Global Policy Forum

By Jennie Rothenberg

During the past several weeks, as Americans have focused on the prospect of war with Iraq, a quiet discussion has been taking place in the offices of the Securities and Exchange Commission. Prompted by the recent spate of corporate scandals that brought low such companies as Enron, Global Crossing, WorldCom, and Tyco, the SEC has been deliberating over a set of strict new rules for monitoring corporate conduct.

This is not the first time that the public has seen fit to mistrust the business world and has called upon the government to impose tighter controls. Indeed, the discussion taking place today in many respects echoes earlier debates—many of which have been articulated over the years in the pages of The Atlantic Monthly.

In the fall of 1907 Wall Street was rocked by financial scandals and a major bank panic in which many depositors tried to withdraw their money at once. As a result the public became wary of the world of big business and called for the government to clamp down harder than ever before on corporate power. But in a January 1908 article entitled "Justice to the Corporations" the Boston banker Henry Lee Higginson spoke up on behalf of the business world. Higginson warned that the public was condemning all corporations without having a true understanding of what corporations are and what they do. He pointed out that most large companies were founded by brave visionaries willing to suffer the risks inherent in embarking on new financial ventures, and that the many technological advances made by such companies had improved the lives of all Americans. He worried that the tough new laws then being proposed would restrict such progress, punishing even corporations that had committed no offenses and hurting the whole American economy. After all, he argued, most companies had undoubtedly been chastened by the financial panic of 1907 (and a series of smaller-scale panics that had preceded it), and would now be on better behavior.

It may never be forgotten that we are all in the same boat, that we must help or hurt one another, and that it is idle to call Wall Street hard names.... Let bygones be bygones. Let us begin anew, knowing that the corporations are to-day obeying the laws, and knowing also that the standards of honesty, honor, and fair dealing between man and man have been carefully studied and are higher than in the last century.

Higginson's confidence, however, was misplaced; the 1920s proved to be an era of massive corporate fraud and insider trading. Companies artificially boosted their stock prices while overeager investors paid for stocks with money they didn't have. In 1926, in an article entitled "Stop, Look, Listen: The Shareholder's Right to Adequate Information," a Harvard economics professor, William Z. Ripley, sent out a prescient warning to the manic investors of his time:

When two highways intersect out in the country, with but an occasional passage of slow-moving vehicles and with a clear view all about, things care for themselves naturally, so far as the public safety is concerned. But when the volume of this traffic increases; when high-powered cars and heavy trucks are propelled at speed by careless or drunken drivers; when a fleet of little irresponsible and often overcrowded craft out for a holiday dots the stream; when great structures, pushed forward to the utmost building line, obscure the vision–then, as the appalling record of deaths and casualties betokens, the time has come for public supervision at the crossways.... This homely figure is quite applicable to the present condition of our corporate affairs in the United States.

Expanding on his traffic metaphor, Ripley declared that the new intersection between Main Street and Wall Street created "an imminent danger of collision." Companies were not providing concrete facts and figures to investors, luring them instead through glossy pictures in popular magazines.

At the time of Ripley's writing, there were no laws requiring companies to undergo audits by outside accounting firms. Ripley described the many ways a business could tweak its own records, omitting important items and misrepresenting its assets. He pointed to a number of real-life cases in which a company's stated earnings had masked the full truth:

The Electric Light and Power Corporation in 1925 asserts clearly enough that it has no funded debt; yet its subsidiaries, whence all its income arises, have in fact $140,000,000 of such indebtedness. So also with the American Superpower Corporation, which reports no funded or floating debt. Yet its two principal investments are bonded up to almost $50,000,000.... It is clear, therefore, that no annual report is worth the paper upon which it is printed, without complete consolidated statements, both of income and of condition, as of a date certain.

The only real guarantee against such practices, Ripley argued, would be action at the federal level. Laws requiring corporate disclosure would have been in place already, he suggested, were it not for a general American suspicion toward "so-called paternalism," particularly following World War I.

It took the total implosion of the stock market in 1929 to bring Ripley's concerns into the mainstream. During the depression of the 1930s, the government began to play a more active role in directing and monitoring the country's economic affairs. President Roosevelt instituted government programs to revitalize the economy, and lawmakers began thinking seriously about how to prevent corporate fraud.

In June 1933, Congress passed the Securities Act, a law requiring every company to release all of its relevant financial information to investors. The new act was highly controversial. In February and March of 1934, The Atlantic ran two opposing articles on the subject. The first was written by Bernard Flexner, a lawyer from a prominent Kentucky family. Flexner fiercely defended the act and argued that the many lawyers and businessmen who were then proposing amendments to it were in fact seeking to render it ineffective.

Too much money and effort has gone into this campaign of propaganda to justify a purpose of mere "clarifying" amendments. Amendments which appear innocent enough will be artfully loaded with ingenious weasel words; seemingly casual changes from section to section will attempt to confuse the careful interrelations which give the Act its lawyer-proof quality.

With an attorney's exhaustive detail, Flexner laid out and dismantled every possible argument for amending the Securities Act. All "technical raking over of the Act," he insisted, was designed to divert attention from fundamental issues and to entangle the public in a net of confusing words. He argued that the new law was not a "doctrinaire brainstorm" but a meticulously crafted document that Congress had pored over for two months. "Every objection now made to it," wrote Flexner, "was, at some time in this long process, raised, considered, and deliberately rejected."

Flexner likewise denied that such a law would weigh down the nation's already depressed economy. On the contrary, he argued, the now-skittish public would not part with its money again until protective new laws were in place. "When lenders will not lend, nor borrowers borrow, for a period of more than a few months or weeks," he demanded, "what reason is there to expect that long-term open-market lending will immediately boom after the repeal of the Act?"

The following month, Eustace Seligman, a lawyer with the New York-based firm Sullivan and Cromwell, published a rebuttal to Flexner's piece. He accused Flexner of using "the familiar 'red herring' method of argument," insulting the intelligence of Atlantic readers by branching off into exaggerated claims about those who wished to amend the Securities Act. Seligman criticized what he felt were the Act's overly stern penalties:

The thesis of this article is that under the Securities Act, to paraphrase Gilbert and Sullivan, the punishment does not fit the crime. The Act imposes too severe penalties for honest mistakes. These penalties are far more severe than those in England, which has had legislation upon this subject developed over a period of many years.

According to Seligman, numerous professions would be harmed by an unamended version of the Securities Act. Investment bankers would no longer safely be able to underwrite a corporation; boards of directors would be held accountable for "multitudinous facts which no one person can possibly know about." In the end, he argued, shareholders would bear the brunt of it all, paying for the losses of companies that had been harshly penalized for minor oversights.

Seligman ended by recommending a dual strategy. First, he suggested, Congress should put in place eight amendments that allowed for varying degrees of punishment. Second, President Roosevelt should appoint a committee including bankers, industrialists, lawyers, and economists to consider the act from all different perspectives.

The committee Seligman envisioned was never established—at least not in quite the form he had proposed. But in June of that year, the President did inaugurate the Securities and Exchange Commission to monitor and enforce the Securities Act. The SEC was to be made up of five members from at least two political parties, all of whom would be forbidden to engage in any business practice or stock market operation that might come under the commission's review.

Sixty years later, however, despite the (by then) longstanding existence of the commission, corporate fraud was still thriving in America. In the mid-1980s a number of large banks failed, causing widespread financial turmoil. In "Cooked Books" (January 1992), William Sternberg argued that part of the problem was that the SEC was too weak. Instead of commissioning audits itself, he pointed out, the SEC permitted companies to hire and pay their own accountants. The result was that accounting firms were essentially employees of the companies they audited, and like most employees, they knew better than to bite the hands that fed them.

You have to wonder how twenty-eight of thirty savings-and-loans that failed in California in 1985 and 1986 could have received clean audits the year before they went belly up. How could Arthur Young have certified Vernon Savings & Loans when more than 90 percent of its loans were bad, or allowed Charles Keating to siphon money from Lincoln Savings & Loan? How could Deloitte, Haskins & Sells have okayed the books at CenTrust Savings Bank of Miami when its chairman was spending millions of dollars in insured deposits on Old Masters and other luxuries? ... And how could Price Waterhouse have taken so long to blow the whistle on the Bank of Credit and Commerce International, known worldwide as the bank of crooks and criminals?

Sternberg asked readers to imagine that the meat they were buying had been inspected not by the U.S. Department of Agriculture but by a private firm, hired by the meatpacking company selling the meat. In that scenario, if the meat were deemed unsatisfactory, the inspectors would report the problem not to consumers or grocery stores but to the meatpacking company itself. If the company refused to make any changes in its practices, the inspector would have two options: he could either decide to see things the management's way, or he could look for another job. This, Sternberg explained, was a good analogy for how the accounting profession currently worked.

Sternberg described how the accounting firm Arthur Young had lied to protect a client, Lincoln Savings & Loan, whose collapse ultimately cost taxpayers $2.6 billion. Arthur Young had assured senators that Lincoln was solvent and profitable, and five of those senators had then met with federal regulators to argue on the company's behalf. Sternberg quoted notes taken by one of the participants at that meeting.

Senator Dennis DeConcini, of Arizona, said, "Why would Arthur Young say these things? They have to guard their credibility too. They put the firm's neck out with this letter."

"They have a client...," replied Michael Patriarca, a regulator.

DeConcini: "You believe they'd prostitute themselves for a client?"

Patriarca: "Absolutely. It happens all the time."

Congress, argued Sternberg, should pass new rules that would eliminate such shady business relationships. "It is hard," he concluded, "to imagine a system more flawed that has undermined the very confidence it is supposed to engender."

In the wake of the recent scandals, such rules have been proposed, debated, and were ultimately passed at the end of January. Early drafts would have required corporations to tell shareholders how much they had paid their auditors. And a corporation's lawyers would have been obligated to report unheeded concerns about their company directly to the SEC. Accountants and attorneys protested, however, and the SEC softened the toughest of its proposals. As a result, many people have criticized the commission, accusing it of caving in to outside pressure. Others, however, have lauded the decision, arguing that the less stringent version of the laws will be in the best interests of the economy and, therefore, the American public.

Henry Lee Higginson, the staunch capitalist and supporter of corporate freedom, would likely have agreed with the latter point of view. As he wrote in his 1908 article:

At such times as we have lately been through some honest men ... are prone to lose their nerve.... At such times hard words and harsh legislation are dangerous because they may easily lead to the long depression usually following panics, and to the consequent idleness of many wage-earners. If, on the other hand, these pioneers and capitalists are not harshly treated, probably after a period of adjustment the corporations will go on and presently flourish.

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