The Regulation of the Stock Exchange

BY CHARLES A. CONANT

SHALL American stock exchanges be put under government regulation and control ?

This is a question which began to be discussed after the panic of last autumn; and the discussion has been stimulated by several recent failures, in which the “ bucketing ” of orders and cool appropriation of customers’ securities seem to have been everyday occurrences. Financial disaster, as on previous similar occasions, has involved a train of losses, impoverishment, and suicides, for which the blame has been cast by many upon the organization of the stock exchange, and often upon the entire system of selling securities on margin and selling products for future delivery. And, as measures for issuing “ more money ” usually appear in Congress in times of stress, there has appeared the usual crop of measures for taxing or hampering transactions on the exchanges.

The question dealt with in this article is, how far government regulation of the exchanges is justifiable or practicable. It is not the purpose to set forth fully here the arguments in favor of organized markets like the stock and produce exchanges. This I have done in several other places.¹ Briefly stated, the stock and produce exchanges form a part of the mechanism of modern industry which is absolutely essential to its efficient operation. The purchase and sale of products for future delivery is a form of insurance against fluctuations, without which the miller or cotton manufacturer would be exposed to all the uncertainties of the market, and being unable to know in advance the cost of his raw material, would be obliged to protect himself by charging a wider margin of profit upon his finished goods.

The stock market represents the public register of values, where the owner of a share in a joint-stock enterprise can determine its value in the average opinion of all men interested in the same security. It affords a wide and convenient market, in which he may transform his security at need into cash at the price which is indicated by the public quotations. The existence of a stock market, where large amounts of securities are dealt in, is also a safeguard to the money market, by permitting securities to be sent abroad in many cases in lieu of gold. This is accomplished by a slight lowering of the price of securities, often without disturbance to the market for merchandise, which would otherwise have to bear the entire shock of changes in interest rates and the demand for money. Against such disturbing influences the stock market acts as a buffer, lessening the shock of movements which would otherwise seriously affect ordinary commercial operations.

The bare fact that the stock market exists is in itself prima facie evidence of its importance to the organization of modern finance. When it is considered that the total wealth of the United States, amounting to $107,000,000,000, is represented to the amount of nearly one-third, or $35,000,000,000, by negotiable securities, it indicates that these securities and the markets on which they are bought and sold have become a factor of first importance in economic life. It is not proposed here, therefore, to discuss at greater length the reason for being of organized markets. It is proposed rather to discuss the question whether the complete freedom which has prevailed heretofore in such markets in this country shall be subjected in the future to some degree of restriction or regulation.

Recent events have brought this problem home, — not merely to the general public who stand aloof from stock speculation or question its wisdom, but to the intelligent speculator and investor, who desire that their operations shall be conducted at least under the same rules of honesty and fair play which govern operations in other markets. The New York stock market, as well as similar markets throughout the country, has heretofore set a high standard of honor, which has justified its members in the boast that many millions of dollars of profits or losses were accepted daily by mere word of mouth. Several recent instances have shown, however, that even where such standards prevail, there are individual lapses which it has not been in the power of the brokers as a body, under their present rules of practice, to prevent.

Among the notable specific breaches of good faith of this kind have been the failures of two brokers who deliberately appropriated the securities of their customers, using them to obtain money to bolster up their own speculations. In one case, where securities were left with the broker simply for the purpose of transfer to a different owner, without being bought or sold under the broker’s direction, these securities were hypothecated for a loan by the broker, which he proceeded to employ for his own purposes. For all practical purposes, such a use of securities constitutes larceny. It is not surprising that the secretary of the New York Stock Exchange and individual brokers promptly proceeded to disavow a suggestion that such appropriation of customers’ securities was a common practice. The weakness of the situation lies in the fact that, even if such disavowals are true, there is no way of determining whether a crime of this sort is being committed until after the fact. The speculator and investor — even the investor in bonds, paying for them in full, who has no wish or intention to engage in marginal speculations — is at the mercy of the good faith of his broker, and that good faith depends upon the broker’s general reputation, and not upon any ascertained public facts, as in the case of bank reports and insurance examinations.

This larceny of securities is, of course, only one of many incidents which have drawn attention to the present legal status of the stock market. Among other points may be mentioned the absence of any law or well-established principle by which brokers are prohibited from being also speculators. The more conservative houses usually assure their clients that their articles of partnership agreement prohibit speculation; but here again the question depends upon the personal character of individuals, subject to no check except their general reputation. And where speculation does take place on the part of brokers, the temptation becomes strong, when money is suddenly needed to pay a loan which has been called to cover a loss, to borrow from the convenient reservoir of customers’ securities.

The day seems to have come for consideration of the question whether the present organization of the stock exchanges is such as to insure public confidence, fair play, and absolute security to honest clients, or whether some degree of intervention by the government to secure these results is required. Speculation is legitimate, and will go on increasing in volume with the growth in the wealth of the country and in the quantity of negotiable securities. To interfere with it without warrant is to tie a ball and chain to the limbs of national economic progress. But more and more, with the growing complication of the mechanism of finance, is growing up a sentiment for such supervision of this mechanism as shall insure its safe and honest working. From the smoke and dust of battle between vested interests seeking economic freedom, and the state seeking to protect the individual against errors of judgment and false statements, emerges the principle so well stated by the eminent capitalist, Thomas F. Ryan, in an article in the Independent, that “It is right that competition between men should be brought within constantly narrower and narrower rules of justice.”

Four points may be named in which improvement might be possible in the present organization of the exchanges: —

(1) Definite assurance of absolute honesty and solvency on the part of brokers.

(2) The enforcement of rules on the exchanges which will shut out securities having any taint of fraud.

(3) The exclusion from speculation of persons of small means, who are not qualified either by their resources or by their knowledge of the subject to take speculative risks.

(4) The checking of improper manipulation by matched orders and similar devices for misleading the public.

Probably the wisdom of nearly all of these prohibitions would be admitted in the abstract by the candid broker or speculator, with perhaps some trifling qualifications.

Absolute honesty and solvency on the part of brokers are requirements which no one can oppose. If there is division of opinion, it must be over the means of attaining this object. In this country, as has been stated, there is substantially no test and no safeguard, except the ability of the broker to buy his seat on the exchange, and his general reputation. That he shall have a good reputation is, to be sure, one of the requirements of the committee which passes upon the admission of members of the exchange. Persons guilty of fraudulent practices, financial blackmail, and grossly false representations, have been refused admission to the exchange, and when found guilty of such practices after admission, have been expelled and suspended. But these penalties usually come after the fact. Whether there should be some further tightening of the lines, some further elevation of the standard, is a question of degree, which is involved with some other questions affecting the capacity of the stock exchange to establish sound rules and impartially enforce them.

In Europe solvency is insured in many cases by the liability of the entire body of brokers for one another. This involves the weight of personal self-interest against the admission of any candidate who is not financially sound, or is of wobbly financial morality. In France, where there are only seventy official brokers, the entire body is bound by law to make good the obligations of individual members.

Absolute honesty on the part of members of American stock exchanges is of paramount importance to the public, because membership in an exchange is the one safeguard which the American investor has. It is easy to warn him against the alluring offers and showy offices of bucket-shop swindlers, by advising him to find out if the parties he deals with are members of a stock exchange. But if stock-exchange members themselves “ bucket ” their orders, then their clients are subject to the same risks as in dealing with bucket-shops. The broker has the same motive for wishing his clients ill luck, he takes the same risks with his own money, and he is under the same temptation to sequestrate his clients’ money. A system which permits this to be done, even sporadically, by men who have been given the official stamp of a stock-exchange committee, calls for amendment. There is no visible difference to the outsider between the responsible and honest broker, and the irresponsible and dishonest, if both can ply their trade without interference on the regular exchanges. Only the man familiar with the inner gossip of Wall Street will know whom to trust, and he will hesitate to back his opinion by positive advice to his friends.

Discrimination by the exchanges as to the character of the securities admitted to quotation involves many nice questions, but probably calls for a little more rigidity than has heretofore been exercised. It has long been the honorable practice of the exchange to exclude from its lists securities which were obviously fraudulent, or which were put afloat by people of little financial responsibility. It has been a subject of criticism, however, that some of the devious projects of high finance, when supported by stronger names and larger capital, have not always been scrutinized with the care which would indicate determination to protect the public against all forms of deception.

The problem of discriminating between securities is a difficult one, because all judgment is finite. What might appear to be a good security to-day may prove to be a very poor one in the evolution of events. The narrowing of the list of undesirable securities offered to the public can be secured only by requiring more complete information from corporations desiring their securities listed. Of course, no system or regulation would be justified which limited securities dealt in on the exchanges to those which were of a purely investment character. Speculation is the anticipation of the future. The far-sighted capitalist who presents an enterprise promising great benefits to the community, if successful, has the right to find a market for his securities among that portion of the public which is willing to take a certain risk for the sake of a large profit. If such securities were ex cluded entirely from the regular stock exchange, they would be dealt in under fewer restrictions and fewer pledges of honest dealing on the curb, or elsewhere outside of the exchanges. This is one of the difficulties which have been encountered in France, Germany, and England, in seeking to introduce greater conservatism into operations on the regular exchanges. The poorer types of securities, highly speculative or largely fraudulent, have found a market where not even the rules of honesty, fair play, and rigid fulfillment of contracts have prevailed, which prevail among brokers on the regular exchanges.

The one requirement which it is in the power of the regular exchanges to enforce upon new or speculative enterprises is reasonable publicity. That such enterprises have great future possibilities is no reason for concealing their balance-sheets. Enterprises which are so much in embryo that they should appeal only to rich men with money to lose have no place on the exchanges, even in the more speculative classes of securities. It is fair to say that they seldom find a place there, even under present practice. An enterprise which has assumed the stock-company form is offered to the public either because its promoters need capital for legitimate development, or because they desire to unload something of doubtful value on the public. Their willingness to tell the public the truth should be in some degree a gauge of this, and a stockexchange committee should have the moral courage and the discrimination to enforce such a test.

The restriction of speculation to those who are competent to carry it on is one of the most important objects to be sought, if any regulation is admitted, but is also one of the most difficult objects to attain. Under the recent modifications of the German Boerse law, only those of sufficient financial standing to justify their entering the speculative markets are allowed to do so. They are taken from the commercial register of business houses. This includes practically the whole mercantile class; but to engage in marginal speculation is prohibited to hand-workers and those conducting small shops, even where the latter are in the commercial register. It is doubtful if this frank distinction between classes would be admissible in this country; but other means may be found of reaching the object sought. It would certainly be proper to provide that a clerk occupying a fiduciary position should be allowed to buy and sell on margin only with the written consent of his employers, and that any broker disregarding this requirement should be liable to expulsion from the exchange.

The checking of undue manipulation is a highly desirable object, but is not perhaps so important as many persons imagine. Within certain limits, it might even be contended that manipulation is justifiable. If a financier or promoter has a new security which he believes represents high value, he does not like to sit with folded hands waiting for the public to discover its value. To a certain extent the measures which he may take to attract attention to the security are in the nature of advertising. Large selling orders, matched by large buying orders, at a graded scale of ascending prices, bring the stock to public attention and make it talked about. If this was the sole object of manipulation, and it was applied only to stocks whose real value needed only to be made known to attract purchasers, then even the rule of the stock exchange against matched orders would hardly need to be invoked for the protection of the public. But in fact, as every one knows, manipulation is often for the purpose of “ unloading ” securities of doubtful value and permitting the seller to pocket the proceeds of sales “ at the top,” and to buy back again at the price to which the stock descends after he has completed the process. Such manipulation is already contrary to the rules of the exchange, but is difficult to prove. The broker who has a selling order is not usually the same as the one who has a buying order, and only rigid inquiry by a stockexchange committee, where manipulation was apparent or suspected, would ascertain the facts. There is no doubt, however, that if the stock exchange should empower its committee to take strong action in a few such cases, and the committee should assert its powers, a moral sentiment would be exercised against manipulation, which would be almost as complete as the influence which now obliges a broker or a client to acknowledge and execute contracts over the telephone, even though they result in heavy losses.

All these evils are capable of some de gree of alleviation through the independ ent action of the stock exchanges themselves. If they do not take such action to a degree which meets the requirements of public opinion, the question will then arise whether and how far the government shall intervene. In all other countries where important exchanges exist, except in England, the government does intervene with a heavy hand. In France the regular brokers have almost the character of government officials acting as registers of transactions, rather than independent men of finance. In Germany an effort was made by the law of 1896 to stifle speculation almost entirely. This end was sought by prohibiting short sales; by requiring the registry of persons engaged in speculation, upon which it was expected that clerks, those with fiduciary relations, and persons of small means, would not dare appear; and by permitting those registered to escape liability for losses by pleading the privilege of the gambler. It is needless to say that these regulations imposed severe restrictions upon the German money market, had a share in crippling the Imperial Bank, and drove speculation into more hazardous channels. They have finally been materially modified by a law of April 9, 1908. It is one of the gravest dangers of seeking legislation on the subject that it will be unenlightened and will go to the injurious extremes of the German law.

If government regulation were to be established in the United States, it would be advisable that it should be under federal law rather than state law, in order not to handicap the operations of one exchange in competition with those of another. It might seem at first blush that no power lay in the federal government to interfere with operations conducted on a single exchange, within the limits of a state. A mighty weapon was forged, however, when it was desired to stamp out the circulation of the state banks during the Civil War. This was the weapon of discriminating taxation. If the federal government seriously desired to regulate operations on the stock exchanges, it would probably be compelled to find a way by imposing a merely nominal tax on the transfer of those securities which conformed to certain requirements, and imposing a heavy tax upon those which failed to conform to these requirements. In this little kernel of regulation by taxation might be found perhaps the meat of complete federal control of corporations. Those which conformed to certain specified requirements in the publication of balance-sheets, the examination of their assets by federal officials, and the keeping of adequate reserves and depreciation accounts, might be subjected to only a nominal tax, while those which failed to comply with such requirements would find the transfer of securities to the public handicapped by heavy charges.

The broker as well as the securities he dealt in could be reached directly by the power of taxation. A heavy license could be exacted from those brokers who reserved the privilege of speculating on their own account, while taking orders from others, while a much lighter fee could be collected from those who acknowledged the propriety of separating the two functions of broker and speculator by limiting themselves to taking outside orders, or refusing outside orders that they might speculate. The broker, in accepting money from clients under the usual implications of honesty and solvency, would be very properly a subject of official regulation, because he occupies toward his client a similar fiduciary relation to that of the banker. Foreign banking corporations are forbidden to accept deposits in New York; but brokers, foreign or domestic, may accept them without limit, with no other responsibility to their clients than the bankruptcy courts or the suicide’s pistol.

In order to ascertain whether the law taxing certain securities was being rigidly complied with, the power could be exercised, which has been often asserted before, of rigid inspection of the books of brokers. Such inspection would reveal whether the broker was conforming to the requirements that he should not hypothecate or appropriate the securities of customers, that he should not indulge in speculation on his own account with customers’ money, and that he should keep adequate margins against his risks. Under cover of the power of federal taxation, there is apparently no limit to the degree of supervision which could be exercised. Most of the securities dealt in are those which are subjects of interstate commerce, and which represent industries themselves engaged in interstate commerce; but it would not be necessary to invoke “the commerce clause” of the constitution to find ample authority for government intervention for the regulation of the stock market. In transactions in wheat or cotton futures, government intervention would be less necessary in some respects, but might be availed of to insure honesty in the execution of contracts, the maintenance of adequate margins, and the exclusion from trading of those not qualified by resources or character to engage in it.

The requirement that brokers shall exact larger margins on speculative accounts is a safeguard which has been suggested by Professor Henry C. Emery and others, and would fall well within the scope of legislation. The broker is in a sense a trustee for his clients in the same manner as a bank for its depositors. He has no more right than the bank, in lending on securities, to lend more than the securities are worth, or so large a proportion of their worth that shrinkage may involve losses on some accounts which would have to be borne, in case of failure, by other accounts. In so far, therefore, as the broker is a trustee for the money of others, he might justly be required to enforce upon his clients the same rule which is enforced against him at the bank, — that there shall be a margin of twenty-five per cent between the present value of the securities deposited and the amount loaned upon them.

That some steps towards the regulation of the exchanges by the government will be undertaken in the future is to be expected, unless the brokers themselves show their willingness and their capacity to protect the public as well as could be done by drastic government regulation. Such control from within is practically exercised on the London Stock Exchange, where complaints are rare of undue manipulation, and where the irresponsible small speculator seldom finds a welcome. The organization of the London Exchange, by requiring only fortnightly settlements for cash, instead of daily settlements, imposes more discrimination upon the broker for his own protection. He cannot afford to take an order from a person who is irresponsible, which may show a heavy loss before the rule of the fortnightly settlement justifies him in calling for cash. If every brokerage office in New York was governed by a similar principle, — if no account should be accepted except from a person of known responsibility and adequate financial resources, — then the suicides of small customers, the defalcations of bank clerks, and the ruin of farmers and shopkeepers far removed from New York would be reduced to a minimum.

If the brokers, therefore, wish to avoid regulation by the state, it lies with them to reform their organization from within. The banks could aid greatly in the work if they would coöperate in limiting speculative loans. There is hardly a greater menace to the security of the New York money market than the vaunted fact that it is the only strictly “ call money market ” in the world. No bank paying deposits on demand has a right to invest nearly its entire assets in loans on securities representing fixed capital. The individual institution may protect itself by the drastic sacrifice of securities when it needs cash, but it does so only at the expense of its clients and with a disturbance to the money market and the market for securities which is abnormal and excessive. The Monetary Commission recently appointed by Congress will not fulfill its whole duty unless it considers the relation of the money market to the great mass of unliquid assets which is piled up by trust companies and state banks upon reserves containing practically no gold, and often consisting of bank notes, representing only a form of credit instead of a means of payment.

The problem of the regulation of the exchanges is a difficult one, and there is danger that if its solution is sought by law, the law-makers will take the bit in their teeth and go too far. Just this was done with the proposals submitted by the German Commission, which became the basis of the drastic legislation of 1896. If the financial interests of New York desire to present the magnificent spectacle to the public and to the world, therefore, of adopting by their own voluntary act such a system for the sound regulation of stock exchange operations as has been extended by the Clearing House committee to bank operations, then they may escape the intervention of law to control the free play of those principles of economics which lie at the basis of the wealth and prosperity of the country. The action taken by the governors of the New York Stock Exchange in some recent cases indicates that they are waking, in some degree, to this responsibility.