Dillon and Carl M. Cannon, Broadway Books, 2010]  Once there is a settlement agreement, another long process drains off fees and expenses before the people who once owned the security ever receive any leftovers. 


The real cause of most of these drainoffs of corporate funds from securities litigation is the volatility of the securities markets.  To make money from a lawsuit, there needs to be a legal duty, along with a breach of that duty, together with damages caused by that breach and, finally, a source of money to pay damages.  In the class action securities litigation world, it all begins with a calculation of damages—the difference in the market value of the securities just before the breach from the value after—and the insurance coverage available to pay the damages.   If the price drop has been large enough, and the insurance policy limits are high enough, a securities litigator can always find the duty and breach which can be said to have caused the drop.  


The effect of the private remedy today is that insurance premiums paid by corporations get distributed to lawyers for plaintiffs and defendants and all the accountants, expert witnesses and other participants in the process.  The insurance companies increase premiums to make sure something is left over for them.  The vision of “private attorneys general” enforcing the securities laws to protect investors is mostly a sham.


Securities Laws Protect Wall Street Schemes, Like “Front-Running”


There are basic confidence schemes that have been used for centuries to trick money from marks.  []  Most of them rely upon the victim’s greed overcoming conscience and reason, as in W.C. Fields’ movie, “You Can’t Cheat an Honest Man” and the book of that title.  [James Walsh, You Can’t Cheat an Honest Man:  How Ponzi Schemes Work and Why They’re More Common than Ever, Silver Lake Publishing, 2010]  Some con games can be worked without violating any criminal law.  Others may be technically illegal but law enforcement officers don’t consider them worth the effort of arrest and prosecution, because they know that they won’t take any heat for letting it go by.


Most of Wall Street’s schemes involve some form of inside information.  The Wall Street participant in a transaction knows something important that the other side hasn’t yet learned.  As Gordon Gekko said in the movie, Wall Street, “If you’re not inside, you’re ‘outside.’”  [This and other quotes from the film, like “greed is good,” can be read at]  One of the insider schemes that the securities laws protect—for Wall Street firms, but not for its employees—is “front-running.”


At front-running’s most primitive form —and against the rules—a brokerage employee receives a large order to buy a traded security and figures the order will cause the price to go up before it can be filled from sell orders. An order for the employee’s personal account is put in first, followed by the price-changing customer’s order, and then followed by the employee’s sell order at the now higher market price.  This gross practice is usually perpetrated by an employee, acting alone, trying to pick up some extra money that doesn’t get shared with the employer.  As a result, the brokerage firm wants to catch this “rogue” and prevent the bad customer relations and publicity that could result.  The even stronger, quirky motivation is that the employee is trying to make a personal profit that should really belong to the employer.  The regulators have computer programs that can pick up trades that look like front-running, so they can help Wall Street clean its house, while getting credit for protecting the public.


While the SEC and FINRA are equipped and willing to help Wall Street catch rogue brokers, it’s a very different story when the front-running is a Wall Street firms’ own practice, like letting favored customers in on “hot IPOs.”  A century ago, J. P. Morgan liberally brought in preferred people to buy at private sales of the holding companies he formed, before they were sold at public offerings.  The Securities Act of 1933 protects a very similar practice.  It says that new issues of securities must be sold only by use of a prospectus, which must be first cleared with the SEC.  But it defines “prospectus” as a communication “written or by radio or television.”  [Securities Act of 1933, section 2(10),]  In the real world of Wall Street, securities are sold by oral communications, by telephone or in meetings.  The whole purpose of the IPO “road show” is to let invited customers hear the company’s officers and the underwriter’s analysts present information that is not written in the prospectus, allowing them to place orders for the offering, front-running the public.


The “quiet period” is another tool given Wall Street under the Securities Act, ostensibly to prevent “gun-jumping,” which is getting ahead of the general public.  The quiet period is the time between a company’s decision to have a public offering of its securities and up to 40 days after the offering is completed.  [The quiet period is part of a complex set of rules about disclosure, revised July 2005 in a 468 page document, SEC Release No. 33-8591,]  Because the company in an IPO has been privately owned, not much information will have been publicly available about it.  SEC lawyers warn that any news or comment that seems to promote the company can cause the SEC to postpone the offering for a “cooling off” period of up to many months.  


In reality, the quiet period’s “main purpose seems to be to give fat-cat players an edge over ordinary investors. How? In the runup to their IPOs, companies stage road shows, where big investors get to hear and question company management and its bankers. Meanwhile, because of regulations affecting the quiet period, the company often refuses to talk to the press or address any questions average investors might have.  Information is often given to pros at road shows that average investors don't have a prayer of receiving. Says Jay R. Ritter, a finance professor at the University of Florida: ‘There's a sleight of hand. Companies can say certain things that they're not allowed to write down.’ For instance, they often discuss analysts' forecasts of their earnings with road-show audiences but don't publish them.”  [Marcia Vickers, “There's No ‘Quiet Period’ For Bigwigs: Before an IPO, institutions get road shows -- while small investors get shut out,” Business Week, August 2, 2004,]

Wall Street Investment Bankers Use the New Deal Laws to Protect Their Monopoly 


The major threat to a monopoly is competition.  Since 1792, when brokers and dealers started the New York Stock Exchange, the first rule of Wall Street has been that securities trading is for members only.  The biggest sin on Wall Street is “trading away,” doing any business outside of club members and club rules.  That includes any moonlighting by an employee or any alliance by a member firm with a nonmember business.  When federal securities laws brought the requirement that broker/dealers must be licensed by the SEC, the full force of the federal government was placed behind enforcement of the club rules.  Anyone caught trading away can be barred for a lifetime from ever being inside the securities business. The SEC gets lots of criticism for being lax in protecting investors, but it has been vigilant in protecting Wall Street from competition.

The federal securities laws effectively incorporated Wall Street’s monopoly agreement into federal law.  The Securities Exchange Act of 1934 makes a criminal of anyone encroaching on Wall Street’s protected turf without being a registered broker-dealer.  [Section 15(a),]  Even activity on the edge of that turf will be blocked.  The Securities Act of 1933 makes it unlawful for any person to use any “communication which, though not purporting to offer a security for sale, describes such security . . . without fully disclosing” the receipt of pay for the communication.  [Section 17(b),] The SEC sued a New York public-relations firm and its owner for disseminating information about stocks on their website,, without disclosing that the featured companies had paid for the touts.  [Litigation Release No. 15950, October 27, 1998] 

The Wall Street way to raise capital is the syndicate of investment banker allies who divide up the new securities for sale to their wealthy customers.  Early on, encroachment on the monopoly of major investment bankers began to come from new firms that used advertising and public relations to educate middle class newspaper and magazine readers about investing in securities.  The Securities Act of 1933 put a stop to this competition.  It prohibited written communications before an offering had effectively been completely sold.  The major investment bankers, who could sell an entire issue with a few telephone calls, again had the field to themselves.

Even within the investment banker syndicates, the managing underwriters often had problems with some of their members secretly cutting prices or selling before the set time.  When competitors agree to restrict competition, it can be very difficult to keep them all in line.  Somebody will be trying to find away around the rules while another may consider open rebellion.  It is not unusual for an industry to get the government to enforce its agreements not to compete.  Their assigned traffic cops become the protectors of the monopolists.  The Securities Act of 1933 put the federal government in the role of enforcing the rules for participants in Wall Street underwriting syndicates. 

Until recent years, a single investment banking firm did not have enough customers of their own to sell an entire issue.  They rounded up other securities broker-dealers to sign an underwriting agreement, with each member of the syndicate agreeing to take a portion of the offering for resale.  Before the Securities Act, syndicate members had begun to seek an advantage over their rivals by violating syndicate agreements that set the price and timing for the sales.  Some of them were “jumping the gun” by selling securities to customers a few days or hours before the planned simultaneous release for sale.  They would plant pre-offering advertising, which tempted them to jump the gun when customers called about the offering.  Another practice among selling group members was to share their commission on an offering with their customers, by discounting a bit from the offering price.  The increased speed of distributions and the focus on retail selling during the 1920s made it difficult for managing underwriters to monitor and control the behavior of hundreds, or occasionally thousands, of securities dealers participating in the distribution of a new issue. By the late 1920s, investment bankers realized that the viability of the syndicate system was threatened.  The answer for Wall Street was to bring in the federal government to enforce its monopoly rules.  The Securities Act of 1933 made it a crime to sell before the managing underwriter chooses to have the SEC registration statement become final.  The Act also prohibited any publicity before that date.


In the late 1930s. the Temporary National Economic Committee investigated the concentration of economic power, “including that created by ‘financial control over industry.’  In the investment banking field, it was clear that the costs imposed by the Securities Act tended to discourage smaller issuers from engaging in public offerings, which deprived less prestigious underwriting houses of business. Under pressure from the SEC, however, the TNEC concluded that the fault lay with ‘the capital markets’ and not with the Securities Act.”  [Paul G. Mahoney, “The Political Economy of the Securities Act of 1933,” University of Virginia School of Law, Law and Economics Working Papers,” Working Paper No. 00-11, May 2000, page 41,]  Wall Street has effectively used the SEC to protect its monopoly even from any judicial supervision.  Anyone running to the courts for enforcement of investor protection will be met with the argument that the courts need to leave securities regulation to the agency created by Congress for that purpose. 


While the SEC has kept the hands of the federal government off Wall Street’s monopoly, state governments can still be a threat in enforcing their laws against fraud.  New York Attorney General Eliot Spitzer forced Wall Street into a 2003 settlement of claimed abuses surrounding underwritten IPOs.  Part of the settlement called upon the SEC to enact enforcement rules.  Seven years later, the SEC had not yet come up with the rules.  Not only that, but the SEC proposed to the court that it take away some of the restrictions in the settlement order.  Even the SEC chairman at the time of the settlement commented in 2010 that:  “This seems like it’s going in the wrong direction,” while Spitzer said:  “That was the moment when Wall Street should have been reformed, and it seems no one did anything.”  [Susanne Craig, Kara Scannell and Randall Smith, “SEC Didn’t Expand Upon Stock-Abuse Settlement,” The Wall Street Journal, March 19, 2010, pages C1, C3]  


Wall Street also brings the government in to enforce rules upon its employees, preventing them from ever competing with their employers.  Trading away is the number one crime on Wall Street.  What “trading away” means is that an employee is doing some business on the side, cutting the employer out of the deal.  We all know people, in the building trades, for instance, who do jobs on weekends or days off, getting paid directly by the customer.  Employers generally look the other way, so long as the side jobs don’t interfere with how the employee performs at the regular job.  It’s hard to believe that prosecutors and courts would step in to punish these moonlighters.


Not so on Wall Street.  It has a government-protected monopoly on the securities business.  Anyone who deals with customers about securities has to be under contract to a licensed broker-dealer.   If a registered representative gets caught doing a piece of business that doesn’t go through the broker-dealer’s books, it can be the end of the representative’s license, the end of any ability to work in the securities industry.  It can also mean fines and imprisonment.


A recent example shows how seriously the government takes its job of protecting Wall Street against competition from employees who receive money that could have gone to their employer.  One of Wall Street’s minor sources of revenue comes from its practice of lending stock to persons who have sold the stock short and are supposed to be in position to deliver the sold shares.  Of course, the shares are actually owned by the firm’s customers, but that’s another issue.  The employing brokerage firm collects the fees charged for borrowing shares.  Morgan Stanley, now owned by Bank of America, found out that some of its employees were directing stock lending business through finders, who then split their fees with the employees.  The Brooklyn U.S. Attorney’s office prosecuted 19 employees.  They were all convicted and were sentenced to up to three years in prison.  After the convictions, Morgan Stanley issued a statement that the employees had violated the firm’s policies.  [Amir Efrati, “Ex-Trader Pleads Guilty in Stock-Loan Case, The Wall Street Journal, April 16, 2010, page C5]


Wall Street is Allowed to Play Both Sides of the Game


Many of the abuses that came from the Crash of 1929 investigations involved securities firms operating a business model with a built-in conflict of interest.  They acted as brokers executing trades for customers and they were also dealing in securities for their own account.  Sound familiar?  That’s because the major broker-dealers and banks are still doing business the same way, often betting against the customer and causing big problems.  Congress and the SEC have never mustered the will to enforce a separation of the broker and the dealer functions.


Some of the biggest conflicts of interest at Wall Street firms come from their dual role of buying and selling securities for customers while also buying and selling securities for themselves.  The SEC defines these very separate roles as “broker” and “dealer.” [Securities Exchange Act of 1934, sections 3(a)(4) and (5),]  Nevertheless, Wall Street firms are licensed as “broker-dealers,” so they are free to trade for themselves at the same time they are advising and placing orders for customers.  A major part of the New Deal legislative proposals was to force Wall Street firms to be either a broker or a dealer, but not allow them to be both.


The draft Securities Exchange Act of 1934 required securities firms to choose between acting as an agent for others or buying and selling securities for their own account.  That would have applied to underwriting new issues of securities, since investment bankers structurally purchase shares or bonds from their client, the securities issuer, and resell them to their customers.  Underwriters would have been required to change their business model.  They could either have acted as an agent for the issuer in selling the securities or they could have purchased and resold the new issue of securities.  The same firm could not have done both.


The proposal to separate the functions of brokers and dealers started out as the Fletcher-Rayburn bill.  Sam Rayburn, the long-time Speaker of the House of Representatives and mentor to Lyndon Johnson, said that opposition to his bill was “the most powerful lobby ever organized against any bill which ever came up in Congress.”  [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 377.] 

Instead of making it into law, the issue was deferred for study to the newly formed SEC.  The new Commission eventually concluded that “although the combination of the broker and dealer functions did involve serious problems of conflict of interest, there was no need to legislate a complete segregation of these functions inasmuch as we had been granted ample administrative power to deal with most of the known abuses.”  [Report on the Desirability and Advisability of the Complete Segregation of the Functions of Broker and Dealer, Government Printing Office, 1936, pages 109-110, quoted by Martin Mayer in Stealing the Market: How the Giant Brokerage Firms, with Help from the SEC, Stole the Stock Market from Investors, BasicBooks, 1992, page 41.]

Government Kicks Commercial Banks off Wall Street’s Turf, Temporarily 

Wall Street investment banks have never been interested in selling securities to the middle class individual. The commission rate is the same on small sales as it is on large ones, while the time involved to make a small sale can be about the same as for a large one.  As long as an issue of securities can be sold to a few large investors, there is no incentive to develop business with anyone other than institutions and wealthy individuals.  In practice, the small investor involves even more work, because of the need to develop a trust relationship and to educate the customer.   

One group willing to sell to the small investor was the commercial banks.  They already had a trust relationship with their middle class depositors and they had learned about marketing new issues when they helped pay for World War I by selling Victory Bonds.  After the War, they created affiliates to distribute securities issued by their bank loan customers, often selling them to their bank deposit customers.  One of the ways they accommodated these retail customers was to sell securities on the installment plan, with 25 percent down and five percent per month.  As the banks grew their underwriting business, they began to draw clients away from the investment banks. 


After the 1929 crash, stories emerged about speculation, manipulation and fraud by the commercial banks and their securities affiliates.  These stories became Congressional testimony, supporting the Banking Act of 1933, which made it unlawful for commercial banks to act as investment bankers or as securities broker/dealers.  In 1934, after the Banking Act had become law, a study was published in the Harvard Business Review, comparing offerings underwritten by the eight largest private investment banks with the eight largest affiliates of commercial banks.  It concluded that:  “One can now say that there has been no significant difference in the quality of the new security originations of these two groups.” [Terris Moore, “Security Affiliates Versus Private Investment Banker—A Study in Security Originations,” Harvard Business Review, July 1934, page 484.] 


The only serious competition to Wall Street’s investment bankers came from commercial banks, which encroached on their turf after their learning curve in the successful Victory Bond programs of World War I.  In the Banking Act of 1933, the investment bankers got Congress to freeze out the commercial banks.  Any bank which accepted deposits, with the new FDIC insurance, could not also underwrite securities or operate a brokerage business.  In the 1980s, investment bankers were out-lobbied and Congress let commercial banks back into the securities business.  Then, after the Panic of 2008, the two remaining big investment banks chose to become bank holding companies, to come under the shelter of the Federal Reserve and its unlimited supply of cheap borrowing. 

The public buildup to forcing commercial banks out of the securities business began in 1932, with hearings before the Senate Banking and Currency, called the Pecora Committee, after its Chief Counsel, who much later published his story of the hearings.  [Ferdinand Pecora, Wall Street under Oath : The Story of Our Modern Money Changers, Simon and Schuster 1939, A. M. Kelley, 1973.  Pecora had been a New York District Attorney.  When Pecora became a New York Supreme Court Justice, Joseph P. Kennedy, the first SEC Chairman, sent him a congratulatory telegram.]  The investment bankers won the battle before the Pecora Committee hearings by cooperating with legislative staff in supplying information and drafting proposed legislation.  [Mahoney, Paul G., "The Political Economy of the Securities Act of 1933" (May 24, 2000). University of Virginia Law School, Legal Studies Working Paper No. 00-11. Available at SSRN: or DOI: 10.2139/ssrn.224729]

The Banking Act of 1933 forced bank managers to choose between selling securities and accepting FDIC-insured deposits.  While investment bankers continued to be unregulated until 2008, commercial banking is heavily regulated, by the regional Federal Reserve Banks, Comptroller of the Currency and state banking supervision.  Much of this regulation is intended to protect the banks from the consequences of mistakes they may make in lending and investing.  Commercial banks must have a protective layer of shareowners’ equity to absorb losses.  Investment banks have had no regulation of their investments or their capital adequacy.  They have been free to borrow as much as they can to invest in whatever they choose.  As described by Justin Fox in  “Investment banks have a natural tendency to expand until they use all of the balance sheet they're given. That's one of the reasons the SEC's 2004 decision to remove constraints on leverage was such a bad one -- they're constitutionally incapable of constraining themselves.”  [“Blame Citigroup’s woes on the Citi-Travelers Merger,”, December 2, 2008]   The limit on deposits and borrowings for commercial banks is around 8%, or 12 times shareowners’ equity.  Investment banks operated at much higher leverage levels.  In the Summer of 2008, the two major remaining investment banks had borrowings equal to 24 and 28 times their shareowners’ equity.  [Peter Eavis, “Life after Debt for Wall Street,” Heard on the Street, The Wall Street Journal, December 3, 2008, page C14.]


Glass-Steagall, named after the two sponsors of the Banking Act of 1933, has been the short-hand term for the law forcing commercial banks to get out of the securities business.  After a long battle between commercial bankers and investment bankers, it was completely repealed.  The fight to bring it back was a big part of the financial reform bill machinations in 2008.  The commercial banks’ attack on Glass-Steagall was like the siege of a city in ancient time.  There was the frontal attack to break down the wall that Congress had built.  Banks recruited a lobbying army in the 1960s, at first just to allow them to enter the municipal bond market.   “Some lobbyists even brag about how the bill put their kids through college.”  [The Wall Street Fix: Mr. Weill Goes to Washington, Frontline, Public Broadcasting System,]

While the main battle was being waged, individual banks directed minor skirmishes toward crumbling some of the most vulnerable parts of the investment banking enclosure.  In 1980, Bankers Trust Co. began advising 12 of its banking clients on the terms of commercial paper they used to finance short-term operations.  Then the bank would act as their agent in finding buyers.  The Securities Industry Association asked the Federal Reserve to tell Bankers Trust that it was violating Glass-Steagall.  Instead, the Fed said it was perfectly legal, finding that commercial paper isn’t a security and that the bank’s activities weren’t underwriting.  The SIA took the Fed and Bankers Trust to court but got nowhere.  [“Bankers Trust is Sued by Trade Association of Securities Industry,” The Wall Street Journal, October 30, 1980, page 25]  These are the major assaults that ultimately gave commercial banks the freedom to compete with investment banks and securities broker-dealers:

1983--Federal Reserve OKs Bank of America acquiring discount broker Charles Schwab & Co.

1984—Senate bill to remove major Glass-Steagall limits is defeated in the House

1986—Fed OKs bank underwriting, up to 5 percent of their revenues

1987—Fed allows banks to sell commercial paper, municipal bonds, mortgage securities

1988—Senate-passed bill to limit Glass-Steagall again fails in House

1989—Fed permits underwriting debt and equity securities, raises limit to 10 percent

1990—Fed says J.P. Morgan can underwrite all securities, up to the 10 percent ceiling

1991—Bush administration-proposed repeal wins in committees, loses House vote

1995—Senate, House banking committees approve repeal.  It fails in conference

1996—Fed allows banks to create investment banks, raises limit to 25 percent

1997—Fed says banks can acquire securities businesses

1998—Citigroup agrees to acquire Travelers insurance and its investment bank

1999—Repeal is part of the Financial Services Modernization Act of 1999

Just a week before Citigroup’s 1998 multi-industry merger announcement, Congress had failed again to repeal Glass-Steagall.  In response, the finance, insurance, and real estate industries (the FIRE lobby) spent more than $200 million on lobbying and made more than $150 million in political donations, targeted to members of committees with direct jurisdiction over financial services legislation.  [Brody Mullins, “Senators Seek Cash as They Mull Rules: Both Parties Have Held Dozens of Fund-Raisers on Wall Street While Fashioning New Regulations for Financial Markets,” The Wall Street Journal, April 21, 2010, page A4.  See Tim Carrington, The Year They Sold Wall Street: The Inside Story of the Shearson/American Express Merger, and How it Changed Wall Street Forever, Houghton Mifflin Company, 1985]

Wall Street did not slow down its spending to influence Congress after the 1999 Modernization Act.  From 1998 through 2008, the FIRE lobby more than doubled what it spent on lobbying the federal government, from $200 million to over $400 million a year, for a total of $3.6 billion.  In the period from 1990 through 2008, Wall Street made $2.2 billion in political contributions to lawmakers, more than any other industry.  The spending rate slowed in 2009, primarily because many big Wall Street firms went bankrupt or were taken over by the federal government.  [Elizabeth Williamson, T.W. Farnam, Brody Mullins, “Finance Lobby Cut Spending As Feds Targeted Wall Street,” The Wall Street Journal, July 1, 2009, page 1; Center for Responsive Politics,  For a detailed narrative of the harm wreaked by “the Money Industry” and its political influence, see Robert Weissman and James Donahue, Sold Out: How Wall Street and Washington Betrayed America, Essential Information*Consumer Education Foundation,, March 2009,]

One piece of  lobbying prepared the way for the 2008 bailout of Wall Street investment banks.  The Federal Reserve had long been authorized to lend money to a business that isn't a bank in "unusual and exigent circumstances," if the business "is unable to secure adequate credit accommodations from other banking institutions."  []  However, the 1932 law required the loans to be supported by collateral from "actual commercial transactions," which  ruled out securities held by investment banks.  At the request of Goldman Sachs, that condition was removed in the "Other Miscellaneous Provisions" section of the Federal Deposit Insurance Corporation Improvement Act of 1991. [Public Law 102-242, section 473,  Reported in Simon Johnson and James Kwak, 13 Bankers: the Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, page 152, citing David Wessell, In Fed We Trust: Ben Bernanke's War on the Great Panic, Crown Business, 2009, page 161]

Congressional politicians have their own set of plays in the laws-for-sale game.  Their goal is to raise large amounts of campaign funds to retain their elected office.  One way to do this is to introduce a bill that would give money to a group with very deep pockets, or would take money away from them—or, better yet, would take money from one big-spending group and give it to another.  This game has many refinements, such as dragging the process on from one legislative session to another, with dramatic near misses, enabling lawmakers to collect campaign contributions in multiple election cycles.  Repeal of the Glass-Steagall Act had been a perfect venue for this game. 

The “Modernization Act” lobbyists were back at it in full force as Congress reacted to the 2008 market crash.  These were the former government employees who passed through the revolving door into influencing legislators and their staff to accommodate Wall Street.  “243 lobbyists for six big banks and their trade associations used to work in the federal government – 202 in Congress, the rest in the White House, Treasury, or at a relevant federal government agency. . . . The six big banks and their trade associations have spent close to $600 million since the first major federal bailout of Bear Stearns in March 2008 on lobbying, trade association activity and political contributions.  Citigroup employs 55 revolving-door lobbyists . . . . The federal government was until recently Citigroup’s largest shareholder.  Other banks are also employing huge lobbying armies: Goldman Sachs with 45, JPMorgan Chase with 32 . . ..”  [Kevin Connor, of the Institute for America’s Future, “Big Bank Takeover: How Too-to-Big-to-Fail’s Army of Lobbyists Has Captured Washington,” May 11, 2010,


No one better exemplifies the revolving door than Robert Rubin.  He was co-chairman of Goldman Sachs, with Jon Corzine, who became a U.S. Senator and New Jersey Governor.  Goldman Sachs shows up as one of the two or three largest contributors to presidential and other political campaigns.  Serving as Secretary of the Treasury under President Clinton, “Mr. Rubin helped loosen Depression-era banking regulations that made the creation of Citigroup possible by allowing banks to expand far beyond their traditional role as lenders and permitting them to profit from a variety of financial activities. During the same period he helped beat back tighter oversight of exotic financial products, a development he had previously said he was helpless to prevent.”  Eric Dash and Julie Creswell, “The Reckoning:  Citicorp Saw no Red Flags Even as it Made Bolder Bets, The New York Times, November 22, 2008.  [] When Robert Rubin returned to Wall Street, it was as a $40 million a year senior advisor to Citigroup.  From there, he telephoned Peter R. Fisher, under secretary of the Treasury for domestic financial markets, “to see if there was anything the Bush administration could do to save Enron, a major Citigroup borrower and client.”  [Joseph Kahn and Alessandra Stanley, “Enron’s Many Strands: Dual Role; Rubin Relishes Role of Banker as Public Man,” The New York Times, February 11, 2002,  For a list of those passing through the revolving door between Wall Street during the Clinton and Bush administrations, see Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, pages 94-96] ] 


Political influence at the national level is like any other product, with the two major parties competing for market share.  The largest contributor to the 2008 presidential campaigns was the finance sector.  [Center for Responsive Politics,]  In the 2009-10 election cycle, the Democrats collected 58% of the contributions to federal candidates from financial institution employees and political action committees.  []   In early 2010, Republican leaders were calling on Wall Street CEOs to capture back the largest amounts.  John Boehner, Minority Whip in the House, had dinner with James Dimon, CEO of J.P. Morgan Chase, while Eric Cantor, the number two House Republican, said, “I sense a lot of dissatisfaction and a lot of buyer’s remorse on Wall Street.”   [Brody Mullins and Neil King Jr., “GOP Chases Wall Street Donors: Data Show Fund-Raisers Begin Capitalizing on Bankers’ Regret Over Backing Obama,” The Wall Street Journal, February 4, 2010, page A6]   (My wife Gwendolyn suggests we replace elections to political office with a model based  on the jury system.  Legislators would be selected by lottery, with minimal qualifications, such as fluency in English, and with limited hardship exemptions.  They would have restrictions on post-service employment, to help insure they couldn’t be bought.)    


Even after final repeal of Glass-Steagall, investment bankers still had an advantage over commercial banks.  They were not regulated by the Federal Reserve board as a bank holding company. In the 1920s, when Congress first began restricting the risks that banks could take, lawyers began creating new companies to put in between the bank and its shareowners.  These bank holding companies would then create other subsidiaries to underwrite securities or engage in other businesses that would be unlawful for a bank.  The expected then happened:  when holding companies got hit with losses from the new businesses, they tended to drain money out of their banks, threatening depositors.  Eventually, Congress passed laws to regulate the activities of bank holding companies.  For years, lawyers for investment bankers were busy finding ways to get around the holding company restrictions, such as using Industrial Loan Company subsidiaries, to make loans like a bank, without serious regulation.


That all changed in 2008.  According to an article by banking lawyers, “the long-standing tradition of avoiding the limitations imposed by federal holding company regulation reversed itself on a dime, in large part because of the need for government support to weather the economic storm.”  This included becoming a holding company to “take advantage of” the U.S. Treasury’s Troubled Asset Relief Program, the FDIC’s Temporary Liquidity Guarantee Program and borrowings from the Federal Reserve Banks.  In giving out holding company privileges, the Federal Reserve Board used “emergency” exceptions to prevent any chance for comments or protest.  It also allowed two years to go by before the new holding companies had to get rid of prohibited nonbanking businesses.  [Vartanian, Lenaghan,  Crisis Revamps Patterns of Bank and S&L Holding Company Approvals, 92 Banking Rep. (BNA) 17 (April 28, 2009)]


You could explain the favors as the Federal Reserve trying to prevent failures of nonbanking institutions that could harm the overall credit system and economy.  Or you could attribute them to the Fed’s bureaucratic mandate to expand the universe of businesses it regulates.  Some might even say it was Fed officials doing favors for members of their social clubs.  Consider one example, of a business that had spent years making sure it avoided regulation, the General Motors Acceptance Corporation.  Once a subsidiary of the automobile manufacturer, it had become majority-owned by Cerberus Capital Management, LP, a private equity fund named after the mythical three-headed dog that guarded the gates of hell.  Its management included former vice president Dan Quayle and former Treasury Secretary John Snow.  They got the Fed to invest $5 billion and take GMAC in as a bank holding company, on condition that Cerberus reduce its ownership to 14.9%.  [Binyamin Appelbaum, “Fed Clears GMAC Plan to Become a Bank,” Washington Post, December 25, 2010,;]   GMAC acquired Chrysler’s finance subsidiary and then it changed its name to Ally Financial.


Wall Street’s two remaining big investment banks were also given a place at the bank holding company trough.  Morgan Stanley and Goldman Sachs each owned an Industrial Loan Company, a license that kept them out from under most federal regulation.  When Lehman Brothers collapsed on September 15, 2008, their attitude changed.  Six days later, the Federal Reserve approved applications for the Industrial Loan Companies to become banks, and for the investment banks to be bank holding companies.  They may have to adjust, however, to no longer being under the benign, helpful regulation of the SEC.  Perhaps they saw the change coming.  The administration’s white paper on financial regulatory reform would have put the Federal Reserve in charge of regulating investment banks.  It would specifically take away the SEC’s authority to supervise investment bank holding companies.  [Financial Regulatory Reform: A New Foundation, June 17, 2009, page 13,]  That suggestion did not make it into the final financial regulatory reform bill.


This urge by investment banks to become regulated businesses is the reverse direction of their position before the Panic of 2008, when, as Paul Krugman put it, “regulators failed to expand the rules to cover the growing ‘shadow’ banking system, consisting of institutions like Lehman Bros. that performed banklike functions even though they didn’t offer conventional bank deposits.”  [Paul Krugman, “Bubbles and the Banks,” The New York Times, January 7, 2010, Krugman, Next up: Financial system reform&st=cse.  William Greider amplifies the relationship between the Federal Reserve and Wall Street in "The AIG Bailout Scandal," The Nation, August 6, 2010,]  


The SEC Deregulates Wall Street’s Sell Side, in its Dealings with the Buy Side


Institutional money managers get many preferences in the marketing of public offerings of securities.  They get to have in-person meetings—“road shows”—with the issuer’s management.  Their orders are first in line.  They can choose to “flip” their shares in a quick resell if the price jumps.  But what if they could even avoid waiting for SEC registration, keep their investment out of SEC public reporting and still have a trading market for selling it?


The SEC accommodated Wall Street’s buy side, and the sell side investment bankers that service it, by adopting Rule 144A.  It allows Wall Street investment bankers to sell new issues of securities to Qualified Institutional Buyers without SEC registration.  The rule defines a “Qualified Institutional Buyer” as an institution, like a mutual fund, pension fund, insurance company or registered investment adviser, which “owns and invests on a discretionary basis at least $100 million.”  [144A(a)(1)(i),]  There are now trading markets for 144A securities, maintained by the largest Wall Street firms, so Qualified Institutional Buyers can trade among themselves.  No SEC registration or other regulatory supervision is involved, so long as both the buyer and the seller meet the rule’s definition. 

Other exemptions for transactions with Wall Street’s buy side include sales under Rule 506 to an “accredited investor” defined in SEC Rule 501(a) under the Securities Act of 1933. []  Also exempt are sales to a “Qualified Purchaser” in section 2(a)(51) of the Investment Company Act of 1940,] and sales to a “Sophisticated Person” in SEC Rule 506(b)(2)(ii), [

These Rules are “firmly rooted in the principle of federal securities laws that sophisticated investors can fend for themselves.”  [William K. Sjostrom, Jr., Professor of Law at Northern Kentucky University, “The Birth of Rule 144A Equity Offerings,” 56 UCLA Law Review 409,448, 2008,]  The decisions by Congress and the SEC, based on the principle that “sophisticated investors can fend for themselves” exempt billions of dollars in securities transactions.  These exemptions for the rich and sophisticated may be justified for individuals who are investing their very own money, although it is questionable whether the government should adopt the adage that “fools and their money are soon parted.”  But at least there could be some public policy support for not spending public resources to protect wealthy individuals from losing their own money through their own poor judgment.

The flaw underlying all these exemptions for investors with lots of money is that most of the persons making investment decisions are employees working for Wall Street’s buy side firms.  They’re managing money for mutual funds, pension funds, government agencies, charities and other funds.  Even hedge fund managers take much of their money from other fund money managers, many of whom are responsible for middle class retirement savings.  These buy side employees may be motivated by such personal issues as getting a larger bonus for short-term performance.  Their short-term self-interest would clearly conflict with the long-term objectives of people counting on their retirement income or the intentions of donors to charitable funds for help to humanity.

The immediate greed of an individual money manager employee is only the most obvious of the conflicts of interest that can be exploited by Wall Street’s sell side brokers and traders.  Personal favors, from hockey tickets to insider information tips, can easily be exchanged for the occasional willingness to buy a “toxic waste” security.  Reciprocity—“I’ll scratch your back if you scratch mine”—is the way of life on Wall Street.  The sophisticated investor exemptions make it easy and acceptable to participate in that way of life, by using other people’s money.

Privatizing Corporate Regulation


We have continuously been struggling with who should monitor the behavior of corporate management.  The most vocal group is, of course, management itself, with variations on the theme that “government stifles free enterprise.”  To accommodate them, we have relied on the oversight of “outside” directors of the corporation.  They are the elected representatives of the shareowners, in charge of decisions about the corporate direction and the hiring and firing of top executives.  We looked the other way when it was obvious that directors were actually selected by the CEO, based upon the loyalty that comes from reciprocal favors.  We pretended that they were elected by the shareowners, when SEC proxy rules made the CEO’s choices all but a sure thing.


We watched while government regulation changed from investigating and restraining unfair dealings to promoting and assisting Wall Street chicanery.  The political appointments and the staff of the SEC were filled with people who “could understand” the industry, because that’s where their careers were.  A short stint with the regulatory agency would be an entry on their resume, putting them on a faster path when they returned to their employer or an ally in the industry.


We acceded to the 1930s decision by Congress to accept audits by private accounting firms, rather than have a government corps of auditors.  There was no effective opposition as the auditing firms began selling tax advice to their audit clients.  We let them hire people who knew nothing about accounting, but sold consulting services to the firms’ clients in computer technology, retail marketing, executive compensation and any other area which could prove profitable.


The revolving door between the SEC and the firms who deal with the SEC has effectively privatized securities regulation.  Policies are decided, regulations are written and enforcement is prosecuted, all by an elite few who go back and forth from the SEC to the firms that represent themselves or their clients before the SEC.  Boards of directors are mostly ineffectual figureheads.  The near absence of qualifications or standards of behavior for corporate directors, together with the SEC restrictions on shareowners nominating and electing directors, has left their selection and retention in the hands of the very CEOs they’re supposed to oversee.  The decision to privatize corporate audits, and let auditors sell unrelated services to their clients, has severely compromised any comfort from the examination and reporting.


All three of these structures for controlling corporate management failed shareowners and the public.  “Outside directors had compromised themselves by having questionable financial relationships with the firms that they were supposed to oversee.  Too many government regulators had been recruited from the ranks of the industries that they were supposed to police.  Above all, auditors had come to see themselves as corporate advisers, not the shareholders’ scorekeepers.”  [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003.]

The SEC Helps Investment Bankers Focus on Institutions and the Wealthy

By the 1980s, corporate chief financial officers were looking for alternatives to underwritten public offerings. To protect their franchise, investment bankers and their lawyers were forced to lobby new paths through the Securities and Exchange Commission, paths which kept them in the game as financial intermediary.  First was Regulation D, especially its Rule 506, adopted in 1982.  It freed offerings, of any amount, from SEC registration, so long as the purchasers met one of two categories.  They could be “accredited investors,” that is, most institutions and millionaire individuals.  The other category could include up to 35 nonaccredited persons who, themselves or with their representative, were “sophisticated investors,” meaning they have “such knowledge and experience in financial and business matters” that they are “capable of evaluating the merits and risks of the prospective investment.”  [Rule 506(b)(2)(ii),]  Since Wall Street investment bankers had no real interest in the middle class, this opened the door for them to sell to institutions and the wealthy, without the hassle of SEC registration.

There was a big limitation on Rule 506, however.  The purchasers could not resell the securities without SEC registration or using some exemption from registration.  Money managers for institutions are accustomed to turning over investments within a year after buying them, sometimes within a few days.  Many of them, like mutual fund managers, are bound by rules that say they can only invest in securities that are liquid, freely tradable.  The SEC fixed that problem by setting up an exemption for registration especially for institutional money managers.  Its Rule 144A allowed sales to a “qualified institutional buyer,” who could resell the security to another “qualified institutional buyer.”  That term meant institutions which invest at least $100 million.  The definition includes a securities dealer, but only if it is acting as agent for a qualified institutional buyer who makes a simultaneous purchase.    [Securities Act of 1933, Rule 144A(7)(a)(1)(iii) and (7)(a)(5),]  This last definition kept the investment bankers in the game.  They could get a commission, as if it were an underwriting.  Sell side firms developed separate trading markets, for Rule 144A securities, so institutions could buy and sell existing securities among each other.  But that is not the full liquidity that would be available in an open market.

That open trading market was still limited to securities registered with the SEC under the Securities Act of 1933.  The problem with SEC registration, in the conventional underwritten public offering, had been the timing for sale.  It can take several months to complete registration.  Then the securities had to be sold immediately upon SEC clearance.  Corporate chief financial officers wanted a way to sell fully registered securities but choose a time when the market was most favorable.  That way, they could get the best price for their shares, or lowest interest rate on their bonds.  SEC Rule 415, which first came out in 1983, allowed securities to be sold over a two-year period after registration was completed.  []  Called a “shelf registration,” this led to what is known as a “bought deal,” a transaction that well-capitalized investment banks could do.  A large corporation would register securities that it would sell over the next two years.  When the “window of opportunity” opened, an investment banker would put together a group of institutional buyers for the securities that had been registered.  If the company went along with the terms, the transaction would be completed with only a notice filing to the SEC.  It works like a private placement but the buyers get freely tradable securities, for which the company can expect a higher share price or lower bond interest rate.


The bought deals are only available to investment banks with sufficient capital to own the securities for the hours or days it takes to line up all the buyers.  They don’t need to form an underwriting syndicate to spread out the risk of being stuck with unsold securities.  One effect of the rule change was that smaller broker-dealers were cut out of the profitable underwriting.  Their individual investor customers were also excluded from the new issues and from the institutions-only aftermarket.  [A.F. Ehrbar, “Upheaval in Investment Banking,” Fortune, August 23, 1982, page 90]

During the 1990s, these rule changes paved the way for an investment banking specialty known as “private investments in public equity” or “PIPEs.”  In 1995, there were 127 of these private placements for securities of publicly traded companies, totaling less than $2 billion.  By 2004, there were over 2,300 transactions, for $57 billion.  As the transaction size increased, the amount increased to 2,725 sales, for $252 billion, in 2008. [Sagient Research PlacementTracker,]


All of these alternatives were still done through investment banker intermediaries.  They were agency transactions, rather than the firm commitment underwriting, but the economic and marketing structures were the same.  In late 2008, an element of direct marketing was introduced in what were called “registered direct offerings.”  They use the SEC Rule 415 “shelf registration,” but the securities are offered only to selected investors.  An investment banker may be used for some sales, acting as a placement agent rather than an underwriter.  According on one CFO:  “In essence we did a 'targeted rights issue' and reached out to our key investors, including our more active, more vocal hedge fund investors.”  [Martin O'Grady, CFO of Orient-Express Hotels Ltd, quoted by Marie Leone in, “Speak Softly and Carry a Big PIPE,” December 2, 2008 [


Build America Bonds Boondoggle


Governments at all levels protect Wall Street in getting its underwriting commissions.  Even when Wall Street has created its own problem, government will step in to fix it.  One of these fixes made it into the stimulus bill, the American Recovery and Reinvestment Act of 2009. 


Virtually every state and local government bond is sold through the monopoly of licensed broker-dealers, at their standard underwriting commission.  The problem that Wall Street created for itself is that these “muni bonds” are not attractive to Wall Street’s principal customers, the money managers for pension funds, IRAs and other tax-exempt funds.   The U.S. Constitution made muni bond interest payments exempt from federal income taxation.  But that’s of no use if the investor is already exempt from paying income tax, since they get to keep all of the interest on any bond they own, whether U.S. Treasury, private corporation or local government. 


It would be in the best interest of the local government and individual investors if this tax benefit were broadly publicized in marketing bonds to people who live in the area served by the government agency issuing the bonds.  But Wall Street can make the most money for the least effort by selling an entire issue of bonds to a few money managers for funds.

Selling to individuals is time intensive, compared to repeat sales to regular money manager clients.  Even with the universal $5,000 minimum purchase required for bonds, it is never as profitable as the single, multimillion dollar sale to a repeat customer.  The commission to Wall Street is a fixed percentage of the entire offering, whether it is sold to one money manager or thousands of individuals.


What Wall Street needed was local government bonds that paid an interest rate that would appeal to tax-exempt institutions.  What if the federal government could subsidize a higher interest rate?  When the 2008 credit collapse came along, government bond underwriters jumped on the “never waste a good crisis” opportunity.  Here was a chance to deal with a problem they were having in marketing state and local bonds: the tax-exempt feature was of no interest to many of their best customers. 


How did the federal government respond to Wall Street’s need to sell local government bonds to tax-exempt institutions?  By having federal taxpayers subsidize the interest rate, so that local government bonds could pay as much as corporate bonds.  Of course, the political gloss was that local governments were being helped, that local economies were being stimulated.  The program was even called “Build America Bonds.”


So what effect did the taxpayer subsidy have on individuals, other than increasing their tax burden?  Take the State of California’s Build America Bond issue in April 2009.  It paid 7.4%, while the state’s regular tax-exempt bonds were yielding 5.3%.  The federal government paid the difference.  If a top tax rate individual purchased the new bonds, the after-tax return would be 4.8%, a half point lower than the tax-exempt bonds.  Wall Street money managers, by contrast, collected more than two extra points of income for their tax exempt funds, courtesy of the U.S. taxpayer.  [Amy Feldman, “Battle of the Muni Bonds, Business Week, May 11, 2009, page 063]  For its part, Wall Street investment bankers charged an extra two percent or so commission.


The conclusion after the first year the bonds were available?  “Investment banks have earned more than $670 million from selling the bonds, with average fees nearly 20 percent higher than traditional tax-exempt bond issues over the past 14 months, according to new data from Thomson Reuters.”  [Dan Eggen, “New bonds to help cash-strapped states also benefit Wall Street,” Washington Post, June 7, 2010,]  After intensive Wall Street lobbying, Congress extended the program through 2012.


The Hedge Fund Loophole for Wall Street and Wealthy Investors


Much of the devastation from the Crash of 1929 and the Depression had fallen on the middle class investors who had been sold shares in investment trusts.  In an attempt to keep that from happening again, the New Deal had created the Investment Company Act of 1940, which set a code of conduct for pooled funds sold to the public.  Gone was leverage—the ability to borrow money to increase the size of investments.  Also gone was performance pay to managers; they had to receive only a fixed percentage of the assets.  Investments were limited to securities for which there is a liquid trading market.  When investment companies came back in the 1950s, they were called mutual funds, regulated by the SEC under the Investment Company Act and its regulations.


Mutual funds were far too tame for Wall Street investment bankers.  They wanted the ability to leverage the investors’ money with massive borrowings, vastly increasing risk and reward.  To manage other people’s money, Wall Street looked for the inducement of a big percentage of the profits they generated.  And they sought the freedom to invest in private deals, for which there might be no trading market.  In short, they wanted a way to manage pooled funds without any of the restrictions put in place after the last great disaster. 


In its pursuit of unregulated investment arenas, Wall Street has leapt upon hedge funds, another big present from Congress.  Hedge funds operate a lot like mutual funds, without being subject to the limitations under the Investment Company Act of 1940 such as restrictions on the kinds of investments that can be made, how the managers are compensated and borrowing to place bigger bets.  Hedge funds escape all those rules.  The way they do it is to have all their investors be wealthy, or be managers of other people’s money. 


If a hedge fund keeps the total number of its investors to no more than 100, each investor needs to be an “accredited investor” (essentially, a millionaire or an institutional fund), along with up to 35 nonaccredited investors who are “sophisticated” in investment matters.  [Investment Company Act of 1940, section 3(c)(1),]  There is another exemption for hedge funds with up to 500 investors, but each one of them must be a “qualified investor,” which includes individuals with $5 million or more of investments or institutions with investments of $25 million.  [Investment Company Act of 1940, section 3(c)(7),]


Managers of hedge funds also escape the regulatory oversight that other money managers are subject to under the Investment Advisers Act of 1940. [section 203(b)(3),]  They fit under an exemption for “private investment advisers,” those with fewer than 15 clients.  A hedge fund counts as only one client, although it might have hundreds of investors.  Even the tax laws favored hedge funds, by taxing their managers’ percentage fees at capital gains rates instead of rates for ordinary income.


Wall Street’s biggest banks often have their own hedge fund subsidiaries.  They also have huge “prime brokerage” departments that service hedge funds.  These departments bring in commissions on the massive volume of trades made by hedge funds.  They also gather interest income from loans made to finance the hedge funds’ positions.  The banks get extra income through fees for lending shares held for their customers, which the hedge funds use to cover their short positions.


Congress Protects Wall Street’s Buy Side


According to its website, “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  []  Experience shows that its real mission is to protect Wall Street’s monopoly and to settle turf disputes among Wall Street insiders.  The biggest conflict in the last 30 years has been between Wall Street’s sell side and its buy side.  Institutional money managers ultimately got the SEC to eliminate fixed commissions on securities trades, which brought their average commission from 26 cents per share to three cents.  [Marshall E. Blume, Jeremy J. Siegel and Dan Rottenberg, Revolution on Wall Street: The Rise and Decline of the New York Stock Exchange, W.W. Norton & Company, 1993, page 227]


The buy side then forced a consolidation of trading on the various markets, with an open communication among all their information systems, so their computers could shop for the best price.  “SEC rule changes adopted in 1998, 2005, and 2007 aimed at ever-lower transaction costs by encouraging formation of electronic communication networks, or ECNs, that challenged the NYSE and Nasdaq for market share.”  [Nina Mehta, Lynn Thomasson and Paul M. Barrett, with Jeff Kearns, Whitney Kisling, Peter Coy, “The Machines That Ate the Market,” Bloomberg Businessweek, May 20, 2010,]


Congress and the executive branch have not left Wall Street’s buy side out of the protection racket.  One big gift came when Gerald Ford signed into law, on Labor Day, 1974, the Employee Retirement Income Security Act of 1974, called “Erisa.”  Employer-sponsored retirement trusts had begun in World War II and become a huge generator of management fees.  Many on Wall Street’s sell side switched over to become customers, buying and selling securities for pension trusts.  They collect fees equal to a percentage of the fund’s assets, whether the fund’s investments perform well or not. 


These buy side managers had another problem that they took to Congress for fixing.  That was the fear that employees or retirees might sue them for poor performance in managing their retirement fund.  The centuries-old test for a fiduciary—someone entrusted with looking after another’s investments—is the “prudent man” rule.  Under the common law prudent man rule, Wall Street money managers could be liable to the employees and retirees if they failed "to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested"  [Harvard College v. Armory, 9 Pick (26 Mass) 446, 461 (1830)]


Worrying about the prudent man rule could keep buy side money managers awake at night.  The reality was that most of them weren’t making investment decisions based on how they would “manage their own affairs.”  Their decisions to buy, sell or hold a security were based on how their performance would compare with other fund managers.  That is how they could show the employers who hired them that they should renew their management contracts.  Investment decisions on Wall Street’s buy side are governed by the “herd instinct.”  Find out what other managers are doing and do the same.  There was a clash between the prudent man rule and making decisions based on comparing satisfactorily with one’s peers in the quarterly reports.  The answer was to get someone to overrule the prudent man rule.  The opportunity came as Congress took up the subject of retirement plans.


Erisa changed the prudent man rule to cast the herd instinct in concrete.  It says that “a fiduciary shall discharge his duties . . . (B) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims; (C) by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so . . ..”  [29 United States Code section 1104(a)(1),“Acting in a like capacity” with “an enterprise of like character and like aims” seems to mean that a fund manager need only act like other fund managers. 


Congress didn’t stop with protecting the buy side.  The gifts in Erisa were also extended to Wall Street’s sell side—and arguably contributed to the market panic of 2008.  As interpreted by the Department of Labor, retirement fund managers must consider diversification of investments.  [29 United States Code section 1104(a)(1)(B),, and Department of Labor Interpretative Bulletin 94-1,]  That meant a huge change for many funds.  Before Erisa, retirement funds were often set up to have only easily tradable securities considered to be of very high quality, for instance, only bonds that were rated “investment grade” by the rating agencies.  Others permitted ownership of stocks, but only those considered “blue chip.”


Wall Street’s sell side doesn’t make much money simply executing orders to buy and sell bonds and exchange-listed stocks.  Big revenue comes from securities that aren’t even traded, such as investments in hedge funds, real estate and “bespoke” derivatives that aren’t intended for resale.  Erisa’s “diversification” requirement gave investment bankers and brokers the raw material for selling investments they fashioned themselves and sold at markups far higher than commissions on traded securities.  The result was that alternative investments and “total return” investing became buzzwords and, up until 2008, the herd of money managers went deeply into all the exotic instruments that Wall Street’s sell side could invent and push.  Erisa’s gift was accompanied by the SEC giving special treatment for new offerings made only to institutional investors, effectively privatizing the review of offering documents and the fairness of selling practices and terms.