CHAPTER 4

Markets, Madness, and the New Deal

I can calculate the movement of the stars, but not the madness of men.

—Isaac Newton [on the South Sea Bubble]

In the 1920s, Wall Street was a world that was really dominated by professional speculators and stock pools. These people had a monopoly over information.

—Ron Chernow

The post-Civil War period through the 1920s probably was the greatest growth and innovative period in American history and certainly the most corrupt. Risk-taking moguls could be inventors, entrepreneurs, speculators, crooks, or any combination.¹ The economy remained volatile, with a major depression every 20 or so years and more modest downturns between. Somehow the flexible framework of governance, entrepreneurial talent, adequate education, growing infrastructure, and hard work (perhaps captured as American exceptionalism) resulted in booming economic growth that led the world by early in the 20th century.

As demonstrated in earlier chapters, consolidations and big business dominated this American landscape. Corporations were designed to produce magnificent profits without necessarily much consideration to employees, customers, or the public at large. Thousands of workers died on the job annually, environmental damage could be immense, and customers could be killed by tainted products. One result was the progressive movement, bringing in some incorruptible politicians and new regulations—some of which proved at least modestly effective. The Woodrow Wilson administration introduced the Federal Reserve, income tax, the Clayton Antitrust Act and the Federal Trade Commission.

The 1920s brought the return of Republican leadership with little interest in business regulation. President Warren G. Harding’s “return to normalcy” campaign pledge brought back more corruption, in part his own administration—Teapot Dome (including the illicit behavior of Ohio machine boss and Harding’s Attorney General Harry Dougherty) may be the biggest scandal in United States history. After the 1920 recession, a major economic boom started, including considerable innovation (radio, electricity, automobiles, and later airlines became high-tech industries of the period). The stock market roared by the end of the decade, stimulated by massive manipulation. But the 1920s did not end well.

Following Du Pont and General Motors (GM), much of American business became really big and concentrated. Industries with relatively homogeneous but complex manufacturing such as aluminum enjoyed economies of scale, barriers to entry, and incentives to control markets. The big business owners and managers preached stable markets, while critics claimed monopoly pricing. Relying on economic theory, the claim was monopoly power produced efficient operations, acquisition (or destruction) of so-called inefficient competitors, and the ability to survive downturns. The large size, complexity and diverse operations required continuous information for decision making, provided by accounting and management innovations.

More corporations became vertically integrated, likely from mining raw materials to distributing complex finished goods, with a centralized headquarters. Dozens of plants around the country could produce various oil, steel, automobile, or chemical products. Mass production of standard products was perfect for large domestic and potential international markets. The GM experience provided many of the answers for how multiactivity operations were controlled by headquarters. These included simplification, specialization of jobs, and a hierarchy for greater management control; coordination of performance using cost accounting and reports developed through experience and, to some extent, outside expertise.

The capital markets were mature by the 1920s, with most big corporations trading on the New York Stock Exchange (NYSE). Smaller firms often traded on other exchanges. With limited rules issued by the exchanges and virtually none by the federal government (except for tax laws that applied to all firms), there was little downside for those firms with financial information to hide. However, the game was fixed with the benefits going to the exchange members and other insiders. Trading fees were substantial, members traded on their own accounts with insider information (and no rules against it), and many stocks were openly rigged. Billy Durant, gone from GM, was a speculator and manipulation player.

The Woodrow Wilson presidency ended poorly—a debilitating stroke for Wilson, a failed Versailles Treaty, rejection of the League of Nations, and the 1920 election returning Republicans to power. The era of reform was over as corruption prospered. The manipulation-enhanced boom ended with the Great Depression and the discovery of how extensive the corruption extended. Franklin D. Roosevelt (FDR) promised a “New Deal” and delivered after the 1932 election. Reform and government regulation returned, including the creation of the Securities and Exchange Commission (SEC), market regulation, financial disclosure, and required corporate audits. Corruption was not over as demonstrated by the McKesson-Robbins fraud. Auditing needed new standards and regulation. The FDR era was one of enhanced regulation, including the establishment of new accounting and auditing regulations. Audit firms became an essential profession as a monitor of financial reporting and control.

Roosevelt and Wilson Attempt Reform

Progressive movements started in the post-Civil War period, both in rural districts fed up with the mistreatment of farmers sending food to market and large urban areas subject to corrupt political machines. Labor unions were forming and bloody strikes recurring. Muckraking journalists at McClure’s and elsewhere described despicable business practices, calling for government regulation. Reform-minded Democrats and progressive Republicans attempted reform legislation. Up and coming politician Theodore Roosevelt uncovered corruption on the New York police force and later fought patronage through civil service reform.

Various states passed antitrust laws with the backing of organized labor, the farm belt’s Granger movement, and various progressives. Because big business was mainly interstate, Congressional action was needed. Both parties campaigned on antitrust reform during the presidential election of 1888. The Sherman Antitrust Act was passed in 1890. Senator George Hoar, one of the bill’s authors, claimed: “the law attempts to prevent the artificial raising of prices by restriction of trade or supply.” The New York Times countered: “That so-called Anti-Trust law was passed to deceive the people … It was a humbug and a sham.”

The Sherman Act made a straightforward claim: “every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce … is declared to be illegal.” With no definition or details, it was up to the president and courts to make it work. During the 1890s only 18 cases filed at a time when thousands of firms merged. However, the 20th century brought in “Trust Buster” Teddy Roosevelt as president and antitrust action increased. Roosevelt led several reform efforts while facing a hostile Republican Congress—Roosevelt was Republican, but a progressive while most Congressional Republicans were conservative and big-business-friendly.

The Department of Commerce and Labor was created in 1903 during the Roosevelt presidency (becoming the Department of Commerce in 1913). Its mission was to create jobs and promote economic growth. Thanks to Upton Sinclair’s 1906 exposé of meat packing in The Jungle, the Food and Drug Act and the Meat Inspection Act started the progress for sanitary food packaging and effective drug labeling. After the Panic of 1907, additional reform legislation followed. The Roosevelt, Taft, and Wilson administrations brought 230 antitrust suits, including U.S. Steel, International Harvester, Standard Oil, and American Tobacco.

Following the Panic of 1907 the Congressional Pujo Committee referred to J.P. Morgan and five other banks as the “Money Trust,” a conspiracy to control money and credit. As directors of hundreds of industrial corporations, bank executives dominated American business. Widespread manipulation and speculation were discovered on Wall Street. The end of the Taft administration and the start of the Wilson presidency saw substantial reform legislation and the start of the corporate and individual income tax. In 1914 the Clayton Act prohibited interlocking boards of competing companies, the Federal Reserve System was created as the central bank, and the Federal Trade Commission established to protect consumers and eliminate “anticompetitive” business practices. Although attempts were made to regulate securities markets, legislation had to wait until the New Deal.

World War I and Beyond

August 1914 brought an unexpected and unnecessary war. Trade was disrupted, including to and from the United States. However, nations at war demanded armaments and food; because the British navy controlled the Atlantic, export markets were open only for the allies. U.S. exports expanded to markets in Asia and Latin America that had been supplied by European businesses. Du Pont, GM, and U.S. Steel were major winners, as was Wall Street.

J.P. Morgan negotiated gigantic loans for the allied nations, including a $500-million issue in 1915; more bond issues followed. U.S. companies were accused of war profiteering as the prices of American products rose dramatically. The solution was the Commercial Agreement signed between Britain and J.P. Morgan where Morgan served as purchasing agent. The agreement resulted in some $3 billion of supplies negotiated by Morgan (for a 1 percent commission), much of this funded by loans originated by Morgan syndicates. This probably reduced the level of war profiteering, but Morgan clients (which included General Electric, U.S. Steel, and Du Pont) benefitted mightily.

The 16th Amendment conveniently passed in 1913, calling for an income tax. Although progressive, tax rates started low. Once war was declared against Germany in 1917 tax rates soared to 77 percent in 1918. Additional excess profits taxes were imposed on corporations. The income tax became the major federal revenue source, as it has remained. Few besides accountants and other tax preparers cheered. An important accounting contribution was the impact on specific accounting procedures, especially depreciation and the use of accrual accounting for tax purposes. Tax rules required various forms of standardization; for example, only certain depreciation calculations were allowable.

Various attempts were made by the states and federal government to impose standard accounting procedures on business, beginning with railroads in the post-Civil War period. The previously mentioned Charles Francis Adams, Jr. proved to be particularly active. The 1906 Hepburn Act provided federal accounting standards. Attempts were made to expand accounting rules to all corporations. The concept of “scientific accounting” typically focused on the uniformity of financial accounting, especially regulated industries (such as utilities, banks, and insurance companies)—following the example of railroad accounting. However, many accounting practitioners preferred “professional judgment” to required standards.

Like the Interstate Commerce Commission, many federal agencies favored uniformity. In 1917 the Federal Reserve published Uniform Accounting. Instead of accounting standards, this was essentially a standardized audit process and a standard audit report. The NYSE promoted limited accounting rules, but no mandate for an audit. Accounting practitioners seemed more concerned with audit issues and viewed accounting rules as audit-related.

The concepts of accounting theory developed during this period, mainly how to interpret assets and liabilities, revenues and expenses, various ideas based on economic values (e.g., market values, replacement costs, capital maintenance) and other determinants. Issues included the relative importance of historical cost and wearing out of assets, the impact of inflation (plus deflation) and other factors related to changing values, when to recognize revenues and how much, many expense and other issues related to accrual accounting, and so on. Different answers could result in vastly different estimates of income and equity values.²

The Not-So-Roaring 1920s

Republicans ruled in the 1920s, returning to the laissez faire government of the 19th century. Innovation and new industries thrived, as did manipulation and corruption. The decade ended in a stock market collapse, to be followed by a decade of depression. Corruption started immediately with the 1920 election. All was not well in the decade. Agriculture, oil, and other commodity prices stayed low—a shock after prices had risen sharply around World War I. Farmers failed by the thousands as did rural banks. Basically, it was an urban boom offset by a rural bust.

Teapot Dome was a unique scandal in American history, but it certainly demonstrated that, despite all the progressive reforms, high-level corruption did not die in 20th century America. Business and politics were in it together, with a little help from corrupt journalists. Oilman Jake Hamon almost literally bought the 1920 presidential election for Republican Warren G. Harding. The price was appointment as secretary of the interior. Hamon was shot and killed by his mistress before being sworn in, but this was still the beginning of the Teapot Dome Scandal, perhaps the biggest business-government fraud in American history.

Harding’s “return to normalcy” campaign pledge, in fact, brought back a hands-off government and, as expected, widespread corruption. After a short recession in 1920, a long economic boom started. Industrial innovations included radio, electricity, airplanes, and automobiles as high-tech industries of the period. Speculation-driven, out-of-control manipulation again resulted in a roaring stock market (and local real estate booms in Florida and elsewhere). Under the 12 years’ rule of Republican presidents (1921 to 1933) taxes and government spending fell, as did government oversight. The top income tax rate for individuals dropped to 25 percent (from 77 percent during the war years).

The decade was not stellar for economic growth, a total 19 percent, 4.2 percent per capita. However, the stock market rose to bubble dimensions by 1929, fueled in part by the high-tech industries of the time. The Wright Brothers started the aviation business, with significant commercial opportunities by the 1920s, first for mail delivery followed by passenger service. Mergers created some big airlines such as the 80 small firms that formed American Airways (now American Airlines) in 1930. Following Edison’s lightbulb, electric utilities expanded across urban America. Highly leveraged holding companies dominated the industry; professionally managed, but leveraged-based pyramiding schemes were high risk in a downturn. Marconi’s wireless led to Radio Corporation of America (RCA) with dozens of stations, selling millions of radios in the 1920s. Entertainment saw the expansion of movies, including talkies by the end of the decade.

Key features of the decade were the level of corruption and manipulation, urban growth versus rural failures, the lack of government regulation of business and finance, and the increase in income and wealth inequality. With little government enforcement, it was caveat emptor for big business and small.

Teapot Dome

As previously mentioned a corrupt President Harding started the ball rolling to the Teapot Dome Scandal. Harding’s attorney general, Ohio political machine boss Harry Daugherty, proved to be the most corrupt top cop in American history. While providing Harding his liquor (“for medicinal purposes only”) during prohibition, he sold alcohol permits to bootleggers. Daugherty also sold pardons and paroles to criminals and received bribes and kickbacks on various projects and contracts. He was fired by new president Calvin Coolidge and indicted for bribery, but amazingly not convicted.

Harding more or less honored Jake Hamon’s commitment, by working with Hamon co-conspirators Harry Sinclair, Edward Doheny, and other oil tycoons. Senator Albert Fall was named interior secretary in place of Hamon. Fall, hopelessly in debt for his New Mexico ranch, illicitly leased Teapot Dome and other navy oil reserves to the oilmen in exchange for substantial bribes. Much of the plot was uncovered by journalists and the details identified after years of Congressional investigations and a special prosecutor. Criminal indictments were filed against Fall, Sinclair, and the others. Only Fall was convicted—the first cabinet member to go to jail for a crime. Sinclair got off the bribery charges, but he served several months in jail for contempt of Congress (for lying) and, later, for jury tampering.

Big Business Gets Bigger

Major industries became dominated by gigantic firms, benefiting from professional management and improved accounting information. The process seemed inevitable in industries with complex manufacturing thanks to economies of scale, barriers to entry, and profit incentives to control markets. Executives talked stable markets and quality products, critics charged monopoly pricing. Large size per economic theory suggested efficient production, the potential for acquisition (or destruction) of competitors, and the ability to survive downturns. Big, complex operations required comprehensive current data to make decisions. Accounting innovations at firms like Du Pont and GM met these needs.

New high-tech firms benefited from these accounting pioneers. Stock market favorites in the 1920s included automobiles, radio, movies, airlines, and electric utilities. All started before the 1920s, but this was the decade that turned innovative ideas into business successes. When a speculation-fueled bull market grew in the second half of the decade, high-tech stocks exploded.

American Marconi Wireless started just before the turn of the century with radios initially used on ships. The navy took over Marconi during World War I, returning the company to its original owners in 1920. The company became RCA under former Marconi executive David Sarnoff. By the mid-1920s Sarnoff turned RCA into a radio network creating the National Broadcasting Company (NBC) with 19 stations. RCA revenues hit $182 million in 1929 selling some 4.4 million ratios (from $4 million and 100,000 radios in 1921). The movie studio Radio-Keith-Orpheum (RKO) was formed by RCA in 1928, competing with 1920s startups becoming Paramount, Columbia, Warner Brothers, and Loew’s.

Thomas Edison invented the light bulb in 1879, simultaneously creating the electric utility industry. Power companies expanded across the country with improved technology and new electric appliances. The utility industry became dominated by holding companies, generally financed by high-debt pyramiding schemes.

The Wright Brothers proved the viability of flying, but commercial applications required bigger, better and safer planes, with vast improvements from World War I. The first commercial use was mail delivery. The most successful airline was Pan American, created in 1927, and expanding internationally by the 1930s. American Airways (now Airlines) was a 1930 merger of 80 small firms. Competitors soon included Delta, Braniff, United, Trans World, Northwest, and Eastern.

The Market Is Manipulated

After a brief recession at the start of the 1920s, economy recovery led to modest growth, some 19 percent from 1920 to 1929. Stock prices, on the other hand, turned euphoric by the end of the decade—fueled in part by easy money from the Federal Reserve. Starting at 104, the Dow Jones Industrial Average (DOW) hit 300 by the start of 1929. With virtually no financial regulation, market players used deception, shady deals and investing with borrowed money. Insider trading was legal and widespread. “Preferred list” meant new securities issues were sold at discount prices to favored customers before issued to the public. Stock pools and syndicates manipulated stock price—100 or more stocks were openly rigged by insiders. Some companies issued unauthorized stock and forged stock certificates. Albert Wiggins, chairman of Chase National Bank speculated in his own stock on money borrowed from his bank and sold short during the 1929 crash—that is, bet against the bank. Richard Whitney, the former president of the NYSE, served time in Sing Sing for embezzlement. Other executives were prosecuted for income tax evasion.

The NYSE, the biggest securities market in the world by then, was a private club with rules benefiting the members, not the public. This included virtually complete access to all market information, the ability to charge substantial fees and privately dominate the market. Floor traders traded exclusively for their own accounts, and specialists in specific stocks (making a market in that stock, but for their own profit). Members were free to conspire with fellow members, using all the tricks developed over the previous century such as wash sales (selling among themselves to produce price patterns), bear raids, and short-selling. The insiders could make huge profits; outsiders were on their own.

Speculation drove margin trading (buying stock mainly on credit, called margin loans issued by brokers). The brokers charged high interest and made money on both high-cost commissions and interest. Of course, speculators saw great profits as stock prices increased. But when stock prices dropped, the buyers were subject to margin calls—providing brokers more money to maintain a positive equity position. Billy Durant, the founder of GM was a major speculator (and market manipulator). Harry Sinclair’s (a Teapot Dome conspirator) formed a pool to manipulate Sinclair Oil stock. Some journalists received “honoraria” for favorable coverage of various stocks.

Accounting and other financial information was viewed a private matter, allowing companies to conceal and manipulate information. Financial disclosure was limited, with the rationale that the information would benefit competitors. Most information disclosed centered on the balance sheet, with the income statement considered of dubious value because of likely manipulation. Of most importance to investors was dividends, real cash payments. As the market shifted from railroads (considered safe investments with stable dividends) to more volatile industrials, more focus shifted to the income statement and the need to calculate earnings accurately.

A prospectus was issued with new securities, perhaps four or so pages written to protect the bankers from lawsuits (and therefor written by attorneys). The prospectus could state an audit was performed, but the auditor worked for management, and management determined the scope of the audit. J.P. Morgan, not always a paragon of virtue, demanded audits for companies he organized (usually giant combinations with monopoly power). The NYSE did not require financial statements for listed firms and until 1910 had an “unlisted department” of firms that disclosed no financial information. Audits were not required; however, 90 percent of NYSE firms were audited (in some form) by 1926.

Crash

The economy turned down in mid-1929, but stock prices continued up. The bust started on Black Thursday, October 24. Stock prices continued down: after peaking at 386 the DOW crashed to 41 in 1933, thanks to margin calls and the usual panic following an extended period of euphoria. The economy turned from a recession to the Great Depression primarily due to inappropriate actions by the Federal Reserve and the government. Eleven thousand banks failed by 1932, industrial production fell in half, steel production dropped 88 percent of capacity, and at least a quarter of workers were unemployed.

Just about every NYSE company crashed during the 1930s. Particularly hard hit were the industries most manipulated, investment trusts, and holding companies using stock pyramiding. The key factor for failure was excess leverage—that so-called earnings magic of gigantic profit. Samuel Insull was the well-respected impresario of electric utilities. Insull cofounded Edison General Electric (with Thomas Edison), later becoming General Electric. He later formed Commonwealth Edison. Insull built a utility empire based on expanding the customer base and economies of scale. Middle West Utilities, formed in 1912 was his first holding company financed largely from bank loans. The basic strategy was acquisition: buying controlling interest in regional operating companies using mainly debt. This strategy probably improved operating efficiency and lowered production costs, but the scheme collapsed because of the huge interest and principal payments. The various holding companies probably controlled about half the electricity generally in the United States. Insull and the rest were accused of looting the companies to enrich themselves.

Insull’s holding company empire controlled over 100 separate utilities with a $3 billion market cap. Huge profits mainly were based on writing up plant assets using company-generated “appraised value” (not illegal but certainly shady accounting). Simultaneously, Insull reported big tax losses. Insull Utility went bankrupt in 1931. Insull initially fled the country but returned to face charges of mail fraud and embezzlement. He was acquitted. Others were convicted, including Howard Hopson, president of Associated Gas and Electric. Hopson paid himself millions of dollars and bilked the investors out of $20 million. His conviction for fraud and tax evasion send him to jail for 5 years.

The other particularly infamous pyramiding scheme was the railroad network of the Van Swearingen brothers, the Alleghany Corporation sponsored by J.P. Morgan, which included shares in Chesapeake Corp., Nickel Plate, Buffalo, Rochester and Pittsburgh, Chesapeake and Ohio and Erie. The Van Sweringens were worth some $100 million at the 1929 market peak. The stock plummeted to 37½¢ a share, then sold at auction for $3 million. In addition to plundering utilities and railroads, pyramiding schemes also were created in insurance, banking, food, and retail.

During the roaring years, banks created investment trusts (basically the private equity firms of the time). The strategy was to create big diversified portfolios of stocks for small investors. Without regulations, virtually any strategy was fair game—including pyramiding. These proved so popular that by 1929 the trusts were worth some $8 billion. The biggest was Goldman Sachs Trading Corporation—and ultimately the biggest loser. Like today’s private equity and hedge funds, Goldman charged 20 percent of income annually. The stock zoomed higher, up to $326—tripling its price in less than a year. With the market collapse, the trading company collapsed to $1.75 a share. The $12 million in losses almost wiped out Goldman, eventually recovering both its capital and reputation.

The big banks made big loans to foreign governments, because of the large fees and high interest rates (especially Latin American countries). As the interest and principal on Latin American debt proved hard to collect, the loans were repackaged and sold to small investors—as safe government bonds. This episode was a major factor for Glass-Steagal Act, separating commercial from investment banking.

The Government Responds

President Herbert Hoover, first elected in 1928, was stuck with the Great Depression. He followed a “traditional approach” for handling recessions which, when combined with Federal Reserve and Congressional ineptness, proved ineffective. While Hoover’s Treasury Secretary Andrew Mellon favored a “leave the economy alone” policy, Hoover was more proactive including federal building programs and various voluntary business and state and local government actions—just too small scale to have an impact. A bank consortium was created, the National Credit Corporation (NCC), for solvent banks to lend to faltering banks, but the big banks expected blue chip assets as collateral; consequently, thousands of little banks failed. The Dust Bowl, a gigantic drought helped seal both farm and rural bank collapse.

The New York Federal Reserve started positive by lowering interest rates and pumping billions of dollars into the banking system. New York was overruled by the Federal Reserve Board in Washington attempting to support the gold standard. Interest rates were driven up, money supply (as measured by M1, currency plus demand deposits) dropped 25 percent by 1933, probably the key factor in creating the deep depression.

As housing foreclosures exploded—the new homeless settled in “Hoovervilles” (showing their lack of appreciated for the president’s action). Action was eventually taken late in Hoover’s term. The Federal Home Loan Bank was created in 1932 to increase housing credit and the Emergency Relief and Construction Act of 1932 passed, which created public works programs and the Reconstruction Finance Corporation (RFC) provided states aid for relief programs, loans to banks, and assistance to railroads and farmers (the RFC would expand under Roosevelt).

The Smoot-Hawley Tariff of 1930, whose unintended consequences included an international trade war, increased customs duties, prompting retaliation and collapsing foreign trade. Rising federal deficits led to tax increases with the Revenue Act of 1932, raising the top income tax rate from 25 to 63 percent, another fiscal disaster. The United States remained on the gold standard, requiring the Fed to raise interest rates by cutting money supply. A devastating new wave of bank failures starting in mid-1932, just in time to insure Franklin Roosevelt would win the upcoming presidential election. States, beginning with Michigan, closed all banks to stop bank runs, 38 states in total. On Roosevelt’s inauguration day in 1933, both New York’s banks and the NYSE were closed. A complete economic meltdown awaited FDR’s action.

What Happened? The Pecora Commission

Hoover and much of the public blamed the depression on the rigged financial system of Wall Street: manipulators, speculators, and especially short-sellers. The Senate Banking Committee investigated, but not much of note happened until the Democrats controlled Congress and Ferdinand Pecora became committee counsel early in 1933:

With Pecora as counsel, the hearings acquired a new, irresistible momentum. They would afford a secret history of the crash, a sobering postmortem of the twenties that would blacken the name of bankers for a generation. From now on, they would be called banksters.³

The hearings continued until mid-1934, producing around 10,000 pages of testimony.

Witness one, NYSE President Richard Whitney denied any wrongdoing by the NYSE. Famous financial speculators included Harry Sinclair of Teapot Dome and Bernard “Sell ‘Em Ben” Smith, who explained their manipulation and insider trading schemes which they viewed as normal business activity. Other potential witnesses scheduled out-of-country trips, while many could remember almost no details.

Pecora was the source for describing most of the outrageous behavior of 1920s Wall Street and big business: the pyramiding schemes of Insull and others, Goldman Sachs Trading and other investment trusts, and the South American bonds in default repackaged and sold to retail investors. The commission heard about tax-avoidance schemes for J.P. Morgan and other banks (the IRS would charge tax evasion and collect some $2 million based on Pecora testimony). The investment bankers testified about “preferred lists” allowing influential customers to buy new issues at discounted prices before the securities went to market. Many testified about rampant stock pool manipulations and insider trading. At National City Bank executives “borrowed” millions of dollars (that did not have to be paid back). National Chairman and President Charles Mitchell received bonuses over a million dollars every year in the late-1920. After testifying, Mitchell resigned and soon indicted for tax evasion. Journalists were bribed to plant glowing (or unfavorable) corporate analyses to move stock prices to benefit insiders.

The Pecora report showed how inflated compensation and illicit practices led to unethical banking and investment practices. However, this analysis focuses on the big banks, not where the most basic fraud and abuse were. Generally, these were NYSE companies following exchange requirements, thus violating no laws. The outright fraud schemes, (perhaps costing the public a billion dollars annually) were done by small “over-the-counter” firms (i.e., not listed on an exchange) and thousands of injunctions and hundreds of criminal prosecutions followed. The public paid big commissions and high prices for questionable and sometimes bogus securities.

Pecora investigated Ivar Kreuger, the “Swedish Match King” swindling millions from American investors. Kreuger created a gigantic international match empire in part through bribery of government officials. He claimed economies of scale and efficiency, but when losses hit in the mid-1920s he turned from illicit to fraudulent practices. Kreuger continued to pay high dividends, based on cash generated from new loans, equity, and occasionally printing and selling bogus certificates—not profits. What little financial information he released falsely suggested he was one of the world’s richest men. When his empire came crashing down early in the 1930s he committed suicide, leaving it up to bankruptcy trustees to figure out what was legitimate and what was fake. Ultimately, stockholders were wiped out and bondholders received about 30 cents on the dollar.

Richard Whitney ran a small bond brokerage and, more important, was president of the NYSE when called to testify at the Pecora Hearings. This patrician pontificated on the brilliance of the Exchange and admitted not the slightest error. Unfortunately, he was ruined early in the Great Depression and covered it up by borrowing from banks (using his company stock as collateral), friends and relatives, then embezzling from organizations where he was treasurer or trustee. When discovered, his firm was suspended from trading and he was sentenced to 5-to-10 for grand larceny. He was paroled from Sing Sing in 1941.

FDR’s New Deal

The year 1932 was the worst year in the Great Depression and, not surprisingly, Franklin D. Roosevelt won the presidency in a landslide. The New Deal record was blemished by various missteps, but economic and financial changes were substantial and generally effective. The banking system on FDR’s Inauguration day (March 4, 1933) was in ruins and within a few days Roosevelt closed all the banks (which he rosily called a “bank holiday”). By March 15 solvent banks were reopened with Treasury, RFC, and Fed support, while some 4,000 insolvent banks were shut down. The gold standard was soon suspended; this stopped the massive exodus of gold to foreign lands. The Fed no longer had to prop up the dollar and, instead, expanded the money supply.

Known for the “first 100 days,” legislation included 15 major bills, aimed to stimulate banking, industry, and farming. FDR continued emergency programs like relief and work programs (which he had used as governor of New York). Relief programs provided jobs, beginning with the Federal Emergency Relief Administration (FERA, 1933–5), replaced by the Works Program Administration (WPA, 1935–43), and the Civilian Conservation Corps (CCC, 1935–42). Farm programs started with the Agricultural Adjustment Act (AAA) passed in1933, to raise farm prices by restricting output—benefiting farmers but with higher prices to consumers; the Supreme Court declared the program unconstitutional, but new farm subsidy programs were passed and maintained in some form ever since.

The National Recovery Administration (NRA) was created in 1933, which set up a cartel system to set prices and wages by industry. The NRA negotiated “business codes” to set prices and wages by industry, plus a set of “fair practices.” The program was at best modestly successful in some industries, but subject to cheating and dominance by big businesses. This act was declared unconstitutional by the Supreme Court. One result was the National Labor Relations (Wagner) Act which greatly increased the power of labor.

The Glass-Steagall Act of 1933 was a major bank reform, creating the Federal Deposit Insurance Corporation (FDIC) to insure commercial bank deposits, a provision favored by bank customers. The major provision of Glass-Steagall—considered a debacle by the banks—was the separation of commercial banks from investment banks. J.P. Morgan became a commercial bank, while Morgan Stanley was spun off for investment banking. A case can be made that much of the success through the early post-World War II period was because of the relative conservatism practiced by banks after the split.

The first New Deal focused on emergency measures. FDR and his advisors attempted substantial restructuring of the federal government during the so-called “Second New Deal” of 1934–36. Low-interest long-term mortgages were provided by the Federal Housing Act (FHA), which created the Federal National Mortgage Association (Fannie Mae) in 1938. The regulation of radio (and later television) started with the creation of the Federal Communications Act (FCC). The National Labor Relations (Wagner) Act created the National Labor Relations Board (NLRB), giving more power to unions. The Social Security Act of 1935 established old-age pensions plus unemployment insurance, disability and other benefits—eventually becoming the biggest New Deal program.

Some programs such as NRA were not helpful, while others such as some of the farm program had mixed results. Several programs were too small or reduced too soon to be effective, including some of the public works efforts. Public policy at the time favored a balanced budget approach (which FDR never achieved as president). After initial success and a recovering economy, his conservative fiscal package in 1935 cut government salaries and veterans’ pensions, and income taxes were later raised to a top rate of 79 percent. Fiscal restraint and Fed money tightening brought on a recession within the depression in 1937. Consequently, the depression did not end until World War II.

The SEC and Market Regulation

Prior to the Great Depression the federal government had almost no say in finance and securities regulations. The NYSE and other exchanges created their own rules. This changed with the Securities Act of 1933 based on FTC oversight, the first New Deal attempt to aid the investment public. The 1934 securities act beefed up the federal role and created the SEC specifically to regulate securities markets. (See Table 4.1 for a summary of the role of the SEC.)

The original 1933 act, the “truth in securities” law, placed major focus on making financial information available to investors in advance of security sales and expanded the list of prohibited practices considered fraud. Despite frantic Wall Street lobbying, the Securities and Exchange Commission Act of 1934 gave the SEC real power to protect the public. The SEC had the authority to require stock exchange registration and regulate stock exchange rules. The securities acts severely limited margin trading, short-selling, and eliminated the ability of floor traders to buy and sell shares exclusively for their own accounts. Several abuses (such as the “preferred list”) were left for SEC study rather than an outright ban. Ultimately, the preferred list and other illicit acts were never eliminated.

A major focus of the SEC was information, including the concept of “full and fair disclosure” of financial statements and related data in registration statements, meaning the information needed by a “prudent” investor. Financial reports were required for registering securities, initial public offerings, annually and more. An annual financial statement called the 10-k had to be audited by CPAs; more frequent statements (not audited) also were required, now on a quarterly basis (10-q). The SEC Act included antifraud and liability sections, which increased the legal risks to accountants; the auditor became accountable to the investing public in addition to the firms audited (although the corporation still chose and paid for the audit). The SEC issues pronouncements that include financial accounting and reporting requirements, including Accounting Series Releases (SARs), Regulation S-X, and Staff Accounting Bulletins (SABs).⁴

Insull’s utility holding company and over 50 others went bankrupt in the 1930s. The industry was considered one of the most corrupt in America, relying on massive leverage, pyramiding, and writing up plant assets to bogus market values. The Public Utility Holding Company Act of 1935 allowed holding companies to control only a single utility system, basically outlawing the earlier extreme pyramiding schemes.

One reason for the early success of the SEC was adequate funding, including a staff of over 1,700. The agency became less effective as the agency budgets were cut, substantially in real (inflation-adjusted) terms. This follows a familiar pattern (especially when the opposition party is in power) as administration effectiveness can be reduced for any department or agency simply by cutting staffs and budgets. As the SEC (and other regulatory agencies) became less effective, corporations were more likely to manipulate the earnings and financial numbers and conduct any number of illicit acts. The most blatant culprits would most likely collapse during economic downturns, leading to public outrage, new regulations, and increased SEC funding.

Accounting Becomes a Major Profession

With the Great Depression, little confidence remained for Wall Street and the financial markets. Virtually everyone was blamed, including the accountants. Few illegal acts were discovered by the Pecora Commission, but plenty of lax enforcement and unethical behavior. The American Institute of Accountants (AIA, now the American Institute of Certified Public Accountants or AICPA) was ready to consider reform, including cooperation with the NYSE, SEC, and IRS. A special Committee on Cooperation with the NYSE was created, focusing on establishing financial accounting principles and other issues. The first reform was instituted by the NYSE in 1933, requiring annual financial audits for all listed corporations.

When the SEC was established by Congress in 1934, it had the force of federal law and the specific: “Authority…to prescribe the form or forms in which the required information shall be set forth, the items or details to be shown in the balance sheet and the earnings statement, and the methods to be followed in the preparation of accounts…” Carman Blough, a CPA, became the first SEC chief accountant—but with limited resources. Blough preferred the accounting standards established by the accounting profession (i.e., the AIA), which happened after considerable debate.⁵ Thus, a key pronouncement was the SEC’s Accounting Series Release (ASR) No. 4 issued in 1938 which delegated accounting standard setting to the organization with “substantial authoritative support.” The AIA took that as authorization.

The “authoritative support” was delegated to the AIA’s Committee on Accounting Procedure (CAP), established in 1936. At the top of the CAP’s list of objectives was uniformity: “The principal objective of the committee has been to narrow areas of differences and inconsistency in accounting practices, and to further the development and recognition of generally accepted accounting principles (GAAP), through the issuance of opinion and recommendations ….”⁶ It was thought that a major problem with earlier financial accounting was the use of “professional judgment,” leading to unique rules applied by different companies (also implying that the auditors followed the procedures preferred by the company audited—read: manipulation). The CAP issued some 51 ARBs over 20 years (1938–59). Although most of these have been superseded, they did establish the most fundamental rules (called GAAP) still used today including depreciation and inventory methods.

As explained in Chapter 1, the McKesson and Robbins fraud demonstrated the need for systematic audit standards and so another AIA committee was established, the Committee on Auditing Procedure (CAuP), creating generally accepted auditing standards (GAAS). A public corporation under the jurisdiction of the SEC was required to have a complete annual financial audit based on GAAS and following GAAP (this was specifically stated in ASR No. 21). Over time the investing public began to trust the audit report and the underlying financial statements (only occasionally with dire results). The reform effort was interrupted by World War II. The post-World War II period came with American economic dominance of the world and a different perspective on business and finance.

The functions of the SEC as stated on the SEC website:

Table 4.1 The role of the Securities and Exchange Commission

Mission	The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.
Purpose of the securities laws	Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing. People who sell and trade securities—brokers, dealers, and exchanges—must treat investors fairly and honestly, putting investors’ interests first.
Commissioners	The Securities and Exchange Commission has five commissioners who are appointed by the president of the United States with the advice and consent of the Senate. Their terms last 5 years and are staggered so that one commissioner’s term ends on June 5 of each year. To ensure that the Commission remains nonpartisan, no more than three commissioners may belong to the same political party. The president also designates one of the commissioners as chairman, the SEC’s top executive.
Registration	A primary means of accomplishing these goals (require that investors receive financial and other significant information concerning securities being offered for public sale; and prohibit deceit, misrepresentations, and other fraud in the sale of securities) is the disclosure of important financial information through the registration of securities. This information enables investors to make informed judgments about whether to purchase a company’s securities. Investors who purchase securities and suffer losses have important recovery rights if they can prove that there was incomplete or inaccurate disclosure of important information.
Corporate reporting	Companies with more than $10 million in assets whose securities are held by more than 500 owners must file annual and other periodic reports. These reports are available to the public through the SEC’s EDGAR database.

Source: SEC webpage: www.sec.gov