Protecting Investors (Not)

The government continually tightens and loosens its laws regarding the investment industry just as it continually raises and lowers income taxes. After each major bear market or scandalous period, the government enacts new laws to protect investors. Consider the new laws shown in Table 14-1.The securities acts passed in 1933 and 1934 followed the corporate governance problems of the late 1920s, the 1929 stock market crash, and the beginning of the Great Depression. The Investment Company Act and the Investment Advisors Act of 1940 followed a bear market that diminished the value of the stock market by 25 percent. The late 1960s experienced a 30 percent bear market. In 1970, the government created the Securities Investor Protection Corporation (SIPC). Investor protection laws also followed the bear market of the early 1970s and the Black Monday market crash of October 19, 1987. And, of course, the recent corporate scandals combined with the severe stock market decline spawned the 2002 Public Company Accounting Reform and Investor Protection Act.

Unfortunately, the laws that are enacted to protect shareholders and investors are often repealed during times of economic strength and stock market euphoria. The 1920s and the 1990s had many similarities. Both decades experienced strong economic expansions and powerful bull markets. Indeed, investors at the end of each decade could have been called irrationally exuberant. In the middle (or toward the end) of the excitement over stocks, the government changed its laws that protected investors.

Consider the examples in Table 14-2In 1927, the stock market was close to the end of a bull market that increased values more than 200 percent. There were many new companies conducting IPOs that were not really strong enough to be offered to investors. Investors did not seem to care and rushed in to snap them up. The commercial banks were prevented from getting into the investment banking activities and sharing in the lucrative fees. They lobbied the government to change the rules and succeeded. Commercial banks began helping companies issue securities. Unfortunately, the stock market crash of 1929 left commercial banks with many losses that jeopardized people's bank deposits. The people panicked and demanded their money back. Of course, banks did not have the cash to return all of the deposits at once because the cash was loaned out. The banks therefore had to close their doors.

Table 14-1. Major Laws Created to Protect Investors

Act	Purpose	Preceded by
1933 and 1934 Banking Act and Securities Exchange Act	Separates commercial and investment banking; creates SEC as market regulators	Stock market crash of 1929 and ensuing bear market removes nearly 90% of Dow value
1940 Investment Company Act and Investment Advisors Act	Regulate investment companies and advisors	Market decline of 25% from October 1939 to May 1940
1970 Securities Investor Protection Act	Creates Securities Investor Protection Corporation and insurance from broker defaults	Market decline of 30% from April 1969 to June 1970
1974 Employee Retirement Income Security Act	Regulates pension funds	Long bear market from December 1972 to September 1974 takes the Dow down 40%
1988 Insider Trading and Securities Fraud Enforcement Act	Increases penalties and liabilities for insider trading and fraudulent activities	Stock market crash of 1987 takes Dow down more than 40%
2002 Public Company Accounting Reform and Investor Protection Act	Increases regulation of auditors , lengthens punishment for white- collar crimes, and creates more corporate fraud laws	Two-and-a-half-year bear market reduced Dow by 35%; Nasdaq declines 75%

Table 14-2. Repeals of Some Investor Protections

Action	Purpose	Preceded by
1927 Government agency policy allows commercial banks to issue securities	Allows commercial banks into investment banking activities	Stock market rose more than 200% from 1925 to 1928
1995 Private Securities Litigation Reform Act	Limits the ability and available damages of investors suing for corporate fraud in federal courts	Dow increased 60% from 1993 to 1995
1998 Securities Litigation Uniform Standards Act	Precludes plaintiffs from bringing securities actions to state courts	Dow increased 125% from 1996 to 1999
1999 Financial Services Modernization Act	Allows commercial and investment banking activities to be combined	Dow increased 125% from 1996 to 1999

Now, examine the three law changes in the 1990s. The Private Securities Litigation Reform Act limited the ability of investors to sue companies and executives for damages due to corporate fraud in federal courts. This law was enacted in the midst of a strong bull market that increased the value of the Dow Jones Industrial Average by 60 percent. It was followed three years later with a similar act that applied to state courts. The Financial Services Modernization Act allowed commercial banks to associate themselves with investment banks again. This is similar to the 1927 capitulation. Again, this reduction in investor protection occurred toward the end of a market rally that increased the Dow by 125 percent.

Another recent example is not listed in the table. In 1997, the SEC proposed new rules that would have severely limited the ability of shareholders to introduce corporate resolutions . The procedure for the SEC to enact a new rule is that the regulator proposes a new rule and then provides a time period in which people can comment on the rule. A consortium of investor activists lobbied strongly against the proposed rule. In the end, the SEC decided not to enact the new limitations. Even though the new limitations were defeated, they are an example of how investor protections are often reversed or limited during an extended bull market.

Our point is that laws are frequently made to protect shareholders and investors. This usually occurs after people become angry over scandals and a bear market. However, these protections can also be reversed in the midst of good times. A strong economy and a good bull market lead to pressure being put on lawmakers to loosen restrictions on corporate participants . The loosened restrictions have the potential to help push the stock market from a bull market to a bubble market. When a bubble occurs, a crash will inevitably follow. This leads to more scandals and more investor protection laws. We need to avoid this cycle. Yet, the social mood can be represented by stock prices. The level of the stock market indicates what kind of mood the people are in. This dictates the tone and character of the resulting action by government, regulators, and investors. ^[1] The relationship we show between how the stock market has performed and the resulting legislation illustrates this point.

It also doesn't help that lawmakers and regulators are so tightly tied into the business community. We have already detailed how President Bush and Vice President Cheney have been criticized for their own behavior as a corporate board member and as an executive, respectively. Former SEC Chairman Harvey Pitt was a corporate lawyer before taking on the role of chief regulator. In addition, the accounting profession contributed nearly $7 million to national political campaigns during the 2001 “2002 election cycle (data available through July 2002). ^[2] The top three individual recipients of this money were Charles Schumer (D “Senate), Michael Enzi (R “Senate), and Max Baucus (D “Senate), who received $75,000, $59,000, and $49,000, respectively. In the presidential election cycle of 1999 “2000, George Bush received $1,100,000, Al Gore $400,000, and Bill Bradley $352,000 from the accounting profession. Both political parties accept big contributions from participants in the corporate system.

The accounting profession is not even a big contributor to political campaigns compared to other participants in the corporate system. Securities firms and investment banks contributed $34 million, lawyers and law firms contributed $50 million, and businesses contributed $75 million in the 2001 “2002 election cycle. With this kind of money flowing to political campaigns, it is no wonder that there is a cycle of strengthening and reducing investor protection laws. After scandals, politicians listen to the anger of the voters and pass tough laws to protect investors. When the next good economic period arrives with a strong bull market, voters focus their attention elsewhere. Then these big contributors get a politician's ear and laws are passed that are more advantageous for the business participants.

Or, take the IPO process. Chapter 7 discusses how investment banks used hot IPOs as a carrot to get companies to use their investment banking services. That is, a bank would allocate a large number of shares of a popular IPO company to executives of a company that might be issuing its own securities in the near future ”a tactic called spinning. The grateful executives would be more likely to hire the bank to underwrite their own issue. But investment banks don't just allocate IPO shares to company executives. They also allocate scarce shares to celebrities and, yes, politicians. All of the IPO shares that go to these VIPs mean that it is more difficult for the average investor to get these shares.

Indeed, the very lawmakers who investigate this investment banking practice have also flipped their own IPOs. For example, Senator Barbara Boxer, a member of the Senate Commerce Subcommittee, received five IPO allocations in 2000 that earned her thousands of dollars in profits. ^[3] The Senator (or her husband) was able to purchase stock from one such IPO, Avenue A, for $24 per share and sell it the next day for $72 per share.

Other lawmakers investigating investment banks participated in the IPO market as well. Some of these people claimed that their broker made their investment decisions for them. Others claimed that they received no special treatment. We are not suggesting that Senator Boxer, or any other politician, has done anything illegal. However, having people who are themselves privileged investigate spinning is not as comforting as a Senate investigation could be. This is just one more reason for investors to be less than ecstatic when politicians try to argue that they truly want to change the system.