CHAPTER 2

Business and Scandals before the Securities and Exchange Commission

In 1789 as the nascent American government was being established in New York City, business-as-usual meant standard corruption practices like bribery and smuggling. Government had little involvement with business beyond chartering corporations and enforcing contracts and property rights. Manufacturing meant mainly handcrafted products, few banks existed before the Constitution was adopted, and financial markets were groups of merchants and speculators meeting on street corners or in coffee houses—something resembling Adam Smith’s laissez faire state. Businesses were largely untaxed, while labor, safety, and environmental issues were of little concern to anyone in power. As the country’s economy grew, banks got bigger and more aggressive, stock and other markets became formal and organized (under their own rules, not the government), transportation became rapid, efficient and more-or-less national, and the factory system developed and expanded. The American story is replete with stories of genius inventors (Eli Whitney and Thomas Edison come to mind), brilliant entrepreneurs (a big list including Andrew Carnegie and John D. Rockefeller), and financiers (with J.P. Morgan perhaps the most powerful). Lesser-known professional managers and accountants made plants run with increasing efficiency.

Without accounting or auditing standards, accounting fraud did not exactly exist, although massive manipulation and financial fraud were commonplace. During the railroad construction booms throughout much of the 19th century, promoters established construction companies to build the track and other infrastructure, charging the railroads outrageous prices. The promoters made a fortune whether the railroads were successful or not, or even if they were not completed. Bribes were common; cash accounting proved to be very flexible for the insiders. Fixed assets could be recorded at cost, some form of market value, or virtually any made-up number to benefit the managers and directors. Audits were often conducted, but the structure of the audit was completely at the discretion of the company treasurer or other corporate executives.

Businesses grew bigger and expanded across state lines. This created legal problems because of interstate commerce—limiting state laws (especially corporate charters) often made it difficult to operate in other states. Corporations turned to secret agreements and various illicit acts to circumvent legal restrictions. Intense competition prevailed, especially during economic downturns. This resulted in increased manipulation, bankruptcies, and attempts by the most ruthless to eliminate competitors or conspire to manipulate markets. The survivors were usually the most competent, innovative, and ruthless. (Having a war chest of cash did not hurt, either.) Survival and growth often meant skirting the law or worse (or, stated another way, extremely unethical behavior when few laws existed).

Governments got bigger and more corrupt. A good case can be made that Aaron Burr introduced the innovative tricks that transformed New York City’s Tammany Hall from a social club to America’s first political machine. Once Tammany’s Grand Sachem’s embraced machine politics government corruption increased on a massive scale (bribery and extortion became part of daily business) and expanded across the nation. For the most part, reform movements would have to wait until much later in the 19th century.

The post–Civil War period is known for the robber barons, a set of powerful and ruthless speculators and business leaders. Some were outright scoundrels, such as Jay Gould. Others were brilliant entrepreneurs interested in building mammoth enterprises, but not much interested in competitor welfare or public relations. John D. Rockefeller created the modern oil business, but became the number one robber baron for such maneuvers as secret railroad rebates, eliminating competition by any means possible, and using questionable legal wrangling to become a global enterprise. Rockefeller also was the most successful and efficient, becoming the nation’s first billionaire. These “positive” characteristics are more appreciated today than at the end of the 19th century.

State laws attempted to regulate businesses of all kinds, basically dozens of experiments in business legislation. Some industries such as banks and insurance were often reasonably regulated. Others, especially large industrials, defied control, both because of effective lobbying of state governments and Article 1, Section 8 (on enumeration of powers) of the Constitution, which gives the federal government control over interstate commerce—reinforced by a number of Supreme Court decisions. After the Supreme Court decision in Wabash, St. Louis and Pacific Railroad Company versus Illinois of 1886 decimated the state’s ability to regulate railroads, Congress finally acted, creating the Interstate Commerce Commission (ICC) in 1887 as a federal agency to do the job. Congress also moved to reduce the impact of corporate monopoly power. Three years after the ICC, the Sherman Antitrust Act began antitrust legislation to ban price conspiracies and limit monopoly acquisitions and power. Federal regulation has expanded ever since, in fits and starts, with the rule of thumb that major legislation followed mammoth scandals and crises.

By the start of the 20th century America was the global giant, overtaking England and Germany in production and industrial efficiency. Part of that success required accounting innovations allowing corporate headquarters to monitor and control massive operations across dozens of plants and distribution centers. The process continued with General Motors becoming the new innovative leader in manufacturing and accounting procedures by the mid-1920s. Unfortunately, the 1920s proved to be almost as corrupt at the late 19th century. This was the decade of Teapot Dome and Charles Ponzi. In addition, rampant speculation and manipulation fueled a market bubble, which burst in October 1929. A recession and stock crash turned into the Great Depression of the 1930s, largely because of misguided efforts by the Federal Reserve and other government actions.

The Founding and Early Business History

The Virginia Company, an English joint stock company (precursor of the modern corporation), established the Jamestown Colony in 1607, the first successful British settlement in what became America. Profitability came after the colony successfully exported tobacco back to the mother land. It would be followed by the Massachusetts Bay Colony, another joint stock company in 1620. The history books focused on religious freedom, and the stockholders focused on expected riches. Other colonies followed with similar capitalist expectations.

A million colonists scrounged around the original colonies by the 18th century. The South had the most people (with a substantial percent of those in slavery). Vast acreage of fertile land and warm weather made this an agricultural wonderland, exporting tobacco, rice, and indigo—cotton would become the big crop with the invention of the cotton gin and a nicely progressing Industrial Revolution in England. New England and the Middle Colonies (Pennsylvania, New York, and New Jersey) had poorer soil and weather, producing more limited foodstuffs. Their success came mainly from lumber, fishing, shipping, and merchandising. The North had the major port cities of Philadelphia, Boston, and New York City. The South had Charleston (New Orleans was a 19th-century acquisition from the Louisiana Purchase).

Britain developed a merchant empire with a big, expensive navy. The colonies provided raw materials and a market for finished goods. Colonists were expected to meet increasingly stringent mercantile regulations, pay customs, and other taxes (the system, especially with a big navy and frequent wars, was expensive) and be perpetually obedient to the king. The colonists, especially the merchant shippers, were good at evading taxes and regulations, with particular expertise in smuggling, bribery, and black market operations.¹ British taxes, regulations, and enforcement techniques became increasingly onerous after the French and Indian War ended in 1763, resulting in colonial unrest and disobedience. The Boston Tea Party of 1773 was, perhaps, the most familiar act that led to the American Revolution (1775–1783).

The American hotheads likely did not think too carefully of the consequences of war with England when they declared independence in 1776. They initially had no government, no army or navy, no banks, no currency, and no means to raise money (the Patriots, after all, expressed a good deal of resentment to taxes). Not even half the colonists supported independence (together, British loyalists and fence-sitters were the majority). They were fighting the greatest professional military force on the planet, with the best banking and fiscal system available. Despite the long odds and substantial setbacks, the colonists triumphed.

With the war won, the provisional government under the Articles of Confederation was bankrupt, in debt, with few resources to reign in 13 independent colonies, and the country in depression. Shays Rebellion (1886–1887) of western Massachusetts (over onerous state taxes) was possibly the last straw and a group of political leaders from the colonies agreed to meet in Philadelphia to rewrite the Articles. The result was the American Constitution, written in 1787 and passed by the required nine states in 1788. America had a new government in 1789 under the first president, George Washington. The depression, no revenues, and massive debt became his problems. He was fortunate to pass the financial problems to his new Secretary of the Treasury, Alexander Hamilton, who created a long-lasting revenue source in custom duties, established the Bank of the United States that acted as a central bank, started a mint to coin money, and developed a process to assume the debts of both the Continental Congress and all the states. By the end of that century, the country had a well-funded, functioning federal government with a stable banking system, and substantial domestic and foreign credit. (If Moody’s had been around at the time, the United States could have had an investment-grade rating even then.)

Despite the best efforts of Washington, Hamilton and a whole host of founding fathers, the country was still an agricultural backwater. Manufacturing, such as it was, was small, local, and labor intensive, mainly in textiles, sawmills, iron foundries, and grist mills. The factory system developed first in textiles, as it had earlier in England. Samuel Slater, an Englishman working as a superintendent in a textile factory, immigrated to New England and established the first American factory making yarn in the 1790s. Once the government, after a bit of lobbying, established high customs duties on British yarn and other textile products, New England textile mills exploded and expanded into integrated mills, producing all steps by machine. The growing size and complexity required sophisticated accounting, with material and labor cost information accumulated for each operating in the entire process and a limited attempt at measuring overhead costs.

Eli Whitney’s 1793 patent for the cotton gin is one of the most famous patents in history, although dozens of people copied and sold cotton gins despite his court actions for protection. Ultimately giving up, he received a contract to produce 10,000 muskets for the Army (conveniently, his friend Oliver Wolcott was Secretary of the Treasury). The concept of interchangeable parts got a boost with Whitney’s contract. He claimed to mechanize the process, but only developed part of the firing mechanism with interchangeable parts; the problem was lack of needed machinery. With improved machinery, interchangeable parts and mass production happened soon in firearms and spread rapidly across American industries. The Springfield Armory would introduce many firearm innovations and developed advanced accounting controls, considered the most sophisticated in use before 1840 according to Alfred Chandler.²

Banking and Financial Markets

When independence was declared, America had exactly zero banks thanks to a British ban on banking or minting money. Philadelphia financier and merchant Robert Morris (he became Superintendent of Finance for the Continental Congress) established the first commercial bank, the Bank of North America, chartered as a national corporation under the Continental Congress in 1781. It functioned as a conservative bank, taking in deposits, maintaining substantial reserves in gold, and issuing short-term commercial loans to established merchants (who still needed collateral for the loans). The bank also provided various central banking-type activities for the Continental Congress and Morris had substantial self-dealings with himself, the bank, and the government. These conflicts of interest would be illegal now, but were considered standard practice at the time.

Two other commercial banks were established in the 1780s, the Bank of New York by Alexander Hamilton and the Bank of Massachusetts by Boston merchants, both chartered by their respective states in 1784. Their practices were virtually identical to Morris’s bank, maintaining conservative practices by keeping large reserves and limiting lending to short-term loans mainly to merchants. During the 1790s (after the U.S. Constitution created a dynamic federal government), another 26 banks were state- chartered, maintaining conservative practices (no American bank failed in the 18th century). As Treasury Secretary, Hamilton created the Bank of the United States in 1791 with a 20-year federal charter, modeled after the Bank of England to serve as a central bank. This was another link in Hamilton’s chain to create a successful fiscal and monetary structure for the nation.

Washington considered himself politically nonpartisan, but before his term was over, Hamilton’s Federalists were battling Thomas Jefferson’s Democratic-Republicans for political and philosophical control. Under partisan politics, self-dealing became especially blatant. New bank charters won approval based on political party, with Federalists dominating the early banks. As leadership changed from one party to another, charters followed new party affiliation and government deposits transferred to party-affiliated banks. It was a short move from partisanship to political corruption. For example, New York City’s Bank of America, the largest bank in 1815 with capital of $4 million, caused a scandal when Federalist politicians were accused of bribery over its charter.

The late 18th-century commercial banks played an important role at the start of the country by creating a stable and successful banking system, even though most people never used banks. The number of banks increased slowly, to 90 by 1811, and conservative practices continued through the War of 1812. A separate laboratory of corporate chartering and regulation developed in each state, with rules ranged from conservative, sound banking to virtually no regulation. Periods of paper currency explosions (banks issued their own paper money) was a sure recipe for banking and economic collapse. The result of “aggressive banking” was periods of rapid growth, expansion of services to farmers, retailers, and speculators. Some canal and railroad builders got initial funding from state banks. The downside was the creation of boom and bust cycles, causing havoc when banks and the economy collapsed.

Unlike urban banks, which tended to operate conservatively, rural banks, more common in the West, tended to be aggressive and often pegged as “wildcat” and “frontier” banks. Lower reserves, more risky loans funded with the bank’s own notes, and a distaste for redeeming notes for gold generated quick profits. Bankruptcy often meant the bank promoters left town in the middle of the night to set up a new wildcat bank in another state.

Each bank produced its own notes in convenient denominations. The notes would be issued when customers took out loans. By mid-century, over 1,000 state banks operated, creating untold currency variations. With thousands of banknotes circulating, counterfeiting became rampant. Various reforms were tried by the states, including new, more stringent regulations and self-policing bank associations. Clearing banks were established beginning with the Suffolk Bank of Boston around 1819. Banks would affiliate with the clearing bank (usually by keeping deposits in that bank) if they wanted their notes redeemed. Some states instituted annual bank examinations, while others established bank commissions to supervise and examine the books of state banks. The result was a crazy quilt banking system, from conservative and stable in some locations to corrupt and risky in others (plus a ban on banking in a few—Texas did not have a bank until the 1860s). Generally, the further from the East Coast, the greater the hazards.

Politics and Political Machines

Political corruption could be found at all levels of government, but was particularly pervasive at the local level. The election of 1800 was a good start date for partisan, corrupt politics, a bitter fight between sitting President John Adams, a Federalist, against sitting Vice President Thomas Jefferson, a Democratic-Republican, and the rivalry filtered down to the local levels. Partisan newspapers supported a candidate and willingly told half-truths and lies about the opponent. New York lawyer and politician Aaron Burr was in the running for president as a Democratic-Republican. Burr could be considered a genius for political organization, especially when it involved dishonesty and fraud. He organized New York City Democrats to control the wards, used door-to-door arm twisting for vote getting and fund raising, lied to journalists using both partisan newspapers and bribery of reporters, and provided rides and other services on election day—this was before the secret ballot and henchmen could encourage “correct party voting.”

The “Sachems” of Tammany Hall observed and expanded on the Burr tactics and Tammany became the long-serving base for the New York City’s Democratic political machine, which specialized in power, corruption, and accumulating wealth by illicit means. William Mooney, an upholsterer and first Grand Sachem, paid himself grandly despite the allotted $1,500 a year salary and pilfered government goods (“trifles for Mrs. Mooney” was his defense). The vast potential for patronage jobs for Tammany supporters was first developed by John Ferguson, mayor of New York beginning in 1815. Tammany-controlled banks distributed stock to Tammany leaders. The Collector of the Port of New York, responsible for collecting tariffs, had the greatest bribery and embezzling potential and often ended in Tammany hands (when a Democrat was president). Collector and Burr ally Samuel Swartwout fled the country when an investigation exposed the embezzlement of $1.2 million of customs funds, followed by similar allegations of his successor as collector, Tammany boss Jesse Hoyt.

William (Boss) Tweed was considered the most corrupt Grand Sachem; his ring stole as much as $200 million. In part because of the infamous Tweed cartoons by Thomas Nast, Tweed was arrested and convicted in 1871, actually dying in jail in 1878—one of the few 19th-century crooks convicted of a crime. Corruption declined after Tweed, but neither Tammany nor corruption went away. Political power and election success, with the resulting patronage, determined relative corruption potential. When Richard Croker became Grand Sachem in 1886, kickbacks and bribery returned, although more modestly than under Tweed. Croker’s growing real estate empire benefitted from insider information and city- controlled property. Following the Tweed tradition (Tweed got Brooklyn Bridge stock, for example), Croker was given large stock holdings from companies wanting to do business in New York. The police department was blatantly set up for plunder and allied with Tammany—with at least limited reforms coming when Theodore Roosevelt became a police commissioner and new Republican mayor William Strong started a reform movement in the 1890s.

Future president Martin Van Buren (1837–1841), who practiced law in New York City, maintained control of Democrats in New York State using political surrogates while in Washington; the “Albany Regency” was the first attempt as a nationwide political machine. The “Regency Code” used patronage as the primary technique to maintain power. Van Buren’s increasing power in Washington made both state and federal jobs available. After the Civil War, Roscoe Conkling was the New York Republican machine boss competing with Tammany Hall. During the administration of U.S. Grant, federal political patronage and corruption was especially rampant. Teddy Roosevelt, a New York State Assemblyman about this time, referred to machine politicians from both parties as the “black horse cavalry.” As a political reformer, Roosevelt was often stymied by the machines.

Chicago, America’s number two city, was a late starter in machine politics, but became synonymous with corruption. Ward politicians blamed rivals for the Great Chicago Fire of 1871, soon transformed into the usual patronage and “vote early and often” campaigns. Democratic Michael McDonald created the first Chicago machine, followed by the Kelly-Nash machine. Prohibition increased the power of organized crime in Chicago politics. While most cities saw the decline of political machines in the 20th century, machine power actually increased in Chicago after 1930. The last major Chicago machine occurred during the reign of Mayor Richard Daley, starting in 1955. The other particularly infamous political bosses of the 20th century were Jersey City mayor Frank Hague and Tom Pendergast and his Kansas City machine. (Future senator and President Harry Truman came out of the Pendergast ring.)

Transportation: Canals and Railroads

Transportation proved to be a major obstacle to economic development. Initially, virtually all trade was done on water, across the Atlantic or down America’s rivers. The major cities were the port cities of New York, Philadelphia, Baltimore, Charleston, and later New Orleans. However, except for available rivers, transport into the interior meant inefficient wagons and carriages. The first great building projects were canals, basically to connect cities to other cities or rivers that connected to other cities. The major issue was that the capital-intensive projects needed government support or capital markets to generate the funds for building. The early financial markets of, for example, Philadelphia and New York, initially funded government bonds, banks, and insurance companies.

Canals and later railroads required state charters, which needed political connections. The promoters of canals and railroads were a strange brew of idealists, politicians, investors, speculators, and various shady characters only interested in a quick buck. Many elites had the connections; promoters made connections with under-the-table cash. Many promoters sought to profit from the construction itself, whether or not the project actually succeeded as a business enterprise, called by critics “plunderers” and “looters.” Despite the mixed incentives of the promoters, the canals and railroads got built. Promoters often sold subscriptions to stock shares, with a small percentage of the price up front and the rest payable over time. The best connected got government financing or other incentives such as blocks of land.

The first canal was the Santee Canal, built in 1792 from Charlestown, South Carolina, to connect to interior rivers. Even George Washington was a canal investor, the Patowmack Company to connect Alexandria, Virginia, to the Appalachian Mountains. By 1860 some 4,000 miles of canals were operating. The most successful was the Erie Canal, running from Buffalo on Lake Erie to Albany in the Hudson River, an easy jaunt by boat to New York City. The building was a political act and centered on the interests of those benefitting from the canal, including early steam boat operator Robert Fulton and New York land speculators. New York City mayor De Witt Clinton was the major political force behind the project—and the canal was dubbed “Clinton’s ditch” by opponents. By 1822, some 220 miles were completed. Canal securities became favorites, first with New York elites and then English and other European investors. Cost overruns were a substantial 46% ($8.4 million vs. a project cost of $5.8 million); a later New York Congressional investigation committee named fraud as the major cause. Despite corruption, the canal was completed in 1825 and was a commercial success from the beginning, moving tons of grain, lumber, and later meat east and manufactured goods and immigrants west.

Railroads, beginning with the 16-mile Mohawk and Albany (from Albany to Schenectady) in 1831, became even more successful and a necessary engine for the rapid economic growth of the second half of the 19th century. The first of the successful major railroads was the Baltimore and Ohio Railroad (B&O), chartered in 1827 by Baltimore merchants to run from Baltimore to the Ohio River, basically to stay competitive with the Erie Canal. The route to Wheeling (on the Ohio River) was not completed until 1853.

Another major railroad was the Erie Railroad, chartered in 1832, running from near New York City to near Lake Erie (or, as the critics exclaimed, “roughly nowhere to nowhere”), for a short period the longest railroad in the world. Funding required common stock and, largely because of the high construction costs, a substantial amount of bonds. Many of these were convertible into stock (and some convertible in either direction). This was a speculator’s perfect security and the Erie would prove to be among the most corrupt of the major railroads in U.S. history—the “Scarlet Woman of Wall Street.”

Four major truck lines developed in the second half of the 19th century. In addition to the B&O and Erie, they included the New York Central (beginning around New York City, it took a route roughly parallel to the Erie Canal and later headed west to Chicago and beyond) and the Pennsylvania Railroad (from Philadelphia to Pittsburg and beyond). The rise of professional management and cost accounting developed in the railroads, with the Pennsylvania taking the lead. The railroads were a mixed bag, with professionalism and a focus on near-lifetime employment at some like the Pennsylvania, while corruption and short-term speculation dominated others, like the Erie.

The big railroads developed top-down management structures because of their size and operating complexity. Profitability when competition and high fixed costs existed required the movement of maximum traffic most efficiently. In addition to professional management, this required substantial improvements in accounting. As summarized by Chandler³ “To meet the needs of managing the first modern business enterprise, managers of large American railroads during the 1850s and 1860s invented nearly all of the basic techniques of modern accounting.”

The Pennsylvania Railroad divided the traffic into three separate companies, each headed by a general manager and J. Edgar Thomson serving as president of all of them. Under Thomson a uniform set of accounts and reporting system was put in place and many operations, such as purchasing, was handled at the central office for maximum economies. The standard measure of performance was the operating ratio (operating revenues divided by operating expenses) to compare volume efficiency. Another common measure was the ton mile as a measure of unit cost, developed by civil engineer Albert Fink, then general supervisor at the Louis & Nashville Railroad.

The Big Scandals

In a century with few regulations, it was difficult to commit criminal acts related to complex business dealings. Many outright frauds of today would have been considered standard practices, such as insider trading, market manipulation, self-dealing, and any number of conflicts of interest. Also, basic frauds such as bribery and extortion were typically overlooked, partly because both judges and legislators were often on the take. Both labor and the environment were often treated harshly, with only limited regulation for their protection by the end of the century. The concept of worker rights did not exist and thousands of workers were killed on the job and perhaps hundreds of thousands injured annually. Despite these caveats, many business scandals occurred. The major scandals included raiding the Erie, the attempted gold corner of 1869, and the Credit Mobilier scandal. Interestingly, these occurred about the same time—Boss Tweed also was being prosecuted about then.

Raiding the Erie

Cornelius Vanderbilt moved from a steamboat fleet to a railroad empire. He sold his ships and achieved effective control of the New York Central by the mid-1860s. His biggest frustration was the conniving at the Erie, manipulated by speculator Daniel Drew. Vanderbilt wanted a well- functioning railroad; Drew wanted to manipulate Erie’s stock. That meant he could push to stock price up or down and also start rate wars with the New York Central and Pennsylvania Railroad. Vanderbilt could form a price/volume agreement with the Pennsylvania (basically a cartel), but not the Erie (Erie’s managers would agree to a plan and then cheat). Vanderbilt’s answer: acquire the Erie. He had to deal with Daniel Drew and his co-conspirators Jay Gould and Jim Fisk. In this major battle involving millions of dollars, Vanderbilt would lose—a rare event. The war included an attempted corner, newly printed Erie securities, accommodating judges willing to subvert justice and bribing politicians.

Drew had served as an Erie director since 1851 and later treasurer; manipulating Erie stock proved to be his most lucrative endeavor. Drew made a successful bear raid in 1866 (driving down the stock price by selling short and using other mechanisms to reinforce a lower stock price) and using Erie’s convertible bonds to cover his short position. Vanderbilt’s Erie raid started soon after. He accumulated enough stock and proxies to gain control. Drew, still Treasurer and claiming to be a Vanderbilt ally, planned a counter-strategy.

Drew’s lobbying resulted in a new state law allowing railroads to exchange stock to acquire other railroads under lease. Drew leased the rundown Buffalo, Bradford, and Pittsburgh, for $9 million, paid for with Erie convertible bonds; $5 million worth went to Drew’s broker and these were convertible into 50,000 shares of stock. Vanderbilt was frantically buying the newly minted stock. Once alerted they were brand new shares, Vanderbilt got judge (and Tammany member) George Barnard to issue a restraining order on these activities, but Drew used his own judge to countermand the order and compel the Erie to convert the bonds. Judge Barnard countered with contempt proceedings against Drew, Gould, Fisk, and other Erie directors. Soon to be called the Erie Ring, Drew and his conspirators fled to New Jersey with all the newly acquired cash.

The Erie Ring used their Albany forces to entice the state legislature to introduce a bill legalizing the new stock and forbid consolidating the Erie with the New York Central. Vanderbilt’s cash bought enough votes to defeat the bill. A similar bill was introduced in the Senate (Gould was leading the Erie forces in Albany at the time) and the bill passed. The house legislators expected a massive payoff in a new round. But Vanderbilt had had enough, sending this message to Drew: “I’m sick of the whole damned business. Come and see me. Van Derbilt.”⁴ Vanderbilt sold his stock back at less than he paid for it and withdrew completely from the Erie—Drew and his co-conspirators won. Gould and Fisk proved even more mendacious than Drew, driving him from Erie management. Gould proceeded to loot the Erie once again, until finally ousted in 1874, leaving a ruined railroad declaring bankruptcy the following year.

The Gold Corner

Gould and Fisk were soon at it again, this time attempting to corner the gold market in New York City. Because much of the city’s gold was sent west in the summer and fall to pay for the annual agriculture harvests, that was the time to act. The plan could succeed only if the federal government did not make Treasury Department gold available to the market. Bribery of corrupt government officials was part B of the plan. The result of the corner would be much higher gold prices, devaluation of greenbacks (the paper currency of the time), and inflation. The rationale was that inflation would benefit the farmers; the harm to merchants and consumers was ignored.

Gould and Fisk, still running the Erie, used the railroad’s cash to buy gold, selling $2.5 million in Erie stock to generate the cash. About $4 million in gold existed in the New York market. The Treasury Department controlled another $15–20 million in gold. The Treasury must be kept out of the market. The plan was to bribe President U.S. Grant’s brother-in-law Abel Corbin. Corbin arranged a meeting between Grant and Gould at Fisk’s theater where the “gold plan” was explained, focusing on the benefit to farmers. Grant agreed, telling Treasury Secretary George Boutwell not to interfere.

Gold stood at $130 (130% of the value of greenbacks), when Gould and Fisk started buying. Corbin, in the meantime, demanded more cash, which was not forthcoming. Fisk and Gould had also offered General Horace Porter, Grant’s private secretary, a bribe, which he turned down. Porter told Grant about the bribe. An outraged Grant changed his mind and ordered Boutwell to break the corner. Gould discovered the Treasury action, sold out, and made millions. Gould neglected to tell Fisk, who continued to buy gold, sending gold over $160. When Boutwell announced the gold sale, the price of gold almost immediately fell back to $130. Fisk should have been ruined, but refused to pay. His brokerage firm defaulted and went bankrupt. Lawsuits followed, but Gould’s judges protected Fisk. Congressional hearings investigated the gold corner. When Fisk was called his answer was: “Nothing is lost save honor.”

Credit Mobilier

The first transcontinental railroad ran from Nebraska to California, finally linking the country from coast to coast. Federal legislation passed during the Civil War and construction completed in 1869, considered by many the most spectacular building project of the 19th century. The multiyear construction resulted in perhaps the biggest scandal of the time, Credit Mobilier. The basic corruption was well known from other railroads, but the scale and the number of corrupt federal officials getting caught was unique.

Many visionaries, including Abraham Lincoln, favored a transcontinental railroad. The discovery of gold and the mass rush of the “forty-niners” made it inevitable. To entice promoters still required a government giveaway of millions of acres of federal land and millions in federal loans. More enthusiasm was generated in California where the Central Pacific Railroad (CP) was chartered by the state in 1861, financed by four merchants, Leland Stanford, Collis Huntington, Charles Crocker, and Mark Hopkins. Called “the Associates,” they were interested in long- run money and power, which limited their immediate pilfering. Theodore Judah, the initial visionary and creator and surveyor of the railroad, died of yellow fever in 1863.

The Pacific Railroad bill was passed by Congress in 1862 and provided both substantial loans and land, based on miles of track completed. The bill created the Union Pacific Railroad (UP) as a federal corporation with Union general and New York politician, John Dix as president. Thomas Durant, a Wall Street speculator, was appointed as vice president and became the real driving force. In total, Congress loaned the two railroads $51 million and 21 million acres of land. The promoters of both companies would sell much of the land though separate land companies; the proceeds went to the railroads only after the promoter’s substantial cut.

Corruption extended beyond Washington. After extensive “lobbying” in Washington the CP had virtually no money for construction. The CP associates developed an extortion racket, including a suggested “subsidy” from cities on the potential route; if they wanted to be on the route, funds were expected. Sacramento, San Francisco, and Stockton were three California cities paying up: cash plus right-of-ways, land, and other benefits. A favorable press required appropriate payments: the Sacramento Union editor reputedly received $3,600 worth of CP stock and reporters lesser sums.

The major public scandal centered on the construction companies established by each: Credit and Finance Corporation used by the Central Pacific and Credit Mobilier (CM) at the Union Pacific. The CP associates and Durant of the UP secretly ran the construction companies and, along with influential politicians and other insiders, owned the stock. George Francis Train, hired by Durant to sell UP securities, found a “shell company” in Pennsylvania and suggested the name Credit Mobilier of America (after a French company). Durant and Massachusetts Congressman Oakes Ames became the major stockholders of Credit Mobilier. Durant did not expect the UP to succeed and wanted the opportunity to make his fortune up front by skimming off as much money as possible through the construction company.

The two construction companies acquired the supplies and completed the construction—either directly or through subcontractors. General Grenville Dodge was the chief engineer of the UP and under his efforts Credit Mobilier profits were massive. Big dividends were paid no matter what, resulting in Credit Mobilier doing a poor job actually paying suppliers, workers, and subcontractors. Associate Charles Crocker ran the CP construction company. He served as president and the four associates owned all the stock, camouflaged by using phony investors. The CP construction company certainly made big profits, but the amount is unknown: when Congress subpoenaed them, the books “mysteriously disappeared.”

Somehow both railroads got built, meeting at Promontory Point, Utah, on May 10, 1869. Then the scandal broke. Congressman Ames had sold stock of both UP and Credit Mobilier to influential politicians as low prices (buyers included vice president Schuyler Colfax; James Blaine, Speaker of the House of Representatives and later senator, presidential candidate, and secretary of state; and James Garfield, Speaker of the House and later president). An 1872 article by Charles Francis Adams, Jr. called “The Pacific Railroad Ring” broke the story, which demonstrated the massive corruption and obvious conflicts of interest: “the members of it are in Congress; they are trustees for the bondholders; they are directors; they are stockholders; they are contractors; in Washington they vote the subsidies, in New York they receive them, upon the plains they expend them, and in the ‘Credit Mobilier’ they divide them.”⁵

The Adams’s story was followed up by a New York Sun investigation, which called Credit Mobilier “The King of Frauds: How the Credit Mobilier Bought Its Way Through Congress.” Congress held hearing, creating the Credit Mobilier Committee. The press dubbed Congressman Oakes Ames “Hoax Ames.” Ames was accused by Congress of stock payoffs, lying to Congress, and massive overcharging of the UP for construction costs. In 1873 Congress censured Ames, who died soon after. Ames had acquired enough shares to push Durant out of CM leadership and Durant escaped almost untouched because he was ousted by Ames in 1869.

None of the perpetrators was prosecuted. The Justice Department did sue Credit Mobilier for fraud and expropriation of funds but the Supreme Court ruled in favor of the company. The railroad eventually repaid the federal debt when it became due decades later, but only after losing in court. Gould acquired the UP in 1873, looting it and driving it toward bankruptcy. The CP continued in the hands of the associates, who continued to expand their giant land and railroad empire, dominating California for the rest of the century.

Industrialization and Monopoly Power

During the 19th century, the United States rose from an agrarian economy to an industrial giant, outstripping both Britain and Germany for manufacturing dominance. America had a unique system of government, banks and capital markets, entrepreneurs and inventors, and the development of a class of professional managers. The earliest factory systems were New England textiles mills, using British models of machinery. The big business for most of the 19th century was the railroads, where efficiency, coordination, timing, and vast information needs led to professional management and improved cost accounting. According to Livesay,⁶ “modern bureaucratic management structures [were created] because they had no choice. Their size and complexity precluded the use of traditional methods of finance and management.” The railroads moved massive amounts of goods and people, which required the lowest possible cost if the company planned to stay in business. This required the best information available. As stated by Chandler,⁷ “to meet the needs of managing the first modern business enterprise, managers of large American railroads during the 1850s and 1860s invented nearly all of the basic techniques of modern accounting.”

The Pennsylvania Railroad was perhaps the most innovative railroad, especially under the presidency of J. Edgar Thomson (1852–1874): “Thomson was indeed one of the most brilliant organizational innovators in American history.”⁸ Andrew Carnegie trained on the Pennsylvania Railroad and used his accumulated knowledge to create and run the gigantic Carnegie Steel Company. After viewing Henry Bessemer’s steel plants in England, Carnegie created a steel manufacturing partnership in 1872 using the Bessemer process. He was confident, backed by his understanding of management and finance and the need for steel rails by the Pennsylvania and other railroads. His accounting system was the best available, using a voucher system to accumulate labor and materials cost for each department and prepare monthly reports. His plants were so efficient that he could operate at near capacity at a profit even during depressions. He sold out to banker J.P. Morgan as part of the consolidation movement working through most industries.

Industries producing complex but relatively homogeneous products could achieve substantial economies of scale with size; with market dominance the major firms could control pricing and limit the entry of new competitors. This, according to the proponents, created stable markets and promoted quality products. The critics claimed monopoly power, outrageous prices, and lack of innovation. The benefits of economics of scale were too attractive for big business to ignore. Consolidations meant horizontal mergers with competitors, vertical mergers to reduce costs, and ensure availability of supplies and distribution channels. The increased complexity required sophisticated accounting and reporting mechanisms through a professional central office. J.P. Morgan and other members of the “Money Trust” consolidated railroads and dozens of other industries, including Carnegie Steel as part of Morgan’s massive United States Steel, capitalized as the first billion-dollar corporation in 1901. The Sherman Antitrust Act of 1890 and additional legislation attempted to eliminate the worst abuses of consolidations, price fixing, and monopoly power by big industrials.

Panics and Crashes

The business cycle measures the ups and downs of the economy from expansion to bust to recovery and another expansion. The country was in depression when the Americans won the revolution and created a new government. Recovery followed George Washington into office, only to be hit by the first downturn (Panic of 1792) within four years. During the 19th century, major panics and depressions occurred about every 20 years (1819, 1837, 1857, 1873, and 1893) with minor downturns in between.

Various economic theories have been posited, with the Minsky Model, taking a broad historical perspective, a particularly useful starting point. Economist Hyman Minsky (1919–1996) focused on investor confidence and the supply of credit, resulting in changing bank lending practices and relative quality of debt: hedge finance (safe), speculative finance (moderate), and Ponzi finance (risky). The key point is that under standard conservative banking practices, interest and principal payments will likely be paid back on time. As speculation begins and then euphoria takes over, riskier lending occurs, which is unlikely to be paid back when asset prices fall and the economy turns down. The point when asset prices collapse is the “Minsky Moment”—Holland tulip prices in 1637, South Sea Company stock in London in 1720, Wall Street stock prices in 1929, American real estate in 2007.

Brunnermeier and Oehmke⁹ expand on the Minsky model to analyze financial crises. In their view, there are two phases: (1) a run-up phase where bubbles form and (2) a crisis phase resulting in a crash. During the run-up asset prices rise, rationalized by innovations (based on, say, railroads, the Internet or financial innovations such as securitization). Consistent with Ponzi financing, easy credit drives up asset prices beyond fundamentals, the creation of investor euphoria—a bubble, fueled in part by “belief distortion.” A trigger event leads to crisis, such as a price drop in key assets, followed by amplification mechanisms such as bank runs and lack of further credit.

The first major 19th century panic and crash was the Panic of 1819. Numerous state bank charters led to over-borrowing, causing speculation and rising prices in land and securities. Also in 1819 was a $4 million payment in gold due to the Barings Bank (President Jefferson borrowed the money for the Louisiana Purchase of 1803). The Second Bank of the United States (essentially the central bank of the time) called in state bank notes it possessed, demanding payment in gold. A ripple effect collapsed the domestic money supply. Credit essentially stopped and borrowers (fundamentally speculators at this “Ponzi stage”) failed in mass. Prices collapsed, banks failed, bankruptcies were widespread, and a major depression was underway.

The Panic of 1837 had many similarities to the earlier Panic of 1819, with too many banks making risky loans, and land speculation driving up prices. The unique events were the roles of President Andrew Jackson and European markets. The textile industry in Britain collapsed, decreasing foreign trade and reducing cotton and other commodity prices. Jackson’s government required specie payments (gold and silver) to purchase public lands, which quickly destroyed land prices. Speculators defaulted, banks failed, and the panic was on. Jackson did not renew the charter of the Second Bank of the United States, which could have limited the damage caused by the panic. With no central bank, a major depression set in—after Martin Van Buren replaced Jackson as president. Van Buren took the blame and was destined to be a one-term president.

Just like clockwork, the Panic of 1857 occurred 20 years after the last, with railroads playing a big role for the first time. After gold was discovered in California, new gold and silver finds increased the supply of specie, driving up inflation and asset prices. The Crimean War of 1853–1856 increased farm exports. The euphoria led to massive railroad construction and speculation in farmland. When the Crimean War ended exports and grain prices collapsed, ending the boom. The immediate cause of the 1857 panic was the failure of a New York trust company, causing bank runs and investors pulling out of securities. Hundreds of the railroads expanding roads using borrowed money failed, as did thousands of other businesses. The depression was short, because of the impending Civil War.

Railroads would play a major role in the remaining two major panics of the 19th century. With the completion of the first transcontinental railroad in 1869, others followed. Jay Cooke took over the Northern Pacific Railroad, relying on cheap credit. Unfortunately, much of his financing depended on German and Austrian speculators. When the Vienna Stock Exchange collapsed in 1873, so did Jay Cooke and Sons. This forced the closure of the New York Stock Exchange (NYSE) and the failure of a multitude of overextended railroads and banks. The depression that followed lasted the rest of the decade.

The Panic of 1893, following the booming decade of the 1880s, resulted in possibly the worst depression of the century. Once again, railroads were overleveraged after massive construction projects (total miles of track doubled during the 1880s). The immediate cause of the panic was the bankruptcy of the Philadelphia and Reading Railroad and the National Cordage Company, after a declining money supply and falling exports. Panic set in as investors cashed out to acquire gold; 150 railroads failed including the B&O, Erie, UP, and Northern Pacific. Also falling were 500 banks and thousands of other businesses. Recovery began in 1896, but the economy stayed in the doldrums throughout the decade.

The Panic of 1907 was caused by an attempted corner of a copper company. The broker involved failed, resulting in a general Wall Street panic and the collapse of the Knickerbocker Trust Company. With other trusts and banks in jeopardy, J. P. Morgan stepped in to bail out much of Wall Street. Morgan’s actions reduced the severity of the collapse, but later Congressional (Pujo) hearings uncovered many financial abuses on Wall Street. One result was the creation of the Federal Reserve System in 1914 and additional business regulation.

Anything-Goes-1920s and the Great Crash

After eight years of Democratic control under Woodrow Wilson, the nation returned to Republican rule in the 1920s, lower taxes, reduced regulations, and a hands-off federal government. The economy boomed, especially in the second half of the decade and considerable innovation happened (automobiles, electric utilities, radio, and airlines were the high-tech industries of the age). The speculation-fueled stock market boomed, creating a classic euphoria—destined for the Great Crash before the end of the decade. This was also the decade of perhaps the greatest government-business scandal, Teapot Dome, and Charles Ponzi, the namesake of the infamous scheme.

Teapot Dome

Teapot Dome in Wyoming was one of several naval oil reserves (the other major ones were in California). The scandal involved a large cohort of corrupt politicians, businessmen, and administration officials out to buy a president and rig leasing (with big bribes) to oil drillers— despite all the substantial reform legislation of the previous 30 years. If corrupt Attorney General Harry Daugherty is included, it could be considered the worst scandal in American history.

Oilman Jake Hamon plotted to buy a Republican president in the 1920 election for $1 million. In return, Hamon would be named Secretary of the Interior, where he would sell oil rights to the federal oil reserves for big payoffs. The offer was accepted by presidential dark horse Ohio Senator Warren G. Harding¹⁰ through his campaign manager (and Ohio party boss) Harry Daugherty. Hamon’s plan was successful and Harding was elected president. Harding’s wife insisted Hamon give up his mistress Clara. Mistress Clara did not take the news well and shot and killed Hamon before he assumed his role as Commerce Secretary. Hamon’s conspirators Harry Sinclair, Edward Deheny, and Robert Stewart, all oilmen, demanded the plan continue. Instead of Hamon, New Mexico Senator Albert Fall became Interior Secretary. After appropriate bribes (Deheny gave Fall $100,000 in cash and Sinclair gave Liberty bonds—Treasury bonds issued during World War I—worth about $270,000), the plan went forth.

Sinclair and Deheny signed leases for the government’s Teapot Dome and California reserve oil. Reporters for the Denver Post uncovered much of the Sinclair-Fall scam. Instead of disclosing the fraud, they demanded a bribe of $1 million from Sinclair. When he refused, stories about the conspiracy began and continued until they got their million bucks. Fall resigned after renewing the Teapot contract and became a “political consultant” for Sinclair and Deheny.

Once allegations began appearing in the press, Congressional hearing were demanded and started under Montana Senator Thomas Walsh in late 1922. As the perpetrators were covering their tracks, Walsh (and later the Secret Service) investigated. Deheny did admit to the $100,000 “loan” to Fall. The Liberty bonds were easy to trace because they had serial numbers. Criminal indictments for fraud were filed against Fall, Sinclair, Doheny, and others. Fall was convicted, making him the first cabinet officer to be jailed for a felony. He served nine months in prison and paid a $100,000 fine. Doheny was tried on the same issues but acquitted. Eliminating the drilling proved difficult. Sinclair beat the Teapot Dome charges but was convicted for contempt of Congress for lying and jury tampering.

The new attorney general filed injunctions to void the leases and stop the drilling at the naval reserves. Despite the massive evidence of fraud, it took a Supreme Court ruling to void the oil reserve leases in 1927.

Montana Senator Burton Wheeler (a protégé of Walsh) investigated Attorney General Harry Daugherty on multiple grounds. Daugherty brought much of his Ohio Gang to Washington—all thugs. The Bureau of Investigation (later the Federal Bureau of Investigation) became Daugherty’s enforcer. Kickbacks were received from contractors to the Veteran’s Bureau. Permits were sold to organized crime to sell alcohol (this was during Prohibition). Pardons and paroles could be bought by jailed criminals. Based on the building evidence, President Coolidge fired Daugherty in 1924. Lawsuits against Daugherty were filed, but he was never convicted.

The Ponzi Schemer

Charles Ponzi (1882–1949) was a crook in Italy, migrated to America as a crook, spent some time in a Canadian jail for fraud, and returned to the United States to promote his infamous scheme. A Ponzi scheme is a scam claiming big returns for investors, but paying off early investors from the cash of later investors. Because no real earnings exist, the scam must collapse sooner or later. Ponzi’s gimmick was international reply coupons, which could be exchanged for postage stamps to a foreign country. Ponzi discovered that the coupons had different prices in various countries, partly because of fluctuating currencies. Coupons purchased in bulk in one country could be sold in another at a profit. That was his story. He established a company in Boston in 1920 claiming to pay investors 50% interest in 45 days or 100% in 90 days. Ponzi paid his early investors the huge return and investors flocked to his door.

Unfortunately, the coupon scheme could not work on a large scale. There was no cash return. The post office gave out stamps, not money; Ponzi’s scheme required millions of coupons. Ponzi’s major problem was increasing attention. The Boston Post investigated, followed by the Boston District Attorney, the state Attorney General, U.S. District Attorney, and the state bank examiner. The District Attorney arrested Ponzi, who pled guilty to larceny and mail fraud.

Ponzi was a small-time crook and his scheme defrauded relatively few investors. However, Ponzi schemes occur regularly and can be sophisticated and long-lasting. The most successful was Bernard Madoff, defrauding investors of billions of dollars over decades, caught because of his own cash squeeze in the 2008 financial debacle.

Market Manipulation and the Market Crash

By the 1920s, Wall Street was the financial capital of the world and the NYSE the biggest securities market. The NYSE had 61% of all American securities transactions in 1929. It was established as a private club to promote the interests of its members, not the public. Among the NYSE members were floor traders (trading only for their own accounts) and stock specialists (making a market in specific stocks, but without any limits on how they could profit from the stock). Conspiracies with other members could lead to stock pools to manipulate stock prices, including long-standing techniques such as wash sales (selling among themselves to drive prices up or down), naked short selling (selling stocks they did not yet own), and bear raids to drive down prices to cover short positions. The insiders profited, outsiders took the losses.

Despite the manipulation, high commissions and other charges to outsiders, the stock market boomed, especially in the last half of the decade—fueled by speculation and margin trading (buying stocks mainly using high-cost credit called broker loans). Brokers profited both on commissions and interest. Margin buying magnified both capital gains and losses, increasing volatility. Even small price drops could trigger margin calls, requiring buyers to cover their losses with cash or the broker would sell the stock—making market declines worse. Because corporate financial information was considered private (the rationale being that disclosure could benefit competitors), corporations could manipulate, misrepresent and conceal relevant financial data. With virtually no standardization of accounting or financial disclosures, dividends were the primary investment focus.

Prior to federal securities laws and regulations, the corporate culture could be deceptive, with little concern for underlying risks. Insider trading was legal and regularly practiced. Investment bankers sold new securities at discount prices to “preferred list” customers before the stocks were available to the public. Stock pools, syndicates established both within and outside the stock exchanges, manipulated stock price—100 or more stocks were openly rigged. The Chase Bank chairman sold his own stock short during the 1929 crash, using money borrowed from the bank. The president of the NYSE would later be convicted of embezzlement. Various bank executives would be charged with income tax evasion.

A few safeguards existed, including some state regulations, legal reviews on new issues, and various stock exchange regulations. Voluntary audits were conducted by about 90% of NYSE firms, but the audit scope was determined by the corporations being audited. The prospectus issued by investment banks for new securities was typically no more than four pages and written by lawyers mainly to protect bankers from potential lawsuits. The Federal Trade Commission, Internal Revenue Service (IRS), and other federal regulatory agencies had additional requirements. Taken together, there appeared to be considerable regulation; however, few if any rules had real teeth—a recurring theme.

The crash happened in October 1929. The Dow Jones Industrial Average (Dow) peaked at 386 on September of 1929, up over 500% from its 1920 low. Stock prices at that level averaged a very high 30 times earnings (a price to earnings or PE ratio of 15 is about average). As the economy slipped into recession (industrial production peaked in June, 1929), stock prices started dropping.

By October 23, the Dow dropped to 306, down 20% from the September high, triggering margin calls. The next day, Thursday, October 24, became Black Thursday, with morning sell orders causing a panic. A consortium of banks under J.P. Morgan agreed to support the market and Richard Whitney, the NYSE vice president representing the consortium, bought thousands of shares of about 20 stocks. The panic stopped for the day. But the following Tuesday, Black Tuesday, was a disaster (and no bank consortium stepped in). The Dow dropped 13.5%, the worst day in Dow history until 1987. By mid-November, the Dow was down almost 50%. The Dow would keep plunging until mid-1932, dropping almost 90%.

Lessons to be Learned

The first 300 years of America was a series of experiments in commerce and establishing the right balance of government and institutions claiming to benefit constituents. Budding entrepreneurs proved to be good at evading debilitation rules. As regulations expanded (created primarily by democratic means), business people continued to exploit favorable rules and avoid or evade difficult ones. Corruption was matched by innovation. Progressive reformers introduced stricter regulations and the response was greater efforts to exploit loopholes and minimize the perceived damage. Whatever the institutional framework, incentives drove behavior. Fortunately, there are limits to corruption. Given democracy in action, property rights, and the rule of law, the long-term results were economic growth, the rise of the middle class, and, eventually, world economic dominance.