The opinion of the court was delivered by: MEDINA
TOPICAL ARRANGEMENT OF OPINION
The Offense as Charged in the Complaint.
Certain Alleged Unifying Elements
The Applicable Law Relative to Conspiracy.
The Investment Banking Business.
I. Prior to the First World War.
II. Between World War I and the Securities Act of 1933.
III. Further Developments 1933-1949.
IV. How the Investment Banker Functions.
The Seventeen Defendant Investment Banking Firms.
11. The First Boston Corporation
12. Dillon Read & Co. Inc.
14. Harriman Ripley & Co., Incorporated.
15. Stone & Webster Securities Corporation.
16. Harris Hall & Company (Incorporated).
17. Union Securities Corporation
I. Did the Seventeen Defendant Investment Banking Firms Use the Syndicate System as a Conspiratorial Device in Connection with Any Integrated Over-all Combination?
II. Alternate Claims Belatedly Attempted to Be Asserted against the Investment Banking Industry as a Whole.
A. The Rule of Reason. B. The Securities Act of 1933, the Securities
Exchange Act of 1934, and the Amendments Thereto; the Rules, Interpretations and Releases of the SEC Thereunder; and the Organization and Functioning of the NASD.
C. The Opinion of the SEC in the Public Service
Some Interim Observations.
Did the Seventeen Defendant Investment Banking Firms Combine for the Purpose of Dominating and Controlling and Did They in Fact Dominate and Control the Financial Affairs of Issuers by Directorships and Solicitation of Proxies?
The Evidence Generally Applicable to Directorships Discloses No Conspiratorial Pattern but Rather the Contrary.
Addinsell and Phillips Petroleum.
Directorship Evidence against Goldman Sachs, Lehman Brothers, Kuhn Loeb, Dillon Read and Blyth.
Cleveland Cliffs Iron Co.
Beneficial Industrial Loan.
Commercial Investment Trust.
Some Further Interim Observations.
The 'Triple Concept'. Semantics. 'Historical Position'. Chicago Union Station. The Alleged 'Practice' of 'Traditional Banker' and 'Successorships'.
The 'Master Mind'. The Telephone Business. Consumers Power. The Alleged 'Caretaker' Situations. Dayton Power & Light. Atlantic Coast Line, Toledo & Ohio Central, Chicago &
Western Indiana, Nypano (New York, Pennsylvania & Ohio) and Dominion of Canada.
The Otto H. Kahn 'Show Window'. Bulgaria. Commonwealth of Australia. Armstrong Cork. Bethlehem Steel. R. H. Macy & Co. Crucible Steel. General Cable.
3. Smith Barney (Edward B. Smith & Co.).
What Is Now Taking Shape Is Not a Static 'Mosaic' of
Conspiracy but a Constantly Changing Panorama of Competition Among the Seventeen Defendant Firms.
Wilson & Co. Rochester Gas & Electric. A. E. Staley Manufacturing Co. Aluminum Koppers, Jones & Laughlin, Lone Star Gas, Gulf
Southern Pacific. Standard Oil of New Jersey.
Crown Zellerbach. Giannini Interests. The So-Called 'Treaties' Between Lehman Brothers and
National Dairy Products. Butler Bros., Associated Gas & Electric, Indianapolis
Power & Light and Tidewater Associated Oil.
Indianapolis Power & Light.
Pennsylvania Power & Light.
Province of Cordoba, Androscoggin Electric Corp., and
Scovill Manufacturing Co., Scripps, Porto Rican American
Tobacco Co., Argentine Government, American Radiator and Grand Trunk Western.
United Drug. Shell Union Oil.
Pacific Gas & Electric. Competition for Leadership 1934-1936. The Alleged Overly-Large Syndicate Formed By Blyth in
Connection with the $ 80,000,000 Issue of March 27, 1945.
The Sale in 1945 of 700,000 Shares of Common Stock of
Pacific Gas & Electric Held by North American.
15, 16 and 17. Stone & Webster, Harris Hall and Union Securities.
Alleged Conspiratorial Opposition of the Seventeen Defendant Banking Firms to 'Shopping Around,' and to the Campaign for Compulsory Public Sealed Bidding; and the Alleged Adoption of Devices to Sabotage SEC Rule U-50 and Compulsory Public Sealed Bidding in General.
General Views on Competitive Bidding and the Advantages to Issuers Arising Out of Continuing Banker Relationships.
The Eaton -- Young -- Halsey Stuart Campaign.
Responses to Requests from SEC to Express Views Relative to Proposed Rule U-20 and Further Amendments to Rule U-12F-2.
Alleged Overly-Large Syndicates and Other 'Devices' to Sabotage Public Sealed Bidding.
The 'Insurance Agreement,' Alleged to Have Been Made on December 5, 1941, and 'Approved' on May 5, 1942.
Administrative Features and Statistics of the Trial
Summary, Rulings on Motions and Dismissal.
Summary Description of Statistical Compilations, Tables and Charts.
This is a civil action in equity to restrain the continuance of certain alleged violations of Sections 1 and 2 of the Sherman Act, Act of Congress of July 2, 1890, c. 647, 26 Stat. 209, 15 U.S.C. §§ 1, 2, 4. It is charged that defendants entered into a combination, conspiracy and agreement to restrain and monopolize the securities business of the United States and that such business was thereby unreasonably restrained and in part monopolized.
The "securities business" which is the subject of these charges is defined in the complaint in terms that are uncertain and in part contradictory. In the clarifying process of pretrial hearings and trial, however, counsel for plaintiff receded in part from the allegations of the complaint. As finally re-defined, plaintiff's position is that the "security issues" to which the charges of the complaint should be understood to relate are intended to include new issues, and secondary offerings registered with the Securities and Exchange Commission under the Securities Act of 1933, 15 U.S.C. § 77a et seq., of securities of domestic and foreign business corporations and foreign governmental units and foreign municipalities, offered to or placed with investors in the United States, but to exclude domestic railroad equipment trust certificates, all notes and serial notes representing term loans by commercial banks, all general and revenue obligations of domestic governmental units and domestic municipalities, and all unregistered secondary offerings of any securities.
The combination, conspiracy and agreement to restrain and to monopolize and the actual restraint effected thereby are claimed to have embraced every method and type of transaction by which issues of the above-defined securities have been transferred from the issuers (or from sellers of blocks of such securities in registered secondary offerings) to the hands of investors, whether underwritten by investment bankers or non-underwritten, whether privately placed or publicly offered to existing security-holders or the general public, and whether in negotiated transactions or at public sealed bidding, with the exception, however, of direct offerings by issuers to their security-holders in which investment bankers are not employed as agents or underwriters. The part of the securities business which is charged to have been monopolized by the defendants in the course of and through the operation of the conspiracy is claimed to have consisted of all new issues of the above-defined securities, and all registered secondary offerings thereof, which have been underwritten by investment bankers in negotiated transactions and publicly offered to existing securityholders or to the general public.
The Offense as Charged in the Complaint
The complaint charges an integrated, over-all conspiracy and combination formed "in or about 1915" and in continuous operation thereafter, by which the defendants as a group "developed a system" to eliminate competition and monopolize "the cream of the business" of investment banking. The prolixity of the complaint and its various involutions are such that it will be convenient to summarize and paraphrase its contents, as was done in the trial brief submitted at the opening of the trial by counsel for the government. The mortar to cement together the various parts of this extraordinary document is provided by a series of definitions, many of which bear little resemblance to the meaning of the various words or phrases used in the business.
The central theme is what has been referred to throughout the case as "the triple concept" of "traditional banker," "historical position" and "reciprocity." To quote from the brief above referred to:
"Under the traditional banker concept that banker who first manages an underwriting for a particular issuer is deemed entitled to manage in the future all additional security issues offered by such issuer. * * * Under the concept of historical position once a banker participates as a member of a buying group in the purchase of the securities of a particular issuer, such banker is deemed entitled to participate on substantially the same terms as a member of the buying group in all future issues offered by such issuer. Under the concept of reciprocity the defendant banking firms recognize a mutual obligation to exchange participations with one another in the buying groups which they respectively manage."
In this connection the complaint specifically charges that:
"Each defendant banking firm keeps a reciprocity record to show the business it has given to each of the other defendant banking firms and the business it has received from each of such firms."
"Over a period of time, the amount of gross spreads which one of such firms enables another to earn by selecting it for participation in buying groups is substantially equivalent (with due allowance for differentials in prestige and underwriting strength) to the amount of gross spreads it has earned in the same period of time as a participant in buying groups formed and managed by such other firm."
As it is evident that no such parcelling out of the investment banking business could function so long as the management of issuers was free to choose and deal with any investment banking house it wished, there is alleged in the complaint as one of the terms agreed upon by the defendants, and as part of the conspiracy and combination, that there should be a species of control over issuers so as to "preserve and enhance their control over the business of merchandising securities:"
"(1) by securing control over the financial and business affairs of issuers, by giving free financial advice to issuers, by infiltrating the boards of directors of issuers, by selecting officers of issuers who were friendly to them, by utilizing their influence with commercial banks with whom issuers do business."
One of the terms of the agreement said to have been made by the members of the combination and conspiracy is that when a "representative" of one of the 17 defendant banking houses becomes a director of an issuer, this is understood by all the rest to be the equivalent of "raising a red flag," and thus warning the others to keep off.
As a measure of combined control over issuers and the several hundred other investment banking houses against whom the conspiracy was to operate, it is charged in the complaint that in 1915 "the modern syndicate method of distributing securities was invented by defendant banking firms and their predecessors," and that defendants agreed that with certain modifications this method should be utilized by defendants to stabilize the business "by fixing and controlling the prices, terms, and conditions of purchase, sale and resale of securities." This "device" is said to be manipulated by defendants in various ways, all as part of the general plan or scheme. For example, it is alleged that defendants as managers of such syndicates not only further the ends of the combination or conspiracy by dealings among themselves, but that they sometimes exclude other firms from participations or selling group positions, and sometimes include such firms "which might otherwise attempt to compete with defendant banking firms;" and that by means of this "device" defendants "agree among themselves upon a uniform, non-competitive price" which, having thus been "fixed" by them, is foisted upon issuers, by what can only euphemistically be called "negotiation," in view of the domination and control exercised or attempted to be exercised over the issuers by defendants. It is worthy of note that the allegations with reference to the syndicate system and its so-called price-fixing features are made solely in reference to the charge of the integrated, over-all combination and conspiracy.
Certain statutory and regulatory provisions of great significance, which became effective in 1934, 1941 and 1944 are reflected in other phases of the combination and conspiracy as charged.
In 1933 the Congress passed the Glass-Steagall Act,
pursuant to the terms of which commercial banks and their security affiliates were required to go out of the investment banking business, if the banks desired to continue taking deposits and performing their other banking functions. The deadline was June 16, 1934. The affiliates were accordingly dissolved; and such banking houses as had bond departments or otherwise engaged directly in the investment banking business, with very few exceptions, elected to continue their banking functions and restricted their operations in the field of securities to governmental and other issues specifically exempted from the operation of the new law. Thousands of employees of these institutions were forced to make new connections, and many joined the staffs of some of the 17 defendant investment banking houses.
It is the theory of the complaint that the pre-existing and flourishing combination and conspiracy met this situation by a further agreement among the conspirators to the effect that certain of the defendant firms should succeed to or "inherit" the conspiratorial "rights" theretofore parcelled out to the commercial banks and their affiliates by the operation of "the triple concept" above described, and that the combination or conspiracy should accordingly, and it is alleged did, continue to operate as before. This is the predecessor-successor phase of the case in a nutshell.The complaint originally read as though certain firms became and were the real successors of others in a legal sense whereas what was intended to be pleaded, as disclosed by an amendment of the complaint made in the course of pre-trial conferences, is that the "successors" were such only in the sense that the alleged conspirators so agreed as part of the operation of their integrated, overall combination and conspiracy.
In 1941 the Securities and Exchange Commission promulgated a rule requiring securities of companies, affected by the provisions of the Public Utility Holding Company Act of 1935, 15 U.S.C.A. § 79, et seq., to be sold by compulsory public sealed bidding, and similar action, relative to debt securities of railroads, was adopted by the Interstate Commerce Commission in 1944. In this connection and in very comprehensive terms the complaint charges that these 17 defendants as part of the same integrated, over-all combination and conspiracy agreed to discredit the use of competitive bidding, private placements and agency sales as methods of disposing of security issues. The competitive bidding phase of the charge is divided roughly into three parts: (1) Opposition to campaigns which resulted in the adoption of the rules above referred to.(2) Refusal to submit sealed competitive bids and the adoption of a great variety of "devices" for the purpose of sabotaging the new rules and hence defeating the purposes of the two governmental agencies which had made public sealed bidding compulsory with respect to a not inconsiderable area of security issues. Such "devices" were alleged to have included: the organization of overly-large syndicates, the grant of participations equal to those of the manager, the reduction of management fees and the merger of accounts. (3) After certain insurance companies had bid in a large issue of securities of the American Telephone & Telegraph Company in the fall of 1941, it is charged that a certain agreement was made on December 5, 1941 and "approved" on May 5, 1942, by virtue of which the insurance companies were to be eliminated as direct bidders for security issues.
According to the complaint the means adopted by the conspirators to accomplish their ends were many and various. They seem to include, under the heading of "customs and practices," said to have been agreed upon to effectuate the design of the conspirators, many of the alleged abuses which over the years have been charged against investment banking houses in general, but which have not as yet been affected by specific legislation.
This in brief is the framework and the essence of the charge against these 17 defendant investment banking firms.Much of the detail is omitted for the moment in the interest of clarity. Many of the charges against defendants were from time to time abandoned and removed from the case and no further reference will be made to them.
Thus "the substantial terms" of the "continuing agreement and concert of action" originally alleged against the group of 17 in paragraph 44 of the complaint included: (1) an agreement to cement their relationships with issuers by securing clearances from such issuers before making their investment banking facilities available to competing business enterprises and by refusing to act as advisers or underwriters for small business concerns; (2) an agreement to utilize their domination and control to encourage and promote consolidations, mergers, expansions, refinancings and debt refundings to increase their investment banking business; and (3) an agreement to concentrate the business of purchasing and distributing security issues in a single market. These were all withdrawn by counsel for the government.
The following "customs and practices," alleged in paragraph 45 to have been "formulated and adopted" by agreement of the group of 17 were originally included but later dropped: (1) the formation of "standby accounts" for all security issues of a particular issuer to prevent the assembling of competing groups and thus discourage issuers from disposing of issues at competitive bidding; (2) in the event of insolvency or reorganization of issuers with whom a "traditional banker" relationship existed with a member of the group, to cause a partner, officer or other nominee to be appointed to influence protective committees for the benefit of such "traditional bankers"; and (3) subsequent to the divorcements required by the Investment Companies Act of 1940, 15 U.S.C.A. § 80a-1 et seq., continuing to influence managing investment companies or trusts in which capital had been "strategically invested" so that voting powers would be exercised "in the interests of defendant banking firms."
Such other issues as were removed from the case by consent need not be specified, except as they may be hereinafter referred to.
The complaint bears every evidence of careful and prolonged preparation, its articulation is close and compact, every word is carefully chosen and fitted exactly in its proper place. Thus it is the 17 defendant banking houses, arrayed against the balance of the investment banking industry, and alleged to be acting in combination to monopolize "the cream of the business," and divide it up among themselves, by excluding those investment banking houses which are not part of the conspiracy. If the charge is true the restraints are ingeniously devised to create a controlled rather than a free market at every level. The operation of "the triple concept" prevents competition as between defendants themselves; the domination and control over issuers and the "fixing" of the price to be paid issuers for their security issues deprives issuers of a free market in which to raise the money they need; non-defendant firms are deprived of an opportunity to compete for the business; the trading operations of dealers and brokers are restricted during the period of the continuance of syndicates formed for the distribution of new security issues; and investors are deprived of an opportunity to purchase securities in a free market.
And all this is said to have gone on for almost forty years, in the midst of a plethora of congressional investigations, through two wars of great magnitude, and under the very noses of the Securities and Exchange Commission and the Interstate Commerce Commission, without leaving any direct documentary or testimonial proof of the formation or continuance of the combination and conspiracy. The government case depends entirely upon circumstantial evidence.
Certain Alleged Unifying Elements Abandoned or Disproved
During the prolonged and extensive pre-trial conferences, there was much discussion of the method to be pursued by the government in attempting to prove that these 17 defendant investment banking houses had formed a combination and were acting jointly as a group. As pointed out in my memorandum of April 9, 1951, filed with Pretrial Order No. 3, United States v. Morgan, D.C., 11 F.R.D. 445, 454-455, the unifying elements of the alleged conspiracy were obscure, as no industrywide uniformity was charged, there was no powerful group such as the "Big Three" operating against independents in the American Tobacco Co.
case, no letter or series of agreements presenting a definite plan to which others might consciously adhere as in the Interstate Circuit
and Masonite Corp.
cases and there appeared to be many non-defendant investment banking firms which were larger, had more capital and did more business than some of the defendants herein. Certain aspects of the present case, however, which have since been abandoned or disproved seemed to have relevance to this important phase of the case.
The first of these was the fact that it was claimed that defendants and their "predecessors" had invented the syndicate system to further their plan or scheme. This charge, which was evidently the basis for the allegation that the conspiracy was formed "in or about 1915," has been conclusively disproved and has been virtually abandoned.
The second such possible unifying element was the Investment Bankers Association, originally joined and for many months of the trial continued as a defendant and alleged co-conspirator.Each of the defendant firms was and had for many years been a member of this Association, particularly during the period when the Association, through its officers and committees took a strong position against the adoption of rules and regulations requiring compulsory public sealed bidding for certain types of new security issues. On motion of the government, however, the Investment Bankers Association was, with my approval, eliminated as a defendant and the charge that it was a co-conspirator was withdrawn. The name of its president Emmett F. Connely, was, however, continued in the list of alleged co-conspirators, evidently because he had made a speech on October 7, 1941 criticizing the purchase of the American Telephone & Telegraph bonds by a group of certain large insurance companies at public sealed bidding and one or two men connected with some of the defendant firms had in one form or another expressed their approval of the speech.
Perhaps the most impressive indication of joint action by the defendants lies in the detailed and explicit allegation of the complaint relative to reciprocity. Not only is it charged that each defendant banking firm keeps a reciprocity record to show the business it has given to each of the other defendant banking firms and the business received from them; but also that over a period of time the profits from such participations are substantially equivalent, with due allowance for differentials in prestige and underwriting strength. If substantiated, these allegations would indicate some systematic and continuous arrangement between the defendants to pay one another off in return for the alleged agreement to defer to one another as "traditional bankers."
Here again, however, there was not merely a failure of proof but an affirmative demonstration that the allegations are without foundation in fact.
No evidence of any kind, whether by way of alleged reciprocity records, deposition proof or documents, was produced on this phase of the case against Dillon Read, Drexel, Glore Forgan, Morgan Stanley, Smith Barney, Union Securities and White Weld; nor were any alleged reciprocity records introduced against Harriman Ripley and Kuhn Loeb. Such records as were received in evidence were of the most disparate character. They covered different periods of time, included non-defendant firms as well as defendant firms, and were so fragmentary and different in character one from the other as to make it clear that they had not been prepared as the result of any joint action whatever. No calculations of reciprocal obligations, such as would have been required by the operation of the conspiracy as alleged, could possibly have been made from these miscellaneous and incomplete loose leaf books and cards.
A careful scrutiny of the documents received in evidence on this part of the case, taken in connection with the socalled reciprocity records and such testimony as was taken by deposition, indicate that a few individual defendant firms, motivated by various considerations of a purely business character, and acting separately and not in combination, did no more than is often found done by business men generally. In the course of a business relationship it is a natural and normal thing for those in the same industry occasionally to seek business on the basis of business given.Were there some uniformity or some common pattern the case would be different. As it is, there is a pattern of no pattern; and I find that, considering all the evidence in the record, including the stipulated statistical data, the reciprocity charge has been disproved.
The Applicable Law Relative to Conspiracy
The Sherman Act is not an open door through which any court or judge may pass at will in order to shape or mould the affairs of business men according to his own individual notions of sound economic policy. Nor was it ever intended by the Congress that judges should determine such policy questions as: the desirability of compulsory sealed bidding for new security issues; the propriety of officers or partners of investment banking firms accepting directorships on the boards of issuers; the good or bad effects of the solicitation of proxies by investment bankers; and whether investment bankers should be permitted to advise issuers concerning their financial affairs, the formulation of long range plans for expansion and refunding, the setting up of specific security issues and kindred subjects and also perform services and assume risks in connection with the registration and distribution of such security issues. The regulation of such matters is a legislative function and the series of statutes which have become law since the great depression of 1929 and the following years bear ample testimony to the fact that the Congress is mindful of its power to regulate such matters, by reason of their connection with interstate commerce.
What the Sherman Act does is to declare illegal "every contract, combination * * * or conspiracy" in restraint of trade or commerce and to make guilty of a misdemeanor "every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce" among the states or with foreign nations. The task of the judge is to determine whether the conduct challenged in the litigation contravenes the prohibitions of the statute. This is no mandate to the judiciary to decide anti-trust cases according to individual ideas of expediency, which may change according to the personal philosophy or even the political affiliation of the judge. It is the combination or joint action of the many which is the essence of the offense. Unless there is some agreement, combination or conspiracy the Sherman Act is not applicable.
But it is supposed by some that the requirement of combination is a mere empty phrase to which one must indeed do lipservice, but which may easily be got around by finding agreement, combination or conspiracy when in truth and in fact no agreement, combination or conspiracy exists, provided the result obtained seems desirable and in the public interest. This is not the law but only another aspect of the false but seductive doctrine that the end justifies the means which, so far as I know, has never taken lodgment in American jurisprudence; and I hope it never will.
True it is that conspiracies whether by business men or others engaged in unlawful schemes are often hard to detect. No direct proof of agreement between the wrongdoers is necessary; circumstantial evidence of the illegal combination is here as elsewhere often most convincing and satisfactory. But, when all is said and done, it is the true and ultimate fact which must prevail. Either there is some agreement, combination or conspiracy or there is not. The answer must not be found in some crystal ball or vaguely sensed by some process of intuition, based upon a chance phrase used here or there, but in the evidence adduced in the record of the case which must be carefully sifted, weighed and considered in its every aspect. This is an arduous but necessary task.
Especially is this true in a case such as the present one where the great bulk of the documentary evidence is initially received against a particular defendant and only subject to connection against the others in the event that the combination or conspiracy is proved. According to well established precedents such documents may be used circumstantially against all; but this works both ways as the probative force of such proof, when considered circumstantially may not tend to support the factual conclusion that the combination or conspiracy existed but rather the contrary. In any event it is well settled that statements contained in such documents, received subject to such connection, may not be used to establish the truth of their contents, except as against the particular defendant against whom such documents are received generally. And it is well that this is so for much that is contained in casual memoranda and even in messages, reports, teletypes and diary entries is mere rumor and gossip, which frequently turns out to be unreliable hearsay. Once the conspiracy is established, however, all such statements become those of agents of the group, to be considered against all the defendants as part of the proofs in the case generally.
The Investment Banking Business
It would be difficult to exaggerate the importance of investment banking to the national economy. The vast industrial growth of the past fifty years has covered the United States with a network of manufacturing, processing, sales and distributing plants, the smooth functioning of which is vital to our welfare as a nation. They vary from huge corporate structures such as the great steel and automobile companies, railroads and airlines, producers of commodities and merchandise of all kinds, oil companies and public utilities, down to comparatively small manufacturing plants and stores. The variety and usefulness of these myriad enterprises defy description. They are the result of American ingenuity and the will to work unceasingly and to improve our standard of living. But adequate financing for their needs is the life blood without which many if not most of these parts of the great machine of busines would cease to function in a healthy, normal fashion.
The initial inquiry in any anti-trust case must be into the character and background of the industry involved. In a case such as this, which covers so long a period of time and a multiplicity of issues and which is largely documentary in character, it is not too much to say that it is impossible to pass upon questions of credibility of witnesses and to understand and interpret the thousands of miscellaneous exhibits, including memoranda, letters, diary entries, teletype inter-office messages and so on without some fairly adequate understanding of the way in which the business is and has been conducted. Thus we turn to the evolution and growth of the investment banking business and the way it functions in the modern American scheme of financial affairs.
By way of prefatory comment and to facilitate orientation, it may be helpful first to describe some of the major factors. The central thought, as in every anti-trust case, must be the character and scope of competitive effort or the lack of competitive effort.
The principal factors which one must constantly bear in mind are: (1) the evolution of the syndicate system from its inception prior to the turn of the century, and its function in the issuance and distribution of securities; (2) the impact on the investment banking business of economic forces and a series of acts of Congress including the Banking Act of 1933, the Securities Act of 1933, the Securities Exchange Act of 1934 and the Public Utility Holding Company Act of 1935, and the various amendments to these statutes, supplemented by rulings and regulations of the Securities and Exchange Commission and the Interstate Commerce Commission; and (3) the complete and comprehensive static and statistical data which show the details of every relevant security issue in the period from January 1, 1935, to December 31, 1949.
While the complaint alleges that the syndicate system was invented at or about the time of the Anglo-French Loan in 1915 by the defendants and their "predecessors," it has been conclusively established, as already stated, that the syndicate system as a means of issuing and distributing security issues was in use at least as early as the 1890's; and in this early period price maintenance was to some extent used, as it was appreciated even in those days that the problem of placing upon the market a large bulk of new securities required careful management and planning lest the very quantity involved should depress the price and make distribution within a reasonable time difficult if not impossible.
The present method for issuing and distributing new security issues thus has its roots in the latter part of the nineteenth century. It is the product of a gradual evolution to meet specific economic problems created by demands for capital, which arose as the result of the increasing industrialization of the country and the growth of a widely dispersed investor class. It was born in large part because of, and gradually adapted itself to, conditions and needs which are peculiar to the business of raising capital.
I. Prior to the First World War
Prior to the year 1900, the large majority of industrial and business units which existed in this country were small in size and their capital needs were small; use of the corporate form was not widespread. There was no substantial and widely scattered class of persons with surplus savings who sought promising investment opportunities. A large part of the capital needed came from abroad.Securities sales operations were conducted principally by selling agents who sold on a commission basis, and more often than not it was the issuer who bore the risk of how successfully and how quickly the required funds would be obtained.
The evolution of the investment banking industry in the United States is illustrated by the early phases of the development of two of the defendant investment banking firms, goldman, Sachs & Co. and Lehman Brothers.
Goldman, Sachs & Co. traces its origin back to the year 1869, when Marcus Goldman started a small business buying and selling commercial paper. In the year 1882, he was joined in that business by Samuel Sachs, and at that time the firm, which had been known as Marcus Goldman, became M. Goldman & Sachs. In the year 1885, when additional partners joined the firm, the firm became Goldman, Sachs & Co., and has continued as such from then on to today. At that time, it was very difficult for small manufacturers and merchants to get capital with which to operate, so Goldman, Sachs & Co. developed the business of buying their short-term promissory notes, thus furnishing them with needed capital, and selling these notes to banks or other investors. This commercial paper business prospered and continued to expand in the 1880's and 1890's, and, by the time of the year 1906, when the opportunity first arose for Goldman, Sachs & Co. to underwrite some financing for United Cigar Manufacturers, now known as the General Cigar Company, the firm had established many contacts all over the country with merchants and manufacturers. During this period, also, partners of Goldman, Sachs & Co. took frequent trips to Europe, because at that time it was difficult to raise capital for American enterprises in the financial markets of this country, and they entered into arrangements with European bankers, whereby they would lend money in this country for their account.
Likewise, the firm of Lehman Brothers traces its ancestry back to about 1850. Since then, a series of partnerships, formed from time to time upon the withdrawal or death of partners or the addition of new ones, has conducted business under the name of Lehman Brothers. The firm had prospered greatly as "cotton bankers," and, years before the turn of the century, it had established its headquarters in New York City.
In the late 1890's and the early 1900's, the prime securities were railroad bonds and real estate mortgages. The public utilities business had not as yet achieved great importance, and, consequently, public utility securities were generally looked upon with disfavor. Railroad and public utility financing was handled by a small number of firms. The railroad financing was done to a considerable extent by Kuhn, Loeb & Co., J. P. Morgan & Co., Vermilye & Co. and August Belmont; and a large percentage of the capital was furnished by French and German underwriters. The public utility financing was done to a large extent by Harris, Forbes & Co., which had become a specialist in the securities of companies providing power and light. Harris, Forbes & Co. was becoming known as an underwriter which understood and knew how to solve the problems of those companies, and had the knack of raising capital for the growing industry. There was an open field in certain light industrial and retail store financing which had been neglected or overlooked.
After the beginning of this century, as family corporations grew larger and needed more capital for expansion, or when the head of a family died and money was needed to pay inheritance taxes, it became increasingly apparent that commercial paper, which was short-term money, was insufficient to meet the capital requirements of those small enterprises. At about this time, Goldman, Sachs & Co., desirous of entering the business of underwriting securities, conceived the idea of inducing privately owned business enterprises to incorporate and to launch public offerings of securities. In the early 1900's it was considered undignified to peddle retail store securities, but Goldman, Sachs & Co. believed that, with the growth in size of family corporations and other privately owned business enterprises, there would be a market on a national basis for their security issues. The problems involved in offering securities to the public, where no securities were previously outstanding in the hands of the public, were new and difficult of solution, and different from the problems involved in the underwriting of bonds of a well known railroad. The sale of retail or department store securities required a different market.
When the opportunity arose in the year 1906 for Goldman, Sachs & Co. to underwrite the financing of United Cigar Manufacturers, it was unable to undertake the entire commitment alone, and could not get the additional funds which it needed to underwrite from commercial banks or other underwriters, as they would not at that time underwrite this type of securities. Henry Goldman prevailed upon his friend Philip Lehman of Lehman Brothers to divert some of his capital from the commodity business and to take a share in the underwriting.The result was that the two firms, Goldman, Sachs & Co. and Lehman Brothers, became partners in the underwriting of the financing of United Cigar Manufacturers. When the opportunity arose in that same year for Goldman, Sachs & Co. to underwrite the financing of Sears, Roebuck & Co., it was perfectly natural for it again to turn to Lehman Brothers for assistance, and the two firms became partners in that enterprise.Thus it was through this oral arrangement between two friends, Henry Goldman and Philip Lehman, through this informal partnership, that Goldman, Sachs & Co. was able to obtain the capital which it needed to underwrite these two security issues in the year 1906. Without such capital, it would have been unable to enter the business of underwriting securities.The events which occurred in the year 1906 set the pattern for subsequent financings which Goldman, Sachs & Co. underwrote prior to the First World War. In the period from the year 1906 to the year 1917, although Goldman, Sachs & Co. occasionally underwrote financings with other partners, notably Kleinwort Sons & Co., merchant bankers of London, its principal partner was Lehman Brothers.
These two firms, as partners or joint adventurers, continued to act together thereafter underwriting securities of clothing manufacturers, cigar manufacturers, department stores and merchants, and the kind of businesses that most investment bankers, who were interested only in the securities of heavy industrials, railroads and to some extent public utilities, would not touch. The two firms began to cultivate acquaintances and build up relationships with securities dealers in other parts of the country who could market in their respective cities or towns the type of securities in which the two firms were particularly interested; and, as their reputations grew, they began to underwrite securities in the industrial field. They added to their staffs persons who were experts on merchandising and retail store methods, and they developed the business of selling their services to family and other privately owned enterprises.
While the evidence is not explicit on the point it would seem reasonable to assume that, prior to World War I, the firms interested in the securities of railroads, public utilities and heavy industries were establishing similar contacts, building up similar staffs of experts in their particular fields and otherwise doing whatever they could to enhance their reputations in their own specialities.
In the period from the year 1906 to the year 1917, Goldman, Sachs & Co. and Lehman Brothers together underwrote the financings of many enterprises which had a small and humble beginning, but which later grew to very great size, among them being United Cigar Manufacturers, Sears, Roebuck & Co., B. F. Goodrich Company, May Department Stores Company and F. W. Woolworth Company. Many of the business concerns whose securities were underwritten by Goldman, Sachs & Co. and Lehman Brothers during this period were houses with which Goldman, Sachs & Co. had previously had commercial paper transactions.As Goldman, Sachs & Co. and Lehman Brothers were better known at the time than many of the business enterprises whose securities they underwrote, investors bought the securities to some extent in reliance on their reputation.
There thus grew up between these two firms an informal, oral arrangement whereby they, as partners or joint adventurers, purchased security issues directly from issuers, and divided equally the profit which was realized from their sale.
There was then no network of securities dealers throughout the country, such as there is at the present time. In or about the year 1905 or 1906, there were only about five investment banking houses which had a national distribution system for securities: Lee Higginson & Co.; N. W. Harris & Co.; N. W. Halsey & Co.; Kidder, Peabody & Co.; and William Salomon & Co. Investment banking houses such as J. P. Morgan & Co., Kuhn, Loeb & Co., and William A. Read & Co. were underwriters of securities primarily in the New York market. Up to about the year 1912 or 1915, there were approximately only two hundred and fifty securities dealers in the entire United States, most of whom were concentrated in the eastern and middle eastern parts of the country. It was not until the time of the launching of the Liberty Loan in the year 1917 that we find a large number of independent dealers engaged in the business of distributing securities throughout the country.
As there was no network of securities dealers on a nation wide scale, the underwriters sold as many securities as they could directly to individual investors, and the sale of security issues generally was not completed rapidly. For example, it took Goldman, Sachs & Co. and Lehman Brothers three months to sell the Sears, Roebuck & Co. security issue which they underwrote in the year 1906, and, in many other instances, it took the underwriters much longer to complete the distribution of security issues. The personnel of the distributing organizations was small, and their operations were concentrated in the eastern and northeastern parts of the country. The purchase and banking groups were characteristically organized to last for a period of one year, and the manager had broad powers to extend the period. This power to extend was frequently exercised by the manager; there are records of such groups continuing from two to five years or longer. Investment banking firms kept lists of investors, and, whenever they underwrote a security issue, they would go directly to the investors and try to sell them that particular security.
This method of distribution was adequate for the sale of a limited number of security issues to a limited investing public; it was wholly inadequate for a later time when new security issues were to follow each other in rapid succession, since the slowness of distribution of a greatly increased volume of securities required excessively large capital resources on the part of the originating banker and the purchase and banking groups for the purpose of carrying the securities. Accordingly, it is interesting to observe that, as an incident of the long periods of distribution, the investment banker's "spread," that is, the difference between the price paid to the issuer for the security and the price received for it from the investing public, was larger during this period than in later years.
Prior to World War I, the United States was a debtor and not a creditor nation. Investment banking firms in this country turned to Europe to find wealthy individuals and other investment bankers who would be willing to share the risk and underwrite the security issues of business enterprises in the United States. European investment banking firms also sold to investors in Europe the securities of American business enterprises. Among some of the European investment banking firms to which Goldman, Sachs & Co. and Lehman Brothers turned to during this period were Kleinwort Sons & Company, Helbert, Wagg & Russell and S. Japhet & Company, all of London, Labouchere Oyens & Company, of Amsterdam, and others in Berlin and Zurich. Goldman, Sachs & Co. had established business relationships with all of these investment banking firms prior to the year 1906, when it was anxious to enter the international banking business in order to be able to furnish its American clients with letters of credit and foreign exchange. All of these contacts became very useful when Goldman, Sachs & Co. entered the investment banking business.
With this background, it is easy to see that many of the issuers, especially those whose securities were not well known to the public, leaned heavily upon the sponsorship of the investment banking firms under whose auspices the securities were sold. Issuers invited partners or officers of investment banking firms to serve on their boards of directors, in order to interest investors in their securities. Some of the prospectuses, which in those early days were little more than notices, stated that a partner or officer of a particular investment banking firm would go on the board of directors of the issuer whose securities were being offered to the public for sale. Investment bankers sometimes asked to be put on the boards of directors of issuers in order to know how they were managed and to protect the interests of the investors to whom they had sold the issuer's securities. Since the investment bankers sponsored the securities and lent their names to their sale, they felt a certain obligation to the investors to whom they sold the securities to see to it that the issuers did not adopt any policies or engage in any practices which would impair the value of those securities. This was especially important in connection with foreign investors.
Another development which was to have repercussions later on arose out of the difficulty of obtaining underwriters to share the risk. Thus it was that, prior to World War I, it was not unusual to find officers, directors and shareholders of issuers made participants on original terms in the underwriting of security issues; and investment bankers approached wealthy friends and other moneyed individuals, who were willing to take the risks involved, and asked them to participate. Commercial banks also took participations in substantial amounts.
In the period under discussion, it was common for an investment banker to purchase an entire issue directly from the issuer at a stated price, and that banker alone would sign the purchase contract with the issuer.Generally, the investment banker's agreement to purchase represented a firm obligation. This investment banker would then immediately organize a larger group, composed of a limited number of investment banking firms, which was sometimes called a "purchase syndicate," whereby he would, in effect, sub-underwrite his risk by selling the securities which he had purchased alone from the issuer to this larger group, at an increase or "step-up" in price. The investment banker who purchased the entire issue directly from the issuer was known as the "originating banker" or "house of issue." The originating banker became a member and the manager of the "purchase syndicate." Goldman, Sachs & Co. is said to be one of the first investment banking firms to develop this method of underwriting securities; and, although this method may have been developed to underwrite the securities of the smaller, less well-known industrial enterprises and of the family concerns which were for the first time launching securities for sale to the public, other investment bankers used the same method to underwrite the securities of large industrial enterprises, railroads and utilities. As business enterprises in this country grew in size, and as the amounts of capital required by these enterprises became larger, sometimes a second group, more numerous than the "purchase syndicate," would be formed in order to spread still wider the risk involved in the purchase and sale of the securities. The "purchase syndicate" would then sell the securities which it had purchased at an increase in price from the originating banker to this second larger group, which was sometimes called a "banking syndicate," at another increase or "step-up" in price. The originating banker and the other investment banking firms, which were members of the "purchase syndicate," usually became members of the "banking syndicate" and the originating banker became its manager. The transfer of the securities to the "purchase syndicate" and then to the "banking syndicate" was practically simultaneous with the original purchase of the securities from the issuer by the originating banker.
Even at a time before there was any delegation of powers to any particular one of the original purchasers, according to the testimony of Harold L. Stuart of Halsey, Stuart & Co., "there was an agreement between the houses to buy them and to sell them and to maintain a price" which was even then called a "public offering price."
Stuart also described the first syndicate in which his firm participated, which was a $10,000,000 issue of First Mortgage Bonds of the Commonwealth Edison Company in December, 1908. There were two managers who were paid a fixed fee, an equivalent of the present day management fee, and the two managers had broad powers. Sales through the manager pro rata for the accounts of the members of the syndicate and also sales of non-withdrawn bonds on behalf of the syndicate members through dealers and directly to institutions and other buyers were contemplated. Further details appear in the syndicate agreements of certain issues of bonds of the Pacific Gas & Electric Company and United Light & Railways Company in 1912 and 1913.
From all the above it is evident that the various steps which were taken, including use of the purchase and banking groups above described, were all part of the development of a single effective method of security underwriting and distribution, with such features as maintenance of a fixed price during distribution, stabilization and direction by a manager of the entire coordinated operation of originating, underwriting and distributing the entire issue.
This evolution of the syndicate system was in no sense a plan or scheme invented by anyone. Its form and development were due entirely to the economic conditions in the midst of which investment bankers functioned. No single underwriter could have borne alone the underwriting risk involved in the purchase and sale of a large security issue. No single underwriter could have effected a successful public distribution of the issue. The various investment bankers combined and formed groups, and pooled their underwriting resources in order to compete for business. These groups of investment bankers were not combinations formed for the purpose of lessening competition.On the contrary, there could have been no competition without them. Unless investment bankers combined and formed such groups there would have been no underwriting and no distribution of new security issues. Perhaps the English system,
which seems superior in the view of some, has many advantages. But the investment banking business in America grew and developed and prospered according to an indigenous American pattern.
The most significant fact about the period prior to World War I is that in it will be found the beginnings, the seeds as it were, from which in the course of time and by a gradual and traceable evolution there grew the elaborate and effective modern methods by which investment bankers, skilled in the application of their special techniques, perform the integrated services by which they earn their livelihood.
Thus in these early times we find investment bankers employing trained experts who spend much of their time developing plans and designing the set-ups of issues of securities which will be especially suitable for the needs of a particular issuer, at a particular time and under particular circumstances. We find groups forming for the purposes of competition, sometimes small groups developing into larger ones. And we find the already well developed shaping up of the syndicate systm, with features of price maintenance and stabilization and broad powers delegated to the managers in connection with distribution and otherwise, not as a means of merely merchandizing securities, as one would buy and sell hams and potatoes, as suggested by government counsel, but rather as a means of integrating the steps of purchase and distribution necessary to the attainment of the ultimate goal of channeling the savings of investors into the coffers of the issuer as a single unified, integrated transaction. No longer does the issuer bear the risk alone and distribute its securities by agents selling on a commission basis. The pattern of performing a series of interrelated services by the investment banker, including the formulation of the plan and method to be pursued in raising the money, the undertaking of the risk and the distribution of the security issue as a whole, has already emerged.
II. Between World War I and the Securities Act of 1933
The aftermath of the war was a period of over-production and mal-distribution accompanied by a sharp decline in the prices of commodities. A nation at peace could not absorb all the products of an economy, which, but a short time before, had been geared for the effective waging of war. Many business enterprises were faced with the problem of reorganizing in order to get their operations back on a profitable basis. By the year 1923, however, the nation's economy had recovered from the "commodity or inventory panic," and business enterprises began to enjoy more prosperous conditions.
In the following decade there was an unprecedented expansion of industrial and business enterprises, an increase in the number and geographical distribution of investors; and the use of the corporate form was adopted more and more widely. As domestic business units increased in size and number, the demands for investment capital reached a magnitude never before experienced. The United States had become a creditor nation; and, for the first time, foreign governments, foreign municipalities and foreign corporations turned to this country to raise capital from private American investors. Those investment banking firms which were dependent upon European capital for their underwriting strength went into eclipse and other banking investment firms came to the fore.
J. P. Morgan & Co. was the leading firm. But all the great publicly owned banks were in the investment banking business, first for their own account and later indirectly through either subsidiary or affiliated corporations formed for the purpose. Dillon Read, Lee Higginson, the old Kidder Peabody and Blair appear to have been perhaps the best known names in all-around business. Kuhn Loeb together with J. P. Morgan & Co. were leaders in railroads, in which field older firms such as Speyer, J. & W. Seligman, and Ladenburg Thalmann were also important. Bonbright, Harris Forbes, Halsey Stuart and Coffin & Burr were leaders in public utilities. Lehman and Goldman Sachs were leaders in merchandising and other fields. The largest distributing firms were those particularly connected with the banks, such as National City, Guaranty and Chase. But a number of other banks were active, such as First National, Bankers Trust, the principal banks in Boston, Chicago, Cleveland and Pittsburgh, and others. Among other firms then in existence but appearing less frequently were E. B. Smith, C. D. Barney, White Weld, Blyth Witter, Stone & Webster, Field Glore, Hallgarten and Brown Brothers.
Security issues followed one another in rapid succession and, whereas before World War I an issue of one million dollars was considered large, in the middle 20's issues of twenty and twenty-five million dollars were by no means unusual.
The impact of these economic forces upon the investment banking industry was precisely what one would have expected. The number of underwriters in the syndicates increased, in order both to spread the risk and to effect a widespread and rapid distribution of the securities to the public. Even so the problems of distribution became so complicated that it became customary to form an additional group called a "selling syndicate" or "selling group." The new "selling syndicate" was much larger and more widely dispersed than the purchase and banking groups had been.
There were three types of these selling syndicates throughout this period. While they represented successive steps in the development of investment banking, and while there were shifts in the type that was most extensively used, all three were used throughout the 1920's.
The first type was known as the "unlimited liability selling syndicate." In this group, each member agreed to take a pro rata share in the purchase of the security issue by the selling syndicate from the previous group, at a stated price, and to take up his share of any unsold securities, which remained in the syndicate at the time of its expiration. The syndicate agreement stated the terms upon which the offering to the public was to be made. Each member was given the right to offer securities to the public, and he received a stated commission on all confirmed sales. However, regardless of the amount of securities which he sold, he still retained his liability to take up his proportionate share of unsold securities. The undivided syndicate combined selling with the assumption of risk; therefore, both houses with distributing ability and houses with financial capacity, but without distributing ability, were included in the syndicate. Usually, a banking group was not organized where this type of selling syndicate was to be used. The purchase group sold the security issue directly to the selling syndicate.
The dealers who did the actual selling of the securities objected to the "unlimited liability selling syndicate," as they were compelled to take up in their proportionate shares the securities, which the other dealers, who were members of the selling syndicate, were unable to sell. Consequently, the second type of selling syndicate, which was known as the "limited liability selling syndicate," subsequently was developed.This syndicate operated in much the same manner as the undivided syndicate, except that the obligation of each member was limited to the amount of his commitment, and, when he distributed that amount, he was relieved of further liability.Each member retained his proportionate liability for the costs of carrying the securities, shared in the profits or losses of the trading account, and was liable for such other expenses as occurred after the purchase from the purchase or banking group. A banking group was usually organized where the "limited liability selling syndicate" was to be used.
The "limited liability selling syndicate" gradually evolved into the third type of selling syndicate, which was simply known as the "selling group." The "selling group" differed from the "limited liability selling syndicate" in that its members relieved themselves of all liability for carrying costs, the trading account and other expenses. Each member of the "selling group" was concerned only with expenses connected with the actual retail distribution of securities. The financial liability of the member was restricted to selling or taking up the amount of securities for which he subscribed. Usually, a large banking group was organized where the "selling group" was to be used. The banking group took over the liability for carrying costs, the trading account and other expenses.
The size and makeup of the selling syndicates varied with the circumstances of the particular security issue.Among the important factors, which were considered in the selection of dealers, were the size of the security issue, the type and quality of the security, the size and nature of the class of investors to whom the distribution was to be made, and the ability of a dealer to distribute securities of a particular type. All of these factors were considered in the selection of underwriters and dealers for the formation of the underwriting syndicates and selling groups.
In all of these types of selling syndicates, the members acted as principals, and not as agents of the manager, in distributing securities to the public. The syndicate agreement specified the price at which the securities were to be sold, and it was a violation of the agreement for a member to sell at any other price. The manager traded in the open market during the period of distribution in order to maintain the public offering price. Through such stabilizing operations, the manager sought to prevent any securities, which had been sold by dealers, from coming back into the market in such a manner as to depress the public offering price. It was felt that with respect to the securities which appeared in the market, the members of the selling syndicate had not performed their function of "placing" with investors, for which they were paid a selling commission; and, consequently, "repurchase penalties" were provided for, whereby the manager had the right to cancel the selling commission on the sale of those securities which he purchased in the market at or below the public offering price. Under most agreements, the manager had the option of either cancelling the selling commission on the sale of the securities, or of requiring the member who sold the securities to take them up at their cost to the trading account.Records of the serial numbers of securities were kept, and the securities which appeared in the market were thus traced to the dealers who sold them. Stabilizing operations and the repurchase penalty were used in all of the three types of selling syndicates which prevailed throughout this period.However, where a "selling group" was used, it became more and more common practice to restrict the re-purchase penalty to the cancellation of commissions.
The operations of the "selling syndicate" like those of the pre-war withdrawing subscribers, dealers and selling agents, were directed by the manager whose general supervisory function over the whole machinery of purchase and distribution was continued.Even in the earlier period provisions for maintenance of the public offering price by persons to whom title had passed had been included in some agreements.
As testified by Harold L. Stuart "you simply had to have such a clause in order to make this business function in putting the securities on the market," because "there were many ways that shrewd people could beat the game and spoil the putting of any security issue on the market unless you did this."
A significant development and one quite in keeping with the economic conditions above referred to, is that the periods for distribution became much shorter than they had been in the period prior to the war.Usually the life of the syndicate was designated as from thirty to sixty days, with a provision for earlier termination or for extension not exceeding a like period by the manager. As a matter of fact, however, the periods of distribution were generally much shorter.
The "market out" clause was evidently developed somewhere in the neighborhood of 1914 or 1915, and its use was fairly general at an early date.
As the amounts of capital required by business enterprises became larger, and the number and size of securities issues greatly increased, the problems with which investment bankers were confronted, in connection with the underwriting of security issues, multiplied. Extensive investigations had to be conducted into the affairs of a business enterprise, and studies made of its financial structure and capital needs, at considerable expense to the investment banker, before that banker would undertake the risk and underwrite the securities of that enterprise. In this connection, investment banking firms were compelled to bring into their organizations individuals who had new types of specialized knowledge and experience; so that they gradually built up teams of specialists, who were experts in the different fields in which their respective investment banking firms underwrote securities.
Throughout this period prior to 1933, officers and directors of issuers continued to be made participants on original terms in the underwriting of the security issues of those issuers and other moneyed individuals also continued to participate. This was the much criticized "gravy train" about which much was heard in the early stages of the trial.The practice seems to have gradually disappeared in the course of time, due perhaps to the fact that the investment bankers in adequate numbers became available as underwriters and the liability provisions of the Securities Act of 1933 made such opportunities for profit less attractive. In any event, government counsel now agree that this issue is out of the case.
While there were some instances in the earlier period of a purchase by the members of a banking syndicate in severalty, the more usual legal form in which the transfer was made from the issuer to the participating underwriters in the decade now under consideration was a joint or joint and several purchase.
More important than any of the other developments between World War I and the passage of the Securities Act of 1933 was the effect of the unprecedented era of expansion upon the participation of the great banking institutions and their affiliates. As the need for vast amounts of new capital for expansion, plant construction and the establishment of thousands of new enterprises made increasing demands for new money, the banks and their affiliates became increasingly interested in managing and participating in the various underwritings. While the evidence in this case relative to the pre-Securities Act period is far from complete,there is ample documentary evidence to show that many of the banks became directly interested through their bond departments and many others formed affiliates, as above stated. J. P. Morgan & Co., the First National Bank and the Bankers Trust Company and many others in New York City, as well as large banking institutions in Chicago, Cleveland and other cities did a large investment banking business. The National City Company, the Guaranty Company and Chase Securities Corporation, affiliates of the National City Bank, the Guaranty Trust Company of New York and the Chase National Bank were in the investment banking business in a big way. The National City Company as of December 31, 1929, had a capital of $110,000,000. On the same date the capital of the Chase Securities Corporation was over $101,000,000. The economic power of these huge aggregations of capital vis-a-vis the relatively small capital of issuers was a factor of no mean significance in the period just before the great depression. There was an additional leverage in the multiplicity of banking functions which could be placed at the disposal of issuers. Added to this was the vast influence and prestige which must have made itself felt in a variety of ways. Issuers were dependent upon these great banking institutions in a way which finds no parallel in the relations between issuers and investment bankers in the period subsequent to the passage of the Banking and Securities Acts.
Before it became necessary by law to choose between commercial banking on the one hand and investment banking on the other, many of these great banking institutions were private banking houses under no statutory duty to make the disclosures required of national banks and others and this, coupled with the lack of legal requirements for disclosure of relevant facts connected with security issues, helped to make the period under discussion what has been described in the trial as an era of "dignity and mystery."
In such an atmosphere it seems altogether probable that, wholly in the absence of any conspiratorial combination, issuers felt a strong inclination to continue to bring out issue after issue with the same bankers. Indeed, it is probably not too much to say that many issuers took pride and satisfaction from the very circumstance of their connection with these giants of American finance. Such sponsorship of an offering of securities to the public was of real value.
In any event, these great banking institutions and their affiliates were doing a huge investment banking business, and they were using the money of their depositors as well as their own resources to underwrite one security issue after another.
Some of the evidence which goes back to this earlier period leads to the suspicion that with reference to one or two particular issuers there may have developed some arrangement or combination of participants, continuing throughout a number of successive issues, which might, taken in isolation and separately, have constituted violations of the Sherman Act.At this late date, after practically all of those personally concerned have died and the files and other documentary evidence are no longer available, no adjudication of the legality of such isolated transactions is possible, nor is such adjudication requested by the government. Some references have been made in the evidence to contracts with a few issuers by which an investment banker was given "preferential rights"; and Harold L. Stuart testified that he tried to get such contracts whenever he could.They seem to have been ineffectual, however, and have long since gone out of use, due at least to some extent to the disapproving attitude of the SEC. In any event, I cannot find that they were sought or used to any extent by the defendants in this case.
III. Further Developments 1933-1949
Following the Armstrong Insurance investigation
in 1905 and Governor Hughes' Committee Report in 1909
there had been other investigations which covered activities of investment bankers. The Pujo investigation
was conducted in 1912 and 1913, the Utility Corporation inquiry by the Federal Trade Commission
started in 1928; and these were followed by a long series of hearings, under the auspices of various committees of the Congress, which resulted in the Banking Act of 1933
(known also as the Glass-Steagall Act), the Securities Act of 1933
and the Securities Exchange Act of 1934.
From December 10, 1931 through February 1932 the Senate Committee on Finance pursuant to the Johnson Resolution
undertook to investigate the flotation of foreign bonds and other securities in the United States. Perhaps the most important of these investigations was the Gray-Pecora investigation of the Senate Committee on Banking and Currency
which began on April 11, 1932 and continued through May 4, 1934.
In this chronological survey of the history and development of the investment banking business it will suffice to say that these statutes, together with the Public Utility Holding Company Act of 1935
and the Maloney Act,
effective June 25, 1938, which added Section 15A to the Securities Exchange Act of 1934, and authorized the organization of the National Association of Securities Dealers, Inc. (NASD), under the supervision of the SEC, which followed,effected changes of the most radical and pervasive character; and these changes were made with a complete and comprehensive understanding by the Congress of current methods of operation in common use in the securities issue business, such information having been made available in the course of the investigations to which reference has just been made.
Institutions which had previously engaged both in commercial and deposit banking on the one hand and investment banking on the other were required to elect prior to June 16, 1934, which of the two functions they would pursue to the exclusion of the other. This resulted in the complete elimination of the commercial banks and trust companies from the investment banking business; and the various bank affiliates were dissolved and liquidated.
The elaborate procedures which now became necessary in connection with the sale of new issues of securities were at first implemented by the Federal Trade Commission and then, upon the creation of the Securities and Exchange Commission, transferred to it. The regulation of the securities business which followed with such salutary and beneficial results has been one of the significant developments of our time. The era of "dignity and mystery" was over.
When we come to discuss the syndicate system and its operation, it will be appropriate to treat in some detail the various applicable provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934, with their respective amendments, and also the numerous regulations, interpretations and releases of the SEC relative thereto. For the sake of continuity and clarity, however, this brief recital of the development of the investment banking business will be continued in order to furnish general background.
Security issue financing was relatively inactive as the result of the great depression, up until about the end of 1934. Thereafter, except for an occasional falling off in the depression of 1937 and in the early years of World War II, the needs of industry kept the demand for new capital at a high level. The reduction of interest rates as the result of government manipulation brought about refundings on a large scale and further refundings continued in volume as interest rates continued to fall.
The size of issues increased. An issue of $5,000,000 was considered small. In this period there were 155 issues of $50,000,000 and larger; 559 issues of $20,000,000 and larger and over 1,000 issues of $10,000,000 and larger.
Due largely to the impact of the income and inheritance tax laws, the importance of the individual as an investor diminished and there was an extraordinary and continued growth in the size and investment needs of large institutional investors such as life and casualty companies, savings banks, investment trusts, pension funds, universities, hospitals and fraternal orders.
Perhaps the most significant change of all was caused by the withdrawal from the field of investment banking of the capital funds of the commercial banks and their affiliates, which had previously been among the foremost managers and underwriters of security issues. As already stated, investment banking firms could participate in and manage underwritings only with their own money. As of the end of 1949 only 7 of the defendant firms had a capital of 5 million dollars and larger, 8 a capital of between 2 and 5 millions and 2 a capital of between 1 and 2 millions. Nor could any of them use all of their capital or borrowing power for underwritings, as each was engaged in other activities which tied up a part of their capital funds and they were all subject to certain regulations of the SEC and the various exchanges which promulgated rules and regulations affecting the amount of capital available for underwriting.
The Revenue Act of 1932, which became effective on June 22, 1932, for the first time imposed a tax on the transfer of bonds, Sec. 724, 47 Stat. 274, 26 U.S.C.A. Int.Rev. Acts, p. 634. A transfer tax on stocks had previously been enacted in 1914; but in 1932 this tax was greatly increased in amount, Sec. 723, 47 Stat. 272, 26 U.S.C.A.Int.Rev. Acts, p. 630. Section 11 of the Securities Act of 1933 imposed on each underwriter a civil liability, for any omission or misstatement of a material fact in the registration statement, equal to the entire amount of the issue. By later amendment in 1934, Title II, Sec. 206 (d) of the Securities Exchange Act of 1934, this liability was changed to "the total price at which the securities underwritten by him and distributed to the public were offered to the public." 15 U.S.C.A. § 77k(e). The liability thus defined plus the transfer taxes made it necessary for the underwriters to abandon the purchase of security issues jointly or jointly and severally, and resulted in the purchase by the various underwriters in severalty, which has been the prevailing method ever since. Otherwise an underwriter might still be liable under Section 11 of the Securities Act of 1933, as amended, for the entire amount of the issue. Significantly, since the 1933 Act, the underwriters still frequently take title jointly or jointly and severally when the security is a municipal or other issue not subject to the Securities Act of 1933.
The old banking and purchase syndicates with the "step-up" of earlier days which had been gradually going out of vogue, now completely disappeared. The form in which underwriting transactions commonly took place from the passage of the Banking and Securities legislation up to the present time is that of a purchase or "underwriting agreement" between the issuer and the underwriters represented by the manager, and an "agreement among underwriters."
The substance of the entire transaction is substantially what it was before. The manager, like the originating banker or manager in the previous periods, handles the negotiations with the issuer and supervises the whole process of underwriting and distribution. The management fee of today is not a new development either in form or in purpose after the Securities Act of 1933, but is the direct equivalent of the management fee paid by the members of the syndicate to the manager for his services in pre-1933 financings, where the syndicate either purchased directly from the issuer or from a prior "original purchaser."
Dealer and group sales are still made, under the authority of the manager who directs the entire process of distribution. But the change in the character of the investing public and especially the development of institutional investors on such a large scale and the impact of regulation by the SEC and of the Securities Act of 1933, the Securities Exchange Act of 1934 and the organization and functioning of the NASD, brought about a gradual decrease in the use of selling group agreements, especially in issues of the higher grades of debt financing and preferred stock.It is worthy of note that in performing his function of making sales for the accounts of the underwriters both to dealers and to institutions the manager sells "out of the pot." In other words, he does not allocate particular bonds to particular underwriters but simply sells "bonds" and does not allocate numbers to any participant until the time comes for delivery of securities to the purchasers.
In accordance with the trend of the previous period spreads are gradually becoming smaller and smaller; and the maximum life of the syndicates is now 15, 20 or 30 days, although in some cases the maximum period may be longer, and it is not unusual to find clauses authorizing the manager to extend the period with or without the consent of a certain proportion of the underwriters. Price restrictions may, however, be removed earlier than the actual termination date of the syndicate, and as a practical matter they are generally terminated within a few days after the offering.
Stabilization provisions have become commonplace pursuant to statutory provisions and administrative regulations and interpretations relating to their use. While the authority to stabilize is generally given, it is only in relatively few cases that the authority has been exercised.
The use of "penalty clauses" has varied and the same is true of the use of price maintenance clauses. This subject will be discussed in greater detail when we come to the portion of this opinion devoted to syndicates. But it is well to bear in mind throughout that the entire pattern of the statutory scheme above referred to, as implemented by the various rules and regulations of the SEC and the rules of Fair Practice of the National Association of Securities Dealers, Inc., approved by the SEC pursuant to legislative authority, contemplates the sale of each security issue at the public offering price proposed in the prospectus and set forth in the registration statement as finally made effective by the SEC. Having proposed and tendered a security issue to the public at the public offering price, it is not strange that those who propose to sell the entire issue at this public offering price should be required to make a bona fide attempt to do so.
Otherwise,the elaborate statutory provisions relative to "the public offering price" would be meaningless.Nor, under these circumstances, should one wonder that some investment banking houses continued to use price maintenance clauses while others did not.
In the previous period a few issues were brought out by public sealed bidding and there were some private placements. In the present period public sealed bidding transactions very greatly increased due to the adoption by the SEC in 1941 of Rule U-50, in connection with all security transactions of companies affected by the Public Utility Holding Company Act of 1935 and to the ruling in 1944 of the Interstate Commerce Commission, requiring all debt issues of railroads to be sold at public sealed bidding.
Due in part to the registration provisions of the Securities Act of 1933, but also in large measure to the increase in the number of institutional investors and their particular requirements, private placements grew by leaps and bounds.
In 1937 the $48,000,000 Convertible 3 1/2s of the Bethlehem Steel Corporation which came out on September 8, 1937 and the $44,244,000 issue of 5% Convertible Preferred Stock of the Pure Oil Company on September 3, 1937 were conspicuously unsuccessful and many of the underwriters suffered serious embarrassment.Repercussions were felt throughout the entire investment banking industry; and thereafter the number of underwriters in practically every syndicate was largely increased in order to spread the risk more widely.
The period 1933-1949 is the critical period in this case, as it includes the years immediately prior to the filing of the complaint in October, 1947.
Fortunately, there is in the record accurate and complete stipulated data with respect to every relevant security issue in the United States from July 26, 1933 to December 31, 1949. The Issuer Summaries, in two volumes, give the name of the issuer, the date of the offering, the description of the issue, the type of transaction, the number of underwriters and whether defendants or non-defendants, the name of the manager or co-managers, contemplated gross spread and certain other information relative to secondaries. The Issue Data Sheets for all underwritten issues of $1,000,000 or more, in the fifteen year period 1935-1949, give all the information and particulars concerning the names and positions of the participants, a breakdown of the contemplated gross spread and so on. Public Sealed Bidding Sheets, which are to be read together with the Issue Data Sheets, set forth the names of the managers of the winning and losing accounts, whether defendants or non-defendants, and the names of the defendant firms who were participants therein. This permits statistical analysis of the entire period. With respect to the period prior to July 26, 1933, Pre-Securities Act Issuer Summary Sheets, containing further stipulated data, whenever available, are in evidence and give the necessary background applicable to all issuers whose various security issues touch controverted issues of fact in the case.
Few if any of the documents in evidence can be properly understood except with reference to the detailed information thus stipulated. Here is an indisputable record of what the defendant firms did as distinguished from mere scraps and fragments of miscellaneous documents containing surmise, conjecture and the thoughts of some who were scarcely in a position to define or implement firm policies. To make matters worse, casual memoranda are subjected by government counsel to critical analysis, such as might be applied to deeds or wills or other documents prepared by lawyers, using technical, closely integrated words of art. ...