When investing, it is wise to examine some of the early experience of investment com­panies and money making scams that have been in action. For one thing, this gives us the reasons for federal regulation and its importance to investors.

A few investment companies were organized in the United States before World War I. Although investment companies in the United Kingdom were well established, it must be remem­bered that until World War I the United States was a debtor nation, and the number of holders of common stocks was rela­tively small. Not until the great bull market of the twenties was well under way did the investment company idea take hold here.

When investment companies began to raise funds, the rush to buy soon developed into a stampede. Without going into de­tails, we may note that by the end of 1926 there were about 160 investment companies of various kinds with assets of about $1 billion. Growth was rapid: 140 new companies were formed in 1927; 186 in 1928. By 1929, the rate of formation was one every business day; assets at the end of the year were valued at over $7 billion. The amount of new capital raised by investment companies in 1929 was about $1.5 billion. Undoubtedly, pur­chases by investment companies contributed substantially to the rise in stock prices during the last three years of the bull market, which ended in 1929.

Some of the bizarre episodes and unsound practices, which characterized the period, occurred because of the very sound­ness of the investment company principle. Investors and bankers alike became careless in their over enthusiasm. Standards of disclosure and ethics were not what they are today and money making scams were abroad. Most serious defects and abuses, by and large, have been corrected by statute and by self-regulation, so that we need present only a brief outline of dubious or reprehensible practices.

THE EVILS CONDEMNED

The evils and money making scams enumerated in the findings and declarations of policy of the Investment Company Act (see Chapter Three) describe the practices, which affected investors adversely. One may add that there is evidence to support the language used in the Act:

1. Investors were without adequate, accurate and explicit information, fairly presented, concerning the character of the securities and the circumstances, policies and financial responsibility of investment companies and their management;



2. Investment companies were organized and managed in the interest of officials and affiliated persons or under­ writers, brokers, or dealers; or in the interest of special classes of security olders or others rather than in the interest of all classes of security holders;



3. Investment companies issued securities containing in­ equitable or discriminatory provisions or failed to pro­tect the rights of security holders;



4. Control of investment companies was unduly concen­trated through pyramiding or inequitable methods of control or control was inequitably distributed, or in­vestment companies were managed by irresponsible persons;



5. Investment companies employed unsound or misleading accounting methods and were not subjected to adequate independent scrutiny;



6. Investment companies were reorganized or changed the character of their business, or the control or manage­ment was transferred without the consent of the security holders;



7. Excessive borrowing and the issuance of excessive amounts of senior securities (leverage) increased un­duly the speculative character of the junior securities of investment companies;



8. Investment companies operated without adequate as­sets or reserves.

How regulation and present practices prohibit or eliminate these abuses and money making scams the next chapter shows. It is difficult to recapture the mood of a period but simple, with the aid of hindsight, to adopt a condescending air now that the entire environment has changed. Investment companies were not unique in a financial world that had lost its bearings.

SOME CASE HISTORIES

Here is a comparatively simple story that falls well under money making scams. An investment company was organized by a brokerage and investment-banking firm. Before the public offering the sponsors issued to themselves gratis option warrants valid for three years for the purchase of a substantial amount of stock at less than half the initial offering price to the public. The exercise of these warrants obviously would dilute the value of the stock. Almost at the inception of the company, the sponsors executed a management contract for a ten-year period, which expressly authorized self-dealing by sponsors with the investment company. The stockholders were not informed about this clause in the contract. Later, after the break in the market, the sponsors, in need of funds, sold to the investment company an unfinished and almost unrented office building, which they were constructing, charging the full amount the company had spent on the project. The investment company sold securities out of its portfolio to make the acquisi­tion. As a result, in less than two and one-half years the spon­sors benefited to the extent of some $650,000. The assets of the investment company, whose contributed capital had been approximately $3.7 million, shrank more than $2 million. A large part of the losses incurred in investments in which the sponsors were directly or indirectly interested.

A company controlled by Associated Gas and Electric Com­pany, which committed all the sins in the index of holding com­pany financial abuses, acquired control of an investment pany with a large issue of outstanding debentures. One of the protective provisions of the debentures was a "touch-off" clause by which die company agreed to maintain at all times a ratio of assets to funded debt of 125 per cent. If the ratio were at any time to fall below 125 per cent, the trustee could declare the debentures to be in default and take steps to enforce the rights of the holders. However - and here is the catch - the trustee was not required to take any action unless the holders of at least 15 per cent of the principal amount of debentures outstanding affirmatively demanded that it proceed, which was where the money making scam did its work as any money making scams find their way to do.

The asset coverage fell close to the touch-off point and im­mediately Associated Gas and Electric, through several sub­sidiaries, began feverish attempts to switch the holders into the securities of other companies in the system. It was then contended that the reacquired debentures were no longer out­standing, thus raising the asset coverage. Ultimately, Associated Gas and Electric maneuvered the situation to abrogate the touch-off clause.

One of the characteristics of the incredible era was the high, wide, and handsome use of leverage. Essentially, leverage is the use of senior securities, which have only limited rights to inter­est and dividends, in order to have additional assets working for the common stock, since junior stock receives the benefit of any increase in income or assets once the limited claims of the senior securities are satisfied. The converse, of course, is also true. The impact on the junior issues of a decline in earnings or assets is accentuated by leverage. Since the principle is still used by a few investment companies and by business enter­prises generally, a word of explanation is needed.

A simple example, applied to any investment company, is that of an enterprise with a capital structure of $1 million in 4 per cent preferred stock and $1 million in common stock. If the company were to earn 6 per cent in any year, or $120,000, on the total of $2 million of capital, there would remain after dividends of $40,000 had been paid on the preferred stock, $80,000, or 8 per cent, on the common stock. If only common stock were outstanding, the earnings would have been equiva­lent to 6 per cent on such stock. As to the effect on changes in asset values, assume the same capitalization at the outset and a 20 per cent increase in the market price of the securities owned. At the end of the year the portfolio has a value of $2.4 million. As the claim of the preferred stock remains at $1 mil­lion, the remainder of $1.4 million represents a 40 per cent increase in the value of the common stock, whereas the total assets of the company increased only 20 per cent.

Leverage is a matter of degree. It has its good side, but is a two-edged sword in a money corporation. Hence, it has been frowned on in banks and insurance companies, whose assets consist largely of securities. Leverage can be drawn so thin that the common stock soars like a fast plane and also plummets in a falling market. There are, moreover, both simple and com­plex versions of leverage. For example, if the securities owned are in turn issues of a company, which is also using leverage to an extreme, as many of the public utility holding companies did in the twenties, the leverage quality will be accelerated both ways, which unfortunately was forgotten in the promotion of investment companies. By pyramiding, or superimposing, one leverage company on another leverage investment company, a small change in the asset value of the company at the base might be reflected many times over in the asset value of the common stock at the top company hence a money making scam is able to develop.

An investment company was organized with a public sub­scription of $25 million (250,000 shares) in first preferred stock and 250,000 shares of common stock. The sponsors paid $5.1 million for 50,000 shares of second preferred stock and 750,000 shares of common stock. After deducting organization and un­derwriting expenses, there were not enough assets to meet the prior claims of the preferred stocks in the event of liquidation; so the common stock had no asset value. Four years later, the net assets accruing to the common stock had increased by $23 million, being practically all of the appreciation in the total assets of the company. On the basis of market values, the spon­sors, who retained 75 per cent of the company's voting power, had profits of some 450 per cent on their original investment; the company profited by some 28 per cent on its total capital contributed. This recalls Will Rogers's famous story of the law­yer who divided the sum he had succeeded in collecting for his client as follows: 80 per cent and 20 per cent; 80 per cent for himself, 20 per cent for the client.

ACCOUNTING PRACTICES

Accounting practices were not uniform and often were dictated by the management or had been adopted, without explicit prompting, to promote management objectives. Reports to security holders seemed to be part of a design to confuse or misinform investors about the facts. The Securities and Ex­change Commission's report contains a brief but comprehensive summary of the evidence upon which it based the statement that accountancy sometimes was transformed into an instru­ment by which abuses were perpetrated and concealed rather than exposed.1

Reports to stockholders (said the Commission) were found to be deficient in numerous respects. Some were deficient in their failure to reveal the method of computation of profits or losses upon sales of securities (i.e. whether based upon average cost; first-in, first-out; or on the identified security basis). In others, there was a deception arising from the failure to qualify the amounts of profits and losses when portfolio securities had been disposed of after a write-down. In these cases, although pro­ceeds from sales of securities were less than original cost, re­sults were characterized as profits without the qualification that they represented merely the proceeds in excess of written-down values. Likewise, trading losses were considerably understated when they were reported without the explanation that they were not based upon original cost. By a failure in some instances to publish adequate analyses, reserve accounts became instru­mentalities for covering up realized losses and for the distortion of trading results. Similarly, inadequate analyses of surplus ac­counts in published reports led to the concealment of substantial realized losses.

FIXED TRUSTS

The fixed investment trust flourished for a short time. In the two years which followed the 1929 collapse in the stock market, sales approximated $600 million. Since 1931, sales and creation of new fixed trusts have been negligible. The fixed investment trust is defined as a vehicle in which the investor acquires an undivided interest in a relatively fixed list of securities, together with certain accumulations which are deposited from time to time by a depositor corporation with a trustee, usually a bank or trust company, for the benefit of the holders of the certificates for trust shares. These certificates are in effect receipts issued in small denominations by the trustee to the depositor, who sells them to the public through dealers. Most fixed trusts were of the unit type, i.e., the deposited securities were deposited in units each identical with every other.

1 Investment Trusts and Investment Companies. Report of the Securities and Exchange Commission, 1939 to 1941.

We need not go into the details of various methods whereby the investor paid more than the indicated cost of acquisition or the degree to which trustees provided for exculpation from all liability except for acts of willful default or gross negligence. For our purposes, it is necessary only to consider briefly the fundamental defect in the very concept of the fixed trust which makes it very like money making scams. As a rule, the underlying securities could be eliminated or altered only in the event of combination, consolidation, reorganization, or sale of substantially all the property of an underlying com­pany. Others provided for a change if a dividend were reduced or eliminated.

A study published in 1937, preceding the report of the Securi­ties and Exchange Commission summarized the reasons for the decline of the so-called fixed trust or "unit-type trust." The au­thor observed that the word fixed was a misnomer from the start, since almost all the companies provided for portfolio elimination under certain conditions; the name, however, had a sales value because of the unpopularity of management com­panies.2

The unit-type company declined for several reasons, the most important of which were the continued decline in stock prices to 1932, irresponsible sponsorship, a gradual increase in con­fidence in the management type, ill-advised efforts to stimulate sales of shares by questionable merchandising methods, the inauguration of new series and the "switching" evil, portfolio eliminations and returns of capital to the investor, the decrease in distributable income and the disappearance of reserve funds, the publication of the requirements of the New York Stock Exchange, restrictive state regulation, and certain internal dis­sensions in the fixed-company field.

EARLY PERIODIC-PAYMENT PLANS

Installment investment, or periodic-payment plans, provided for relatively small payments, as low as $6 or $10 per month, by subscribers. Generally, the plans included an optional provision for life insurance. The chief abuse lay in creating the impres­sion that these plans were similar to relatively risk-free pro­grams, such as savings bank thrift plans, insurance company endowment plans, guaranteed face-amount certificate plans, and building and loan plans, all of which used periodic pay­ments, hence making them like money making scams.

The installment investment plans were directed toward the low-income groups, usually the least informed in matters of finance and investment. Often, the investor was led to believe that in ten or twenty years he would get a specified fixed sum.

2Marshall D. Ketchum, The Fixed Investment Trust (Chicago: University of Chicago Press, 1937), p. 29.

In general, the investor obtained a certificate evidencing his beneficial interest in an account to which were credited shares in other securities "underlying" the installment investment plan.

These underlying securities in turn were usually shares of an­other designated investment company.

A participant was actually an investor in the underlying shares of an investment company two degrees removed, and two sets of charges and deductions were imposed for each of the trusts. The principal, whether at the end of the life of the trust or earlier, fluctuated in accordance with changes in the market value of the common stocks in which an indirect interest was acquired, and dividends varied with the payments made by the companies whose securities were owned. The chief point to remember is that the installment investment plan, where the basic investment is in common stocks, does not give the in­vestor the position of a creditor.