Tag Archives: securities exchange act of 1934

How Ferdinand Pecora Helped Destroy Our Markets

As astounding as it is that anyone would accede to statutes criminalizing the raising of crops on one’s own land for personal consumption or invoking mythical creatures to justify the destruction of the free market, the brazen ease with which Leviathan’s handmaidens seduced the American people to acquiesce in such degradations is even more astonishing.

But apparently, second-hand exposure to phony spectacle can work wonders in making people feel better about government control of their markets or other interventions in the natural order. And so to promote public acceptance of the subversive Exchange Act and fulfill the progressive goal of destroying private control of the New York Stock Exchange, Ferdinand Pecora entered the U.S. political stage.

Pecora, a Sicilian-born, New York lawyer, began his professional career as a Wall Street clerk. After completing law school, he worked as a competition suppressor for big Wall Street firms (that is, a local prosecutor of smaller “bucket shop” operations) and gained national fame in 1933 as fourth and final counsel to the U.S. Senate’s Committee on Banking and Currency for its investigation of stock exchange practices.

The Senate retained Pecora initially to write a report of the evidence, so called, that three prior inquisitors had gathered in hearings begun in April 1932, during the final months of the Hoover administration. But Pecora persuaded committee chairman Duncan U. Fletcher that the record was incomplete and additional hearings were necessary. Pecora proved so captivating as impresario and leading actor in the ensuing charade that newspapers adopted “Pecora Investigation” as shorthand notation for the entire affair.

Recall that in Hill v. Wallace, 259 U.S. 44 (1922), the Supreme Court gave Congress a formula for promulgating exchange regulations immune to constitutional challenge. The court prescribed in pertinent part that Congress conduct public hearings to elicit evidence in support of its usurpations.

The court presumably intended that Congress hold the show trial before executing the prisoner. But Congress had no time for such formalities. Leaders in all three branches of government, in both major parties – progressives all – had decided to scrap laissez faire in favor of the fascist or corporatist arrangement of economic relations. The Roosevelt administration preferred to act while its electoral mandate was fresh. And so, while a purported investigation of exchange practices played out on the public stage under Pecora’s direction, New Deal lawyers James Landis, Benjamin Cohen, and Thomas Corcoran wrote the Exchange Act backstage.

Pecora excelled at fallacious argumentation. His style of witness interrogation would be familiar to modern-day fans of Jon Lovitz skits on Saturday Night Live. Assuming a dramatic, accusatory tone, Pecora would ask ridiculous questions having obvious answers in the vein of “So, Mr. Jones, is it fair to say that when people trade on the New York Stock Exchange, they seek to profit from these activities?”

When Mr. Jones would affirm innocently the obvious, a cigar-chomping Pecora would respond in the manner of a homicide detective who had just tricked his suspect into making a confession. “Aha! You admit, then, that people trade on the exchange to make money!”

Pecora conducted hearings not as an impartial inquiry but to adduce “facts” in support of the legislation that Landis, Cohen, and Corcoran were drafting behind the scenes. No matter what witnesses said – no matter how contrary was their testimony to the need for or wisdom of the Exchange Act – Pecora spun their answers into confirmation of the righteousness of the progressive cause.

[To see an example of such deceitful conduct, read Pecora’s questioning of NYSE President Richard Whitney and the accompanying analysis, beginning at page 30 of Stock Exchange Practices, the Report of the Committee on Banking and Currency Pursuant to S.Res. 84 (72d Congress) and S.Res. 56 and S.Res. 97 (73d Congress) (the “Pecora Report“) [PDF, 43 MB]. Nothing in Whitney’s answers affirmed the points that Pecora sought to make. Yet Pecora declared victory nonetheless.]

Fortunately for progressives, many Americans were no longer inclined to suffer the terrible burdens of independence.

As the Pecora show enjoyed its run in Senate chambers amid rave reviews in establishment papers, the United States suffered under a widespread depression, the third since the turn of the century. The Federal Reserve System, federal income tax, and federal deposit insurance were as yet new creatures. A credit-fueled boom in stock markets cracked up in September 1929, leaving at least twenty-eight exchanges to compete for a trickle of the pre-crash volume of order flow.

Further, an influx of enterprising Irish, Italian, and Jewish immigrants in the nineteenth and early twentieth centuries had yielded many successful merchant and trading operations, as well as banking businesses to support them. They resented limits on their opportunities borne of ethnic or religious bigotry. With immigrant populations now large enough to act as powerful political blocs, some of these institutions developed the capacity to use government power to overcome their market frustrations and chose to do so, quaint notions of freedom of association be damned.

Investment and commercial banks, particularly those headed by recent European immigrants or associated with Rockefeller interests, chafed under the domination of the New York Stock Exchange and Federal Reserve Bank of New York by their arch-rival, the waspy Morgan firm.

Under these conditions, the Pecora investigation played well to the public, no matter how farcical it was. People throughout the country followed news accounts of the hearings closely. As such no one seemed to notice, much less complain, that the Exchange Act became law two days before Pecora even concluded his scandal mongering.

Aside from the factors frustrating the public at large, the New York Stock Exchange’s natural monopoly on securities trading galled progressives. Their irritation with the exchange’s freedom dated to the late nineteenth century.

Monopolies that derive their competitive advantages from network effects – such as the New York exchange prior to the Exchange Act or Microsoft in the 1990s – have little use for politicians. Unlike the state, they enjoy voluntary patronage and refute the statist argument that economic goods such as security and communications cannot be trusted to market forces.

Not surprisingly, statists loathe natural monopolies and seek inevitably to destroy them and to erect state-dependent oligopolies (or “cartels”) in their stead.

The hearings fueled jealousy and hatred of wealthy “banksters,” as Pecora called them, but revealed nothing about the commercial interests pushing for regulation. Masterfully, the demagogic Pecora left Americans both thirsty for revenge and ignorant of the Exchange Act’s dangers. He set the stage for power lust and ethnic rivalry to join forces in replacing the free market with a government-imposed cartel.

Suggestions that markets were lawless dens of iniquity in the 1920s and early 1930s were false. Governments already regulated stock markets. All states had “blue sky” laws and agencies for their enforcement. What progressives sought was not the regulation of markets, but their nationalization.

Acting as fascist revolutionaries out to destroy centuries-old traditions of economic freedom and rule of law, Pecora and his co-conspirators gave Congress the institutional, political, and constitutional cover it required in order to effect the nationalization of our markets under the Exchange Act – the true purpose of the act all along.

Pecora admitted in his 1939 memoir that the New York Stock Exchange had been a battlefield for the progressive agenda – the “real center of warfare” – and confessed to the dirty, underhanded tactics he and his cohorts had employed to destroy the exchange as a private institution.

“When open mass resistance fails,” Pecora crowed, “there is still the opportunity for traps, stratagems, intrigues, undermining – all the resources of guerilla warfare.”

TabbForum published a version of this essay today, with only modest differences in content and formatting, under the heading The Nationalization of Our Markets: Welcome to the Pecora Theater(free registration required). I am grateful to Marc Beauchamp, Les Kovach, and Robert Zorn for their helpful suggestions concerning this essay.

The Exchange Act rests on a false premise

The U.S. Congress contrived a fraudulent device in order to usurp the rights of the people to conduct their own affairs in the trading of securities. The U.S. Supreme Court abetted this unlawful act and served as accessory, both before and after the fact. Through their wrongdoing, these supposed public servants harmed our market relations and effectively destroyed the free enterprise system.

This device was a congressional declaration that what amounts to a supernatural being – a national public interest – affects securities transactions. The Supreme Court instructed Congress in the creation of this device and preordained its constitutionality so as to prevent the parties it injured from obtaining relief in courts of law. Through these coordinated steps the federal government seized total power and control over securities transactions, firms, and markets.

Congress premised the legal necessity and propriety of the Exchange Act on its assertion that “transactions in securities as commonly conducted upon securities exchanges and over-the-counter markets are affected with a national public interest” (original Exchange Act [PDF], Title 1, Sec. 2). It derived this language from the Supreme Court’s majority opinion in Board of Trade of City of Chicago v. Olsen, 262 U.S. 1 (1923).

Prior to Olsen, multiple congressional attempts to wrest control of exchange regulation from private exchange governors and the states failed to survive legal challenges on constitutional grounds. But then an activist Supreme Court, determined to break free of the chains of common law and logic and to engage instead in the making of social and economic policy, intervened.

In Hill v. Wallace, 259 U.S. 44 (1922), a case testing the constitutionality of the Future Trading Act of 1921, the court reluctantly overturned the act as a violation of Congress’s tax powers. But the court spelled out a procedure Congress could follow and a new theory it could use so that comparable, future acts would survive legal challenge.

Two weeks later, Congress followed the court’s guidance in Wallace. It made cosmetic modifications to the Future Trading Act and rebranded it as the Grain Futures Act. This nearly identical act would also find its way to the highest court, but this time the outcome would be different.

In Olsen, the Supreme Court for the first time upheld Congress’s taking of regulatory authority over exchanges and dealer markets from private parties and the states. The majority held in doing so that “The Chicago Board of Trade is engaged in a business affected by a public national interest, and subject to national regulation as such.”

This conjuring by the highest court of a “public national interest” was odd, even for a court bored with traditional jurisprudence. Even stranger was the court’s assertion that this anthropomorphic creature it dubbed a national interest affected the business of a local exchange. But for the court to subject the object of the creature’s actions to federal control was despotic.

The court’s imaginative rulings in Wallace and Olsen freed Congress to extend its sphere of control from a grain market in Chicago to all exchanges. Congress exercised its newfound freedoms with abandon in creating the Exchange Act.

By that act, the mythic, national public interest came to lurk behind every securities transaction in the United States, distorting markets and limiting innovation, raising prices and barriers to entry, and creating haves and have-nots, among other ill effects.

If we restate the Exchange Act’s premise in active voice for clarity – a national public interest affects transactions in securities as commonly conducted upon securities exchanges and over-the-counter markets – its absurdity becomes obvious. But as imagined by its storytellers, this “national public interest” creature thinks and acts autonomously, though millions of individuals with disparate interests comprise it. And a chosen few – chiefly lawmakers, judges, and bureaucrats who serve as a priesthood of sorts – know the creature’s will and do its bidding faithfully.

In reality, the set of factors that may affect or influence transactions in securities is numerous, ranging from fear to greed, from the size of a trading floor to the processing power of a matching engine, from Regulation ATS to Regulation T, from the rate of capital gains taxes to clearing fees to preferences for other goods. So large is this set that a complete enumeration of its members is impossible.

But the set includes only real factors of production, objectives, preferences, and constraints, whether owned or felt by actual individuals or firms, even if irrationally. And even though we cannot list all of its members, the set most definitely excludes Santa Claus, the Easter Bunny, and the national public interest totem, no matter how fervently the priesthood protests otherwise.

Seventy-six years after the Exchange Act’s passage, the Dodd-Frank Wall Street Reform and Consumer Protection Act [PDF] (“Dodd-Frank”) amended the Exchange Act’s original premise by striking the word “affected” and inserting “effected” in its place (Dodd-Frank, Title IX, Sec. 985(b)(1)). The words affected and effected are homophones but not synonyms – that is, they sound alike but have different meanings. By substituting one for the other, the government changed the Exchange Act’s legal premise.

To appreciate the significance of this change, observe that only twice in history has Congress amended Sec. 2 of the Exchange Act. The Securities Acts Amendments of 1975 [PDF] made the first such amendment, creating the national market system controversy that rages to this day. More than three decades later, on July 21, 2010, came the second, Dodd-Frank.

In a November 1975 speech [PDF] to the Joint Securities Conference in Boston, Commissioner Phillip A. Loomis, Jr., of the Securities and Exchange Commission (“SEC” or “Commission”) referred to Sec. 2 of the Exchange Act as “the traditional standard for Commission actions, the public interest and the protection of investors.”

Given the importance of Sec. 2 and the continuing controversy attending the first amendment to it in 1975, what are we to make of the deafening silence surrounding the second amendment under Dodd-Frank in 2010? The government ordered the substitution of effected for affected in the “Technical corrections to Federal securities laws” section of Dodd-Frank. The report of the conference committee that produced the final version of Dodd-Frank contains no discussion of the matter. Google appears to contain no index of legal analysis or newspaper coverage of this amendment. And in signing Dodd-Frank into law, President Barack Obama made no comment on the change.

If the Exchange Act’s original premise was merely absurd, the new premise was positively stupefying. Stated in active voice, Congress now demanded that we accept this proposition as justification for federal regulation of securities markets:

A national public interest effects transactions in securities as commonly conducted upon securities exchanges and over-the-counter markets.

Yes, the priesthood would now have us believe, the imaginary being national public interest actually trades. Its powers are not merely influential, inspirational, or motivational, but kinetic. Just as God parted the Red Sea, the national public interest matches buy and sell orders and pronounces them “Done!”

Let us set aside for now that in substituting “effected” for “affected,” Congress deviated from the exquisitely fallacious formula the Supreme Court devised in Wallace and then ratified in Olsen for testing the constitutionality of federal exchange regulation (see part 1 <LINK>). As I will describe in my next essay, even with a Supreme Court acting as nursemaid for its usurpations, Congress struggled to craft the original Exchange Act in a way that would survive court challenge.

What is inexcusable is that we allow this officious priesthood to utter such claptrap, that we listen to it and take it seriously, and then act as if the nonsense made sense.

A desire for profit may affect transactions in securities markets, and the New York Stock Exchange may effect transactions undertaken for such motive, but the national public interest neither affects nor effects anything: it doesn’t exist, except as a deceptive construct conjured by activist judges and then aped by legislators in defiance of common sense and law.

Responsible adults do not knowingly harbor or act on false premises; they reject them and correct their ways accordingly. They do not acquiesce in bad laws, but repeal them. Repeal of the Exchange Act is long overdue. The sooner we get after the business of doing so, the sooner our markets will heal and the benefits of vigorous competition under a system of free enterprise be restored.

TabbForum recently published a version of this essay in two parts, with only modest differences in content and formatting, under the headings “The Exchange Act Destroyed Our Markets, Part 1: A False Premise” and “The Exchange Act Destroyed Our Markets, Part 2: Justice Demands Repeal (free registration required).

Neglect of first principles leads to dysfunctional markets, and worse

Roscoe C. Filburn was a lawbreaker.

Roscoe Filburn

Ohio farmer Roscoe C. Filburn. Source: University of Louisville Louis D. Brandeis School of Law

His offense? He grew wheat on his own land, tended it by his own hand, and consumed it for his own satisfaction, rather than purchasing it from another, in violation of the Agricultural Adjustment Act of 1938 [PDF], as amended.

Before Filburn’s death in 1987, he would play a pivotal role in what may be the most important court case in U.S. history: Wickard v. Filburn, 317 U.S. 111 (1942).

As described by the Supreme Court in Wickard, “The general scheme of the Agricultural Adjustment Act of 1938 as related to wheat is to control the volume moving in interstate and foreign commerce in order to avoid surpluses and shortages and the consequent abnormally low or high wheat prices and obstructions to commerce.”

The court noted, but not ruefully, that since it had already sustained the federal power to regulate production of goods for commerce in United States v. Darby, 312 U.S. 100 (1941), the question before it in Wickard “would merit little consideration…except for the fact that this Act extends federal regulation to production not intended in any part for commerce, but wholly for consumption on the farm.” It pleased the court, in plain language, to have the opportunity to decide the question whether the federal government may regulate purely private activity under the Commerce Clause (U.S. Constitution, Article I, section 8, clause 3), even though the activity did not constitute commerce.

Life sometimes gives us elemental evidence that we have gone astray. Imagine it is our fervent desire to have that sublime experience of seeing the sun set into the ocean. Placing either our ardor or sense of convenience ahead of due regard for first principles – in which direction must we travel in order to attain our goal, and why? – we head for the nearest beach, which happens to sit at the western edge of the mighty Atlantic. Soon enough, the error borne of our impulsive conduct is manifest. Though the ensuing sunrise may diminish our frustration, it cannot erase our mistake. As cognitive dissonance works its magic, we may convince ourselves that we prefer sunrises to sunsets anyway. But our original desire remains unfulfilled nonetheless.

As Bastiat instructed us in The Law [PDF]:

It is not true that the mission of the law is to regulate our consciences, our ideas, our will, our education, our sentiments, our works, our exchanges, our gifts, our enjoyments. Its mission is to prevent the rights of one from interfering with those of another, in any one of these things.

When acts as natural as harvesting and consuming our own food on our own property are adjudged illegal under the supreme law of the land, as a society we stand guilty of malign neglect of the most basic principles for peaceful, harmonious, beneficial society. The discovery of such perversion of the law should alarm and mortify us, and we should resolve to retrace our steps to the source of our error at the earliest, so that we may correct our ways. To continue such neglect indefinitely works only to our detriment.

Whether our present mode of government is one of delegated or assumed powers – whether, in other words, we empowered the government or it usurped its powers – by virtue of Supreme Court interpretations of the Commerce Clause in Wickard and other cases we now have, for all practical purposes, a government of unlimited powers. Nothing could be more dangerous.

The government argued in Wickard that if Filburn needed more wheat than it had permitted him to grow on his own property, he should have purchased this wheat from another farmer. By not purchasing this wheat on the market, Filburn withheld his quantum of demand, thereby affecting the price of wheat and the government’s ability to control its price. Further, the additional quantum of supply that remained on the market as a result of Filburn’s insistence on growing his own wheat affected virtually everything else on the market. The additional wheat required storage and transportation, thereby congesting grain elevators and railroads. This congestion in turn affected the ability to store and transport other goods and accordingly, the prices of these other goods.

This official line of reasoning in Wickard constituted “a huge and dangerous leap of logic, in a world where all sorts of things have some effect on all sorts of other things,” wrote economist Thomas Sowell. “Since virtually everything affects virtually everything else, however remotely, ‘interstate commerce’ can justify virtually any expansion of government power, by this kind of sophistry.”

The U.S. government presumes to know what should be the prices of various commodities within specific frames of time, and the precise levels of supply and demand – and the intersections of same – that will produce these prices. It presumes to know substantially all of the factors that may influence these prices and all of those that these prices may in turn influence, and to what extent. It then proceeds to dictate, under penalty of “law,” the actions that putatively free individuals may, shall, or must take in order to produce these prices and to bring about the conditions precedent or subsequent that the government desires.

This government presumes to know, too, what should be the rate of interest at every point and for every conceivable type of liability in the term structure, and whether the prices of various widely-held assets, including dwellings and ownership interests in business enterprises, are too low or too high. It forces us to accept monopoly money of its creation under “legal tender” laws and then counterfeits that money to create “wealth effects” – greater levels of consumer spending borne of the perception, but not the reality, of greater wealth. And it presumes to speak for every person as to what is “fair” in business dealings with others, even if the parties should aver otherwise, to know when the rate or magnitude of change in prices of any good transits from “orderly” to disorderly, and to require licenses for the exercise of natural rights.

Has any god in any religion in the history of mankind ever flattered itself to hold such omniscience and omnipotence, or held private action and property in such contempt? Even the gods in the Epic of Gilgamesh [PDF] showed more respect for individual prerogative.

Is it any wonder, then, that we careen from crisis to crisis, each followed by political carnivals contrived to obscure the truth? That thereafter, in due and predictable course, our government buries us under new laws, regulations, rules, and bureaucracies that solve nothing, remove us even further from the essential truths and principles that formed the very basis of our society, and establish the predicates for the next, even worse crisis?

But none of these developments is worse than that now manifest in this latest crisis: the destruction of the principle of equality under the law. We have institutionalized the practice that great risks may be taken for private gain, with the profits to be enjoyed by the few, the losses to be borne by the many. And we have federal prosecutors admitting that size matters in ways none of us heretofore imagined: if one sits atop a bank of sufficient “systemic importance,” otherwise criminal acts that would land executives of smaller banks in the dock may be forgiven.

Meanwhile, we argue endlessly and stupidly about what are or should be private matters, while ignoring the root causes of problems and first principles that should guide all of our actions: What caused the “flash crash?” Should we ban “high-frequency trading?” Should we allow “locked markets?” Should we have a “consolidated audit trail?” Should we force the swaps market to adopt a central-clearing model? Should we fall off the “fiscal cliff?” Should we have a “national market system?” Should banks engage in “proprietary trading?”

These debates evade or ignore how we arrived at this moment wherein private institutions are deemed too big to fail; of executives considered too important to prosecute; of revolving doors and regulatory capture; of massive, long-running frauds undetected by the very people who are supposed to prevent and detect them; and, worst of all, of the willingness of sentient adults alive today to incur trillions of dollars of debt they will never repay and that will someday fall on the shoulders of children not yet born, to parents who have yet to meet.

We arrived at this moment of dysfunctional markets and destructive law not by accident, or all of a sudden, but deliberately, in step-by-step fashion according to a clear design, over many decades. At every step along the way, our antagonists did of calculated necessity what we have for too long failed to do: they argued from first principles. They argued fallaciously, but too few of us rose up to object to their absurd contentions. And so they predicated their laws, their hearings, their legal briefs and rulings on axiomatic arguments of Fairness, and Equity, and National Public Interest, and Delegated Powers, and Economic Efficiency, and so on, ad nauseum. And when the federal legislators got it wrong, such as when they first attempted to regulate commodity exchanges, federal judges at the highest level stepped forward with relish and drew them maps for future legislation that would survive legal challenge from those their laws oppressed. But I will save Hill v. Wallace, 259 U.S. 44 (1922) for discussion at a later date.

Financial and monetary laws and regulations are the cornerstone of the whole wretched mess – they always have been. Were it not for such laws, particularly laws concerning the redemption of war bonds that I will explicate in a later essay, we would never have abandoned the first United States of America – that union established under the Articles of Confederation – for the second, established under the Constitution. As a people we have achieved great things despite, not because of, these laws. But we have diddled too long. We have neglected the machinery of healthy society for too long. We have exhausted ourselves in trivial debates, while eschewing the ones that matter.

If we are to have a good, peaceful, sustainable society – that is, a society that respects natural, individual rights to life, liberty, and property – then sooner or later, we must revert to first principles. We must take a break from ceaseless, mind-numbing, policy debates and hold philosophy debates in their stead. We must realize that the right question is not should we audit trading algorithms? – whoever we are – but whose business is it to decide, and why? Do we really want to have a society that rewards failure and excuses criminal conduct? Should malum prohibitum trump malum in se as the organizing principle for our laws? Did we really mean to have a society that made it illegal for Roscoe Wilburn to grow and use his own wheat as he saw fit?

In a sense, we must now go back and have the debates that the great mass of us skipped and still ignore. We could start any number of places, and in due course we will cover the true causes of Shays’s Rebellion, Alexander Hamilton’s perfidy, several of the Supreme Court’s follies in service of unlimited federal powers under the Commerce Clause, and the madness of Dodd-Frank [PDF]. But there is no better place to start than with the imposition of the Securities Exchange Act of 1934 [PDF], as amended (the “Exchange Act”). In this legislation and the rules and regulations promulgated thereafter, we have the template for creation of the modern, bureaucratic state under which we now live – the phony “hearings” destined for a pre-ordained outcome, the political puppet show, and the use of false premises to justify anti-competitive laws, all of which solve nothing but make matters worse.

Writing in the California Law Review less than six months after the Exchange Act’s passage, Columbia law professor John Hanna said approvingly, “The venerable and once esteemed policy of laissez faire has received many assaults in all countries since the War, but scarcely ever has it sustained more comprehensive and conclusive repudiation than by the security legislation of the present Administration.”

Indeed. So let us end our neglect of first principles, starting – in my case – with a discussion of the false premise on which the Exchange Act rests, the subject of my next essay.

TabbForum published this essay earlier today, with modest differences in editing and formatting, under the heading “The Root of Dysfunctional Markets, and Worse” (free registration required). This version contains different hyperlinks to source material.