RESPONSIBILITIES OF INVESTMENT BANKERS

Another characteristic of the period was the attitude which the public took toward the large underwriting houses. They were generally regarded as sponsors of the issue and the public relied to a great extent upon the prestige of the banking names over which the issue was brought out. J. P. Morgan in 1933 stated that the public was entitled to look to Morgan & Co., in his case, as its protector. How well the investment houses of that time discharged that function is a matter of record, and perhaps the less said about that the better.

However, the avoidance of legal responsibility in addition to the avoidance of moral responsibility was another matter which gave the Congress grave concern at that time. The selling group dealers in a distribution of the type that I have described were the ones that had to bear the brunt of legal responsibility for any fraud or misleading statements that had been made about the issue. It was impossible to pin responsibility on the issuer or the original underwriter of the securities because they were not the people who had dealt with the buyer. The bankers, the originating houses, were thus beyond reach in many cases.

Let me illustrate this: You will remember that one of the largest and most well-known issues that was put out during that period was one of $50,000,000 of 5 percent secured debentures of Kreuger & Toll Co. which was sponsored by Lee Higginson & Co. and other leading banking houses of the period. In that issue the indenture permitted the issuing corporation to substitute collateral for that which originally underlay the bond issue, but there were certain safeguards established in the indenture.

The first important restriction in respect of the substituted collateral was that it should constitute either securities of a government or a political subdivision or else should consist of a first mortgage on real

estate.

Secondly, and strangley enough, it was provided that the par value— not the market value-of the substituted collateral should be sufficient to avoid any impairment of the required ratio of 120 percent of the principal amount of debentures outstanding.

The trustee under the indenture was entitled to rely on the certificate of Kreuger & Toll as to the eligibility of any substituted collateral. Shortly after the disposal of the bonds to the public, Kreuger & Toll commenced to substitute, systematically, foreign bonds of exceedingly speculative nature for the relatively sound collateral which had originally underlain the American bond issue. Although it was the continuing duty of the investment banker who sponsored the issue, as Mr. Morgan pointed out, "to see, so far as he could, that nothing is done which will interfere with the full carrying out by the obligor of the contract with the holders of the security," neither the original sponsor in this case nor the indenture trustee made any inquiry concerning the compliance of Ivar Kreuger with the requirements governing the substitution of collateral. As a result, in that case, when the Kreuger interests collapsed, the American bond issue was left with only $9,750,000 of substituted collateral instead of 120 percent of the $50,000,000 outstanding American debentures.

EXCESSIVE UNDERWRITING PROFITS

The underwriting business in the 1920's was also typified by excessive profits. The underwriters' compensation is usually represented by the spread between the price which he pays for the security and the price at which he sells it to the public. The selling group dealer in turn makes his money from buying a new security from the underwriter at a concession under the offering price to the public.

In addition, during those days, the underwriter was often granted options and other similar forms of extra compensation. Aside from the substantial spreads which many of the houses took during that period, these additional options and stock bonuses reached amazing proportions. For instance, there was the case of the issuance of the common stock of Pennroad Corporation, which was formed in 1929 by the Pennsylvania Railroad Co., Kuhn, Loeb & Co., as the banker, offered voting trust certificates for 5,800,000 shares of the stock of Pennroad. On the advice of Kuhn, Loeb & Co., the certificates were offered to the stockholders of the Pennsylvania Railroad.

Kuhn, Loeb & Co. agreed to purchase approximately 15 percent of the entire offering provided the stockholders of the Pennsylvania Railroad took up the other 85 percent. In addition to that they were granted a 4 months' option on any of the stock not purchased by the stockholders.

Furthermore they were granted an option to acquire a half million more shares at prices rising successively from $16 to $19 a share. That, I believe, was stated to be in consideration of the advisory capacity which Kuhn, Loeb occupied in the transaction. If I am not mistaken the advice which they gave consisted merely of advising them that stock should be issued rather than bonds, because the stock market was better than the bond market at the time, and secondly, that the company should not have the whole issue underwritten.

The offering to the stockholders of the Pennsylvania Railroad was very successful. Ninety-seven percent of the stock was quickly taken up by the stockholders. The underwriter's name, incidentally, did not appear on the prospectus; therefore they assumed no liability or obligation to the purchasers of the Pennroad stock. But out of this one transaction the firm realized a profit of over $2,700,000 on the half-million-share option which you will remember was given for advice. They realized another million-dollar profit on the 242,000 shares which they actually took up. Finally, they received a further fee of $1,500,000 for the original conditional agreement to purchase 15 percent, which they did not have to carry out. Thus the profitthe total profit-on the deal was $5,300,000, or slightly more than 6 percent of the total financing.

Now, there are two things to note about this example: In the first place, the banker got almost $3,000,000 for advice which was dispensed without any legal responsibility; secondly, the value, of the Pennroad stock which was held by the public had shrunk in the amount of $106,000,000 by 1933.

ARTIFICIAL MARKET SUPPORT

The speed with which large issues of securities during that period were sold was achieved only in part through the process of syndica

tion. Another device which was found necessary in order to accomplish rapid distribution was the "pegging" of the price of a security during distribution, variously known as "pegging, fixing, or stabilizing" the price. Obviously, if the price of the bonds during the offering sell below the offering price before they are completely sold, no further securities can be sold. That seldom happened during that period because the markets were almost invariably given artificial support. Various mechanisms were used to accomplish this, the best known and easiest one consisting of overselling the issue to the selling group. The originating underwriter of $10,000,000 of bonds, for instance, might sell $10,500,000, or some such additional sum, such as a half a million, or a million more than he had to offer. In other words, he would sell short. This gave him an absolutely free hand to purchase that amount of bonds, without risk to himself, in order to support the market price while the distribution was being made. I do not believe I need to mention other characteristics of the distribution processes of that kind-the ways in which the large underwriters brought pressure on the smaller members of the selling groups, for instance. Of course, that was a well-known feature and one which again insured speed in disposing of the securities at least so far as the underwriter was concerned.

Generally speaking, this system in all its aspects, assured a speedy distribution of the securities with a minimum of work and a maximum of profit to the underwriters.

Speaking again of the pegging activities, price fixing, stabilizing, and so forth, of course, in the absence of any public disclosure that device was deceptive in the extreme to the member of the buying public, because he was led to believe that the price at which he was buying and at which the bonds were generally selling in the market, was a true and accurate reflection of general supply and demand for the securities and was not influenced by the activities of the person who was selling the bonds.

In that example I gave of $20,000,000 Chile Mortgage Bank bonds, which were sold to the public at around 97, the price in that instance was pegged for 60 days. When the market support was withdrawn the price promptly dropped to 94.

Another outstanding issue of the period was the issue of $98,000,000 German bond issue floated by J. P. Morgan & Co. in 1930. The bonds were brought out at a price of 90, and for about 18 days thereafter Richard Whitney & Co., for the account of J. P. Morgan, bought $9,000,000 of the bonds in the open market to support the price while 1,000 selling group dealers were retailing them to the public. When the peg was pulled in that case, the bonds dropped from 90 to 86 and by 1932-even before Hitler-they were quoted at 35.

FALSITY AND INADEQUACY OF INFORMATION ABOUT NEW SECURITIES

Ohe result of the development of this highly successful distributive process during the period before the Securities Act was the fact that the supply of securities to underwriters began to dry up. This resulted in a frantic search by all of the underwriting houses for issues of the securities that they could sell to the public. The net effect of this search was that, very frankly speaking, as many of the witnesses

said during the hearings on the subject, securities were manufactured for sale to the public.

The National City Co. was well known in that field of activity. In fact, I employ the word "manufactured" in that sense because it was used by Charles Mitchell, the president of the National City Bank, who described the activities of the National City Co. in those

terms.

Of course, the bank underwriting affiliates were in a particularly happy position in this regard, because they had access to the depositors and customers of the bank which looked to its officials for impartial advice and guidance in investment matters.

For instance, take the National City Co.'s activities with respect to the flotation of the Peruvian bonds during 1927 and subsequent years. In 1927 it headed a group which floated the first $15,000,000 of Peruvian 7-percent bonds. The bonds were offered to the public at 962 and the banker received a gross spread of 5 points-or slightly over. However, at that very time, the National City Co. probably knew better than anybody else, because of information from its foreign representatives, that affairs in Peru were exceedingly bad; the political situation was unstable and the internal debt structure was overburdensome. In fact, just prior to the floating of that particular issue, a vice president of the National City Co. wrote a memorandum in which he stated that the Peru debt record was bad and described the financial condition of the government as-and I quote "positively distressing." There was also a further memorandum in the files of the National City Co. which stated-and again I quote "Peru bad debt record adverse moral and political risk. Bad internal debt situation."

Of course, when the first $15,000,000 was floated, no statement of this information was given to the public, in spite of the fact that it was well known to the originating house.

Again, in December of that year, the National City Co. headed a group which distributed another issue of $50,000,000 of 6-percent Peruvian bonds at the offering price to the public of 9112, and again the gross spread to the bankers was 5 points. But within 6 months prior to this second and larger issue, one of the vice presidents and, in fact, the overseas manager of the National City Bank had advised Mitchell, the president of the bank, that "as a whole," as he put it, "I have no great faith in any material betterment of Peru's economic condition in the near future," again substantiating the previous advice of one of the vice presisdents who was in Peru, I believe, at the time.

There was a good deal of information available to the National City Co. As to the nature of the population of Peru, it was known to them that it was largely Indian and that the population as a whole consumed almost no manufactured products. Yet the prospectus which was issued for the $50,000,000 issue stated without qualification that Peru had a population of 6,000,000, which was an overestimate by half a million. In fact, Mr. Hugh Baker, the president of the National City Co., admitted he doubted very much that the public would have bought these bonds had the information known to the underwriters been equally available to others.

74947-42-pt. 1- -2

Then there was a third issue in the following year, 1928, of $25,000,000 of Peruvian bonds, where again the gross spread to the underwriters was 5 points. However, in between the second and third Peruvian loans, there were no less than five communications given to the National City Co. by its officers and other employees referring to unfavorable aspects in the economic condition of Peru. On September 14, 1928, immediately prior to the flotation of this last issue, the Lima branch office cabled "we have assumed, (a) no further national loan can be safely issued, and (b) integrity Republic's finances threatened until floating-debt problem solved." None of this material was made available to the public in connection with the sale of the bonds. It is not surprising that all of these issues, amounting to $90,000,000 and held by the public, went into default

in 1933.

Mr. BOREN. Mr. Chairman

The CHAIRMAN. Mr. Boren.

Mr. BOREN. Was the pegging process used in the distribution of these Peruvian bonds also? Whatever risk the original houses took in handling these bonds was offset by their gross profits?

Commissioner PURCELL. By their gross profits; yes. Perhaps there might be other items which would go into the gross profits such as some sort of a bonus or payment for services, or something of that kind. I do not know whether that took place or not. What was your precise question?

Mr. BOREN. What financial risk did the originating houses take in the handling of these bonds?

Commissioner PURCELL. Well, practically speaking, under the circumstances under which they were issued, very little. Of course

Mr. BOREN (interposing). You mean because they had these subsidiary firms which were able to sell them to the public?

Commissioner PURCELL. That is, the selling group.

Mr. BOREN. Yes.

Commissioner PURCELL. That is one factor.

Mr. BOREN. And because of that, and because of the large amount that they had as a margin in the handling of bonds, they did not have occasion to stand any possibility of assuming the ownership of these bonds themselves.

Commissioner PURCELL. Well, unless some violent upheaval had taken place while the bonds were still in their possession, during the period after the bonds had been bought by the National City Co. and before they had been sold to the dealers, there would be no risk whatsoever. Of course, there was a possibility of loss-they must have known it, because they had their information about the situation in Peru--there was a possibility, since there was a bad political situation there, that there might have been an upheaval of some kind in the country during that period when they owned the bonds and before they had sold them.

Their job, of course, was to get the bonds to the public as rapidly as possible and with the least fanfare about bad conditions in Peru. Mr. BOREN. And, if they should happen to fail in that distributing process they would have been caught with these bonds probably at 86 as compared with 91, which was their actual investment?

Commissioner PURCELL. That is what they bought them for.