Securities and Exchange Commission Is Established

Date June 6, 1934

The Securities Exchange Act of 1934 created a quasi-judicial administrative body, the Securities and Exchange Commission, with broad powers to regulate the securities markets and protect the public interest.

Locale Washington, D.C.

Key Figures

• Franklin D. Roosevelt (1882-1945), president of the United States, 1933-1945
• Ferdinand Pecora (1882-1971), legal counsel to the U.S. Senate Banking and Currency Committee
• Sam Rayburn (1882-1961), U.S. congressman from Texas
• Duncan U. Fletcher (1859-1936), U.S. senator from Florida
• Richard Whitney (1888-1974), president of the New York Stock Exchange

Summary of Event

The Securities Exchange Act of 1934 solidified the expanding role of the federal government in protecting the investing public. Passed in the aftermath of the greatest stock market collapse in history, this legislation established a new administrative agency with broad powers to ensure that many of the financial abuses and deceptive practices of the past would not recur.

Historically, as economic activity increases in volume, complexity, and sophistication, the corporation emerges as the dominant form of business organization. Corporate entities thrive because of the continued and expanding capital investment of people willing to accept the risks and rewards of ownership but unwilling or unable to participate in actual management of the business operation. Through the issuance of securities by corporations, ownership can be spread over a broad base of individuals, thus maximizing the potential for invested resources.

In order to facilitate this capital exchange process, organized marketplaces have developed throughout the world. These capital markets provide the mechanism for the corporate distribution of debt and equity securities as well as the subsequent transfer of these securities between individuals.

Because of the inherent separation of corporate management from ownership, current and potential investors operate under a distinct informational disadvantage. Capital contributors are at the mercy of claims made by “insiders.” Exploitation of unwary investors inevitably occurs, and securities markets merely serve to provide an organized forum within which to execute such schemes on a broad scale.

Government, concerned with ensuring an adequate supply of available capital in order to sustain economic growth, has a natural interest in protecting investors and maintaining public confidence in these securities markets. In the United States, attempts at regulation of securities were first made at the state level. In response to widespread fraudulent activities of stock promoters, Kansas enacted a statute in 1911 to protect the public interest. In the first year following enactment of this law, approximately fifteen hundred applications to sell securities in Kansas were filed. Only 14 percent were accepted; the rest were judged to be fraudulent (75 percent) or too highly speculative (11 percent).

Other legislatures followed Kansas’s lead, and by 1913, twenty-two other states had passed laws similar in intent but widely varying in approach. These state securities laws are often called blue-sky laws, because the speculative schemes they attempted to foil often involved little more than selling “pieces of the sky,” or worthless securities.

For various reasons, the individual state attempts to regulate securities markets were not very effective. Perhaps the greatest problem arose from the tactic of “interstate escape.” Individuals or companies could continue deceptive and fraudulent practices merely by moving across state lines (physically or through the mails) to other jurisdictions where regulations were inadequate, poorly enforced, or perhaps even nonexistent. To limit such evasion, some form of federal intervention was needed.

During the 1920’s, a veritable explosion took place in securities market activity. Small investors entered the market in numbers larger than ever before. National brokerage firms doubled the number of their branch offices and reported phenomenal increases in business. Despite the vigorous trading and investing activity that was occurring, the strength of the market was quickly eroding as a result of a number of prevailing traditions.

First, stock price manipulation was common. This was often executed by means of a manipulation pool, in which a syndicate of corporate officials and market operators join forces and, through a succession of equally matched buying and selling orders (“wash sales”) among themselves, create the false impression of feverish activity, thus driving up the price of the stock. At the height of this artificial activity, the stock is sold, huge profits are reaped by the syndicate, and the stock price subsequently plummets. As an example of the success of this gambit, a pool formed in March, 1929, to trade in Radio Corporation of America (RCA) stock operated for only a seven-day period and netted a profit of almost $5 million.

The excessive use of credit to finance speculative stock transactions (that is, buying stocks “on margin”) was another tradition that undermined the stability of the market. An investment as small as one hundred dollars could purchase one thousand dollars in securities (with a 10 percent margin), and there were no limits to the level of credit a broker could extend to a customer. This practice effectively lured potential capital away from productive economic investment and toward mere market speculation.

A third practice that hindered the efficient operation of the securities market relates to the misuse of corporate information by insiders. Corporate officials could withhold information, either positive or negative. By timing the release of information until after they had already positioned themselves in the market, they could benefit from price fluctuations when the news finally became public.

The weight of these traditions finally culminated in the stock market crash of October, 1929, which was a financial earthquake of dramatic proportions. The aggregate value of all stocks listed on the New YorkStock Exchange (the largest capital market in the United States, handling 90 percent of all stock transactions on a dollar basis) declined from $89 billion before the crash to only $15 billion by 1932. The economic depression that rapidly deepened following the crash was the worst economic crisis in U.S. history.

In March, 1932, the Senate Banking and Currency Committee was empowered to investigate the securities industry. This inquiry was continued and greatly expanded in scope after the election of Franklin D. Roosevelt as president in November, 1932. Roosevelt had been on record since his tenure as governor of New York as being highly critical of various stock market activities. The 1932 Democratic national platform on which he ran explicitly called for federal supervision of securities transactions.

Ferdinand Pecora served as legal counsel to this committee during its extensive investigations in 1933 and 1934. He compiled an impressive body of evidence concerning financial corruption and malpractice. Pecora personally elicited much of the damaging evidence from the most prestigious financial leaders of the time and was invaluable in documenting the need for securities regulation. For example, his investigation disclosed that of the $50 billion of new securities issued during the decade after World War I, half had proved to be worthless.

With the passage of the Securities Act in 1933 (signed into law on May 5, 1933, soon after Roosevelt’s inauguration), the federal government finally entered the arena of securities regulation. This bill was championed in Congress by Representative Sam Rayburn of Texas and Senator Duncan U. Fletcher of Florida. The 1933 act is primarily a disclosure statute, concerned only with the initial distribution of a security. Although it was an important first step and forerunner to more ambitious efforts in securities regulation, this legislation failed to address adequately many of the practices in the capital market that contributed to the 1929 collapse.

Fletcher and Rayburn once again introduced bills in Congress, based in large part on drafts written by investigator Pecora. At the time, there was significant and widespread opposition to stock market regulation. Government interference, it was argued, would likely upset the delicate workings of Wall Street. Richard Whitney, president of the New York Stock Exchange (NYSE), was at the vanguard of this resistance. Whitney organized a well-financed protest campaign and mobilized forces to defeat the proposed legislation. Overt threats were even made to relocate the NYSE to Montreal, Canada, which offered a less obtrusive regulatory environment. Intense lobbying efforts did result in some modifications of the original bills, but finally, on June 6, 1934, Roosevelt signed the Securities Exchange Act.

Significance

The major provisions of the Securities Exchange Act deal with three broad areas of regulation in an attempt to prevent the abuses previously cited and thereby protect the public interest: full and fair disclosure, supervision of capital market practices, and administration of credit requirements. This act requires that all national securities exchanges register with and be subject to the regulations of the Securities and Exchange Commission (SEC), an administrative agency with quasi-judicial powers that was created by this legislation. The immediate result was the closing of nine stock exchanges that could not meet the new requirements, including a one-man exchange operating out of an Indiana poolroom.

All corporations with securities listed on a national exchange must file detailed registration statements with the SEC and are required to disclose financial information on a periodic basis in a form that meets certain standards. The SEC retains discretionary power over the form and detail of such disclosures. The SEC also requires periodic audits of these firms by independent accountants.

This last requirement has had a dramatic impact on the growth and development of the accounting profession. Certified public accountants were effectively granted a franchise to audit corporations with publicly traded securities. There was a substantial cost involved in terms of increased risk exposure. By expressing an opinion on the veracity of financial statements filed with the SEC, the auditor becomes legally liable to third parties (including investors) who may subsequently be harmed by reliance on that information.

In the area of actual market practices, the SEC had immediate and far-reaching impact. Because of the relative informational advantage that market participants have over the public, the SEC now closely scrutinizes their activities. Exchanges, brokers, and dealers must all register with the SEC and file periodic disclosure reports. Corporate insiders are subject to especially strict rules designed to prevent unfair profit-taking. Certain stock market manipulation schemes (for example, wash sales) are prohibited. In fact, any fraudulent, manipulative, or deceptive securities dealings, whether specified by the act or not, are prohibited for all market participants. The penalties for infraction include fines, imprisonment, or both.

Finally, in the area of credit, the 1934 act authorizes the Federal Reserve system to administer the extension of margin credit in securities trading, with the SEC as ultimate enforcer. This important component of government economic and monetary policy was no longer to be left in the hands of individual brokers.

The first Securities and Exchange Commission was composed of a presidentially appointed five-member bipartisan panel that included Ferdinand Pecora. Ironically, Pecora was passed over as chairman in favor of Joseph P. Kennedy, who the year before had participated in a pool syndicate operation.

Since its inception, the SEC has progressed through a number of different phases. The first decade of operation was an innovative period in which the permanent machinery and procedures necessary to carry out the functions and responsibilities of the SEC were established. This period was also marked by a concerted effort on the part of the early commissioners to promote the agency to both the public and the business community as a powerful partner in the quest for honest financial activity, not as a mere enforcement arm of the government.

It was during this early period that a philosophy of operation began to evolve. Rather than merely coercing compliance through enforcement actions, the SEC often adopted the policy of encouraging self-regulation within a framework of governmental constraints. By inspiring confidence in the laws that it administered, the SEC hoped to foster a heightened sense of social responsibility and ethics among the private sector, leading to development of self-monitoring systems. This pragmatic approach was perhaps most evident in the area of establishing accounting and reporting standards. Although the SEC had been empowered to develop and maintain standards and principles of accounting practice, it generally deferred to the accounting profession. Such concession did not occur automatically. The SEC first had to satisfy itself that the private sector’s system of establishing accounting and auditing standards had progressed to an acceptable level.

The next twenty-year period was characterized by very little significant legislation or innovation. Investor confidence in the capital markets was generally high, and the SEC routinely carried on the mission that had been developed. Revitalization of the SEC came in the early 1960’s, after a rash of litigation related to the civil and criminal liability issues involved in inaccurate financial disclosures. Various amendments to legislation administered by the SEC followed. In the 1970’s, major legislation was passed to combat corporate bribery and other illegal business practices.

During the 1980’s, the SEC was guided by a doctrine of facilitation. Major efforts to expand full and fair disclosure and to streamline and standardize reporting requirements demonstrated the SEC’s commitment to improving the efficiency of the flow of information and ultimately the flow of capital investment in the economy. Continuation of this tradition will likely ensure that the SEC remains a potent regulatory force in the mission of protecting the public interest.

In 2002, after a raft of high-profile bankruptcies involving corporate fraud, Congress passed the Sarbanes-Oxley Act, which represented the most comprehensive reform of corporate business practice since passage of the Securities Exchange Act in 1934.

Bibliography

Chatov, Robert. Corporate Financial Reporting. New York: Free Press, 1975. Readable scholarly study of the broad regulatory process and the various social and political controls used in public policy formation and implementation. The SEC serves as the focal point for this detailed analysis of independent regulatory agency behavior.

De Bedts, Ralph F. The New Deal’s SEC. New York: Columbia University Press, 1964. Provides an interesting historical perspective on the origins of the SEC and a description of its early, formative years of operation. Offers in-depth coverage not normally found in writings on New Deal reforms. Relaxed narrative form.

Ginzberg, Eli. New Deal Days, 1933-1934. New Brunswick, N.J.: Transaction, 1997. Relatively light treatment of early New Deal legislation for nonspecialist readers.

Hughes, Jonathan, and Louis P. Cain. American Economic History. 6th ed. Boston: Addison-Wesley, 2002. Comprehensive volume on the economic history of the United States includes discussion of securities legislation.

Kindleberger, Charles P. Manias, Panics, and Crashes: A History of Financial Crises. 4th ed. New York: John Wiley & Sons, 2000. General survey of financial speculation and monetary crises from the eighteenth century to the late twentieth century.

Pointer, Larry Gene, and Richard G. Schroeder. An Introduction to the Securities and Exchange Commission. Plano, Tex.: Business Publications, 1986. Designed as a supplemental text for undergraduate accounting students, this booklet is nontechnical and serves as a good, brief overview of the SEC for the general reader. Provides some historical perspective but focuses on the SEC’s structure and operation.

Rappaport, Louis H. SEC Accounting Practice and Procedure. 3d ed. New York: Ronald Press, 1972. Exhaustive reference work and guide to the broad range of financial reporting requirements of the SEC. Often very technical in presentation, a natural outcome of the inherent complexity of the subject matter. Provides numerous illustrative examples.

Tyler, Poyntz, ed. Securities, Exchanges, and the SEC. New York: H. W. Wilson, 1965. Provides the general reader with background information essential to an understanding and appreciation of more complex writings in the area of investing, capital markets, and regulation. Contains reprints of short articles, excerpts from books, and other documents. An interesting and very readable compendium.