He agreed to pay them a sum of between $50,000 and $60,000 for 60 percent of that common stock. He said he was not interested in the other 40 percent, which, of course, obviously had no control or asset value, providing they would let him make Northern Fiscal finance that payment.

It was done in this way: He sold to Northern Fiscal some Canadian penny gold stocks for the sum of $50,000 or $60,000 and took from Northern Fiscal cash and securities which it had in its portfolio, which in turn he delivered to those persons who were selling him the 60 percent of the common stock.

Now, that kind of thing can go on indefinitely, in the sense that as one management has taken part of the portfolio and wasted it and is beginning to believe that it should not continue in management, it can arrange for the sale of the company in its then crippled state, to some still more predatory management, which would go on and complete the thing. Ultimately you would find that there would be a tendency to have a chain of investment trusts, which in the last analysis would mean that all of them would lose.

Now, I regard these particular people as amateurish, for this reason. I thought I might be able to point out how they could have done it if they wanted to and would have made our task in convicting them much greater. Instead of organizing a company, such as Northern Fiscal, with penny gold stock and other assets of less than $3,000, if they had been men of means, they could have bought indirectly and separately sufficient shares of stock in an existing corporation to have controlled that company. They could then indirectly and separately, and in such a way that it would have been extremely difficult for us to prove it, have caused that corporation to buy the controlling stock of Insuranshares, and when we came to the vital problem of proving the intent and of disproving the defense of mistaken but honest business judgment, it would have been practically impossible to do it.

It would be easier for us to do it with the grand jury powers, because we can subpena all records, but it would, even for us, be a considerable task.

In this instance we were assisted, even with all our powers, and even with the amateurish actions of the people who were doing this, by the fact that the S. E. C., through Mr. Schenker and Mr. Smith and others, had conducted extensive examinations and had discovered a great many of the facts, and through the additional fact that the securities department of the stock exchange had likewise conducted examinations and, through their control over members of the stock exchange, had obtained documents and evidence which ordinarily, in an ordinary civil case, would not have been within the power of the plaintiff to produce.

Senator WAGNER. The stock exchange authorities were cooperative, were they not?

Mr. FULTON. They not only were cooperative, but they did a splendid job in ascertaining the facts, and so did the Securities and Exchange Commission, and we started really with the benefit of what they had done and then proceeded beyond that.

Now, the ordinary litigant has broad powers, especially in the Federal court today, under the new Federal rules, but, in the last analysis, it is difficult for any plaintiff to find out what the facts are if he does not know something of what they are before he begins. In complicated cases, where you have a great number of corporations

and a great number of transactions, it is very, very difficult for a litigant to ascertain what they are before he starts, and even though he may have sufficient powers to obtain the facts if he knows what to look for, in the ordinary instance he would probably miss them in the complicated cases.

I have, like Mr. Cook, not read this bill in detail, and I have no opinion as to whether the bill is, in all of its provisions, the right kind of bill. I assume it is and I assume it is being worked on, but I do not know. However, I have read parts of the bill for the purpose of ascertaining whether this bill in its present form would have prevented the frauds, and I am firmly of the opinion that it would.

Section 13 of this bill, on page 30, specifies in subsection (b) thereof that:

No registered investment company shall change any fundamental investment or management policy unless each such change is authorized by the vote of a majority of its outstanding voting securities.

Under that provision, if properly administrated, it would be illegal, and I assume also criminal, if a letter were mailed, to do the things that were necessary to be done here.

They could not have, for example, exchanged the New England fund stock which was a valuable investment, for the Northern Fiscal preferred stock without getting a vote of the majority of the outstanding voting securities, which not only would have taken time but would have meant publicity which would have been fatal.

Senator HUGHES. The voting securities there would be a majority of the common stock, and they had it in their own control.

Mr. FULTON. They had 30 percent. They could have called a meeting. The owners of that stock were a series of individuals.

Had they called a meeting and had they stated that they were going to transfer the assets from the New England fund into Northern Fiscal stock their participation in the transaction would have been so obvious that their liability would necessarily have made them pause before they did it.

Now, in addition, it must be understood that the Pennsylvania banks which owned the Insuranshare stock were not willing to make that transfer, and on the present record deny that they knew it was contemplated. If they had called a mettinf for that purpose they would have had to know and in this instance they would have been codefendants in the criminal case instead, as is the situation, civil defendants in civil litigation.

Now, on page 36, in section 16, there is another provision which deals with this matter, and that is the provision that not more than one-third of the board of directors can be changed without action by the stockholders.

That would have meant that they could not have transferred the control by simply causing directors to resign and, as they resigned, by electing nominees of the new interests. That would have meant that there would have had to be a stockholders' meeting, and time was of the essence in this type of transaction. There had to be a simultaneous exchange of checks and securities. It could not be 100 percent simultaneous, because you would have had to have the new board before you could authorize taking out the portfolio for the new owners, but it was so close to being simultaneous that the whole thing could be done in an hour.

If you had to call a meeting of the stockholders to approve this it would mean that whoever put up that money to pay for the controlling stock would have had to wait for days and weeks, and in addition, with that first provision about the change of investment, would have had to take a chance of the stockholders approving the change in investment policy, and in addition to that, would have had to incur the publicity.

Senator WAGNER. The publicity is very important, too, is it not? Mr. FULTON. The publicity is the most important feature.

The third provision I had in mind is section 17, on page 36, which refers to the purchase and the sale of securities between the investment trusts and those affiliated with it.

In each instance you can see that they sold securities to the investment trust and they purchased from the investment trust. Under section 17 they could not have done that without these attendant safeguards and attendant publicity.

For those reasons, I am sure that, whatever may be the merits or demerits of the bill generally, these particular frauds could not have been consummated.

Senator WAGNER. Mr. Fulton, you have had a chance to examine the charters of some of these organizations about which you have testified?

Mr. FULTON. I have.

Senator WAGNER. Is there any limit as to what their activities. can be in relation to business transactions?

Mr. FULTON. Of course, it would be impossible to say there is no limit, because it is not infinitive, but, as you know, as a lawyer, those charters contain page after page of the most broad general powers, so that the investment trust could buy, sell, and exchange almost anything for almost any purpose. The only limit that I know of is the limit that at some point either someone like Mr. Cook or someone like the prosecution authorities would step in and say that "You have definitely done this with knowledge and intent to defraud the investment trust and not simply with mistaken business judgment." That is the only limit I know of.

Senator WAGNER. Of course, we do not want to have it understood that all investment trusts are of this type. There are very excellent investment trusts.

Mr. FULTON. There are, and in addition to that, the investment trust is a very desirable instrumentality for enabling the small investor to spread his risk, and as such should be given real consideration. Senator WAGNER (chairman of the subcommittee). Thank you very much.

I think that we will take a recess until tomorrow morning at 10:30. (Thereupon, at 12:35 p. m. an adjournment was taken until tomorrow, Thursday, April 4, 1940, at 10:30 a. m.)

INVESTMENT TRUSTS AND INVESTMENT COMPANIES

THURSDAY, APRIL 4, 1940

UNITED STATES SENATE,

SUBCOMMITTEE ON SECURITIES AND EXCHANGE

OF THE BANKING AND CURRENCY COMMITTEE.
Washington, D. C.

The subcommittee met, pursuant to adjournment on yesterday, at 10:30 a. m., in room 301, Senate Office Building, Senator Robert F. Wagner presiding.

Present: Senators Wagner (chairman of the subcommittee), Maloney, Hughes, Miller, Downey, Townsend, and Frazier.

Senator WAGNER. The subcommittee will come to order. We will hear Mr. Carl S. Stern.

STATEMENT OF CARL S. STERN, ATTORNEY, SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, D. C.

Mr. STERN. Mr. Chairman and gentlemen of the subcommitteeSenator WAGNER (interposing). I think you had better give your full name. As I understand it you have been one of the special attorneys who have studied the investment trust matter on behalf of the Securities and Exchange Commission, or appointed by them for that purpose.

Mr. STERN. Not quite, sir. My name is Carl S. Stern. I am one of the legal staff of the Securities and Exchange Commission. I was called into this Founders study after the preliminary work of investigation had been done, and I conducted the public hearings. I make this explanation because I do not want to come under any false representations, I wanted to keep within the limits of my connection with the investment trust study, for I merely conducted the hearings in connection with the Founders study. I had no part in the preparation of the reports, except a very tiny one-of reading them over and making suggestions. But I have recently refreshed my recollection so as to re-present this story very much abridged to the committee here. Senator TOWNSEND. You had no part in the preparation of the reports as I understand you?

Mr. STERN. A very small part, that of reading them over to revise them, or to suggest revision here and there. My work was entirely with other parts of the matter. As I have said, I conducted the hearings, and am fully conversant with the facts.

Senator WAGNER. And what you will tell us is in connection with your conduct of the investigation?

Mr. STERN. Yes.

Senator WAGNER. And the facts themselves?

Mr. STERN. That is correct. I was assigned to this from another branch of the Commission, and my part in it was limited to what I have said. I wanted to make that clear to the members of the subcommittee for the very good reason that I do not know as much about the general investment trust study as do a great many other men here, and my knowledge is more or less confined to the Founders system, to what I discovered there.

Senator WAGNER. Tell us about that.

Mr. STERN. In order that you might have some idea of this complex situation we have had these charts prepared, which give you the appearance of the Founders group as that group existed in 1929. This story is quite a different story from that already told to the members of this subcommittee; this is not a story where there was gross or crude fraud. This is a case in which the techniques, such as were used, were refined and which was the art rather of the prospectus writer and the skill in manipulation rather than in crude handling. However, the results for the stockholders were even perhaps more detrimental than in some of the cruder cases.

Senator TOWNSEND. Your first heading states that the United Founders Corporation was formed in February of 1929, and that the capital raised was $301,741,000. Will you state how that capital was raised?

Mr. STERN. Yes, sir; but I did not want to bother with this chart at this time; rather than go into the details just at the moment I wanted to give you the general picture. I will take it up from time to time, and will start at the beginning. The story of Founders starts out with two men and $500. It starts in 1922. One man put in $500, and the other man was a bankrupt, recently discharged from bankruptcy.

Senator TOWNSEND. Who were they?

Mr. STERN. They were William R. Bull and Christopher F. Coombs. From this small beginning, in 7 years the group had become the largest group of investment companies under a single control in this country, or as far as the investment-trust study disclosed, anywhere in the world.

By 1929 the capital paid into the 13 companies shown on that chart by the public exceeded $500,000,000.

Now, so that the subcommittee may get some appreciation of what this $500,000,000 amounted to in comparison with other concerns handling investment funds, I should like to state briefly that there are 564 principal savings banks in the country, and that only one of them exceeded that figure, and that is the Bowery in New York City, and the Bowery's resources as of January 1, 1939, were $583,000,000; that out of 14,931 commercial banks and trust companies in the United States, only 16 had resources in excess of $500,000,000; that of the 306 leading life insurance companies, only 12 showed total assets exceeding $500,000,000. So that of all these savings banks, commercial banks, trust companies, and life insurance companies in the country, only 29 had assets as great or greater than Founders had at its peak.

Looking at it from another point of view, in the six Southern States of North Carolina, South Carolina, Georgia, Florida, Alabama, and Mississippi, the total savings in savings institutions, including postal savings, savings banks, and commercial banks, were $484,000,000.