The Rise of the Regulators

These are busy times at the Securities and Exchange Commission and other financial regulatory agencies. Officials are scrambling to write rules for carrying out their broadened missions under last year’s Dodd-Frank legislation, formally known as the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Financial crises often bring expansions of regulatory authority in their wake, along with uncertainty over what these will mean in practice. Regulators typically have considerable discretion as to how to implement their powers, which thus are shaped not just by the written law but also by the politics and personalities involved.

The Panic of 1907, involving bank runs and stock price plunges, brought new interest in regulating finance. President Theodore Roosevelt broached the issue of federal oversight of the stock market in 1908, but Congress showed little interest and his administration was drawing to a close anyway. In 1912, Roosevelt made such regulation a plank of the platform for his unsuccessful “Bull Moose” presidential run.

In 1911, Kansas, prompted by bank commissioner Joseph Norman Dolley, became the first state to enact a “blue sky” law requiring registration of securities and brokers. Such laws — so named since they aimed to combat investment offers based on “blue sky” or “hot air” — were adopted by most states over the next few decades. An effort to harmonize this patchwork of laws in the late 1920s achieved little, however.

The 1913 Federal Reserve Act, creating a central bank and lender of last resort, marked a major step-up in federal involvement in the financial sector (expanding the previous role initiated by Civil War legislation that had allowed nationally chartered banks and set up the Office of the Comptroller of Currency). But Washington’s focus still was on stabilizing banks and the dollar, not on overseeing stocks and bonds.

The securities business thus remained lightly regulated overall through the Roaring Twenties. Industry touted its ability to self-regulate, as it had done since the 1790s by fixing brokers’ commissions. In 1922, the New York Stock Exchange imposed capital requirements on its member firms. Amid prosperity and rising stock prices, there was little public or political pressure for a tighter regulatory regime. Soon there would be.

Depression Landmarks

The 1929 Crash and the Great Depression’s onset opened the way for a sweeping transformation of the regulatory landscape. The Senate’s Pecora hearings (in which banking committee lawyer Ferdinand Pecora grilled top financiers) fueled a growing push for new regulation. Financial reform became a priority in the New Deal agenda of President Franklin D. Roosevelt and Democratic majorities in the House and Senate.

This would take various forms including mandatory bank deposit insurance, regulation of bank account interest rates and the Glass-Steagall separation of investment banks and deposit-taking institutions. Moreover, the New Deal brought the federal government into oversight of securities markets for the first time.
The Securities Act of 1933 set up registration and disclosure requirements for companies that issued publicly traded securities and did not meet certain exemption requirements (such as making offerings only to residents of their own states). The Federal Trade Commission was briefly the agency in charge of such securities registration.

The following year, the Securities and Exchange Act set up the SEC and expanded the federal oversight role beyond securities issuance and into the day-to-day secondary market. The new agency would have the power to regulate stock exchanges and prohibit manipulative trading practices, such as when “pools” coordinated transactions to bid up the price of an investment briefly before dumping it on unsuspecting investors.

To be the SEC’s first chairman, Roosevelt appointed Joseph P. Kennedy (father of future president John F. Kennedy), a businessman with experience in the shady practices the agency was supposed to combat (“It takes one to catch one,” FDR reportedly said). Kennedy tended to move cautiously on enforcement, focusing on egregious offenders while avoiding a broader crackdown that could spook the already depressed markets.

The SEC took a less conciliatory approach in the late 1930s under William O. Douglas, its third chairman (and later a Supreme Court justice). Douglas placed a new emphasis on the agency’s subpoena power and litigation skills. He also pressed successfully for a reorganization of the New York Stock Exchange (see sidebar “Fight at the Exchange”).

Further legislation in the late ’30s and early ’40s elaborated the new regulatory picture. The Maloney Act of 1938 provided for a national organization of brokers and dealers to create and enforce disciplinary rules; consequently, the National Association of Securities Dealers was set up in 1940, with the SEC empowered to review its decisions.

Also in 1940, the Investment Company Act and the Investment Advisers Act required investment companies and advisors (then commonly spelled “advisers”) to register with the SEC. The legislation contained a fiduciary standard for some advisors but exempted brokers as long as their advice was “incidental” and not given special compensation. That issue would resurface some 70 years later, with the Dodd-Frank law giving the SEC the power to apply a fiduciary standard more broadly.

Postwar Swings