The Pecora Commission: The Hearings That Built the SEC, 1932–1934

On the morning of 21 February 1933 a former assistant district attorney from Manhattan asked Charles E. Mitchell, chairman of the National City Bank of New York, what he had been paid in 1929. Mitchell had come to Washington expecting to defend his bond department against loose accusations and to be home by the weekend. He answered, and was asked again, and asked about the arithmetic behind the answer, and four days later he resigned. Outside the hearing room the American banking system was in its last week of operation. Michigan had closed its banks on 14 February, Maryland followed on 25 February, and by 6 March every bank in the country would be shut under presidential proclamation.

Ferdinand Pecora was fifty years old, born in Nicosia in Sicily and brought to New York at five, a chief assistant district attorney for New York County through the 1920s who had prosecuted bucket shops and lost a bid for the top job in 1929. He had been hired the previous month at $255 a month to wind up a Senate investigation that three earlier counsels had failed to move. Instead he ran it for fifteen months, produced roughly 12,000 pages of printed testimony, and supplied the factual record on which three federal statutes and one new agency were built.

A Resolution Herbert Hoover Wanted

Senate Resolution 84 passed on 4 March 1932, and its original purpose had almost nothing to do with what it became. Hoover was convinced that bear raiders were driving down share prices and delaying recovery, and he wanted the Senate Committee on Banking and Currency to expose short sellers. Peter Norbeck, the South Dakota Republican who chaired the committee, was a road contractor by trade with no particular expertise in securities. His first counsel resigned. His second, the Philadelphia lawyer William A. Gray, spent the spring of 1932 chasing the short-selling theory and found that the bears had been a symptom rather than a cause.

By the autumn of 1932 the inquiry had stalled and the committee was about to expire with the Congress. Norbeck, who had lost his own seat, wanted one more attempt and needed counsel willing to work for a clerk's wage on a mandate expiring in March. Pecora took it on the understanding that he would write a final report and close the file.

He read the record instead. What he found in the National City Company's underwriting files persuaded him that the committee had been investigating the wrong end of the market — not the men who sold shares short in 1930 but the institutions that had manufactured and distributed the securities in the first place. Michael Perino's account of the hearings traces how completely the inquiry's centre of gravity shifted in those six weeks, from a search for saboteurs to an audit of the distribution machine (Perino, 2010).

Sunshine Charley

Mitchell was the archetype of the salesman-banker. Under his direction National City had built a retail securities force of some 350 salesmen operating out of branch offices in more than fifty cities, selling bonds to depositors who had walked in to open savings accounts. His bank's securities affiliate, the National City Company, had been organised in 1911 precisely because national banks were barred from dealing in securities directly, and it operated as a separate corporation owned by the same shareholders through a trust arrangement.

Pecora's questioning established a sequence of facts that no amount of later argument dislodged. Mitchell had drawn more than $1 million from the bank's management fund in 1929 alone, and roughly $3.5 million across 1927 to 1929, at a time when the fund's payouts were computed on profits that included gains from selling the bank's own stock. In late 1929, with National City shares collapsing, he sold 18,300 of them to his wife at a price well below his cost, booked a loss of about $2.8 million, and paid no federal income tax for the year. He bought the shares back from her afterwards. The transaction was, on the tax law then in force, defensible. As testimony it was fatal.

There was worse in the bank's treatment of its own staff. After the crash National City advanced some $2.4 million in interest-free loans to officers whose personal holdings of bank stock had been wiped out — the so-called morale loans — secured by the same worthless shares, with repayment never seriously pressed. Depositors who had bought National City stock on the salesmen's advice received no such accommodation.

Mitchell resigned on 26 February 1933. He was indicted for tax evasion, tried, and acquitted in June 1933 on the ground that the sale to his wife had been a real transaction; the government pursued him in civil proceedings for years afterwards and eventually collected over $1.1 million.

Peru at Five Cents

Compensation made headlines. What mattered more for the shape of the eventual legislation was Peru.

Between 1927 and 1928 the National City Company underwrote and sold to American investors roughly $90 million of Peruvian government bonds in three issues. Pecora produced the firm's own internal credit assessments. Victor Schoepperle, a National City vice-president who had surveyed the country, had written that Peru represented "an adverse moral and political risk" with a bad debt record and chronic fiscal disorder. The bonds went out to the public regardless, marketed through the same branch network that sold savings certificates. By the time of the hearings Peru had defaulted and the paper traded near five cents on the dollar.

The committee also drew out that National City interests had paid some $450,000 to Juan Leguía, son of the Peruvian president Augusto Leguía, during the period the loans were being arranged. A second episode involved the bank's Cuban sugar exposure: rather than write off about $25 million of uncollectable loans, National City organised the General Sugar Corporation to hold them, keeping the loss off the bank's published balance sheet and out of the shareholders' view.

Two structural conclusions followed from this material, and both found their way into statute. A bank that both lends and distributes securities has a standing temptation to refinance its own bad loans by selling bonds to its depositors. And an investor cannot price a security whose issuer's condition is known to the underwriter and to nobody else.

The House of Morgan Under Oath

J.P. Morgan Jr. appeared on 23 May 1933, the first time the head of the firm had submitted to public interrogation. He read a prepared statement whose central sentence was a defence of an institution rather than a transaction: "I state without hesitation that I consider the private banker a national asset and not a national danger."

Two disclosures overshadowed it. Morgan partners had paid no federal income tax in 1931 or 1932, having carried forward losses under provisions available to anyone; the firm had complied with the law and the law looked indefensible to a country in its fourth year of depression. Then came the preferred lists. In the 1929 offerings of Alliance Corporation and Standard Brands, Morgan had allocated stock at issue prices far below the level at which the shares immediately traded, and the allocation went to a roster of names that included Calvin Coolidge, the sitting Supreme Court justice Owen J. Roberts, Charles Lindbergh, Bernard Baruch, William Gibbs McAdoo, Newton D. Baker and John J. Raskob.

Nothing in the arrangement was illegal. The committee did not need it to be. A market in which favoured buyers receive an issue at one price and the public receives it at another is not a market the public can reasonably be asked to enter, and the hearings made that proposition intuitive to people who had never read a prospectus. On 1 June a press agent placed Lya Graf, a twenty-seven-inch circus performer, on Morgan's lap while photographers worked; the picture ran everywhere, and the dignity of the House of Morgan did not survive it.

The Chase Short Sale

Albert H. Wiggin, chairman of the governing board of Chase National Bank, testified that autumn. During the crash of 1929 he had sold short 42,506 shares of Chase National stock through Shermar Corporation, one of six private companies he controlled, three of them incorporated in Canada for tax purposes. The financing came from Chase itself. He cleared roughly $4 million betting against the institution he ran, while drawing a salary of $275,000 and, on his retirement, a pension of $100,000 a year voted by his own board. He surrendered the pension in January 1934 after the disclosures.

Section 16 of the Securities Exchange Act — the requirement that officers, directors and large holders report their trades and disgorge short-swing profits, together with the ban on insiders selling their own company's stock short — is sometimes called the Wiggin provision for good reason. Joel Seligman's institutional history of the SEC traces how closely the drafting followed particular episodes in the hearing record rather than any general theory of market failure (Seligman, 1982).

Pecora took his seat as counsel with the index at 59.93, its lowest year-end reading since the 1890s and barely a fifth of the 1928 close. That number is the political condition of the whole episode. Legislation that would have been unthinkable in 1928, and merely difficult in 1930, passed in 1933 and 1934 against organised opposition from the exchanges and the investment houses because the constituency for defending existing practice had been liquidated along with its portfolios. The crash of October 1929 and the long slide that followed created the audience; Pecora supplied the script.

Three Statutes

Roosevelt sent his securities message to Congress on 29 March 1933, describing the principle in a phrase that became the standard summary of the whole programme: "This proposal adds to the ancient rule of caveat emptor, the further doctrine 'let the seller also beware.'" The Securities Act, signed on 27 May 1933, required registration and a prospectus for new public offerings and imposed civil liability on directors, underwriters and accountants for material misstatements. Administration was given initially to the Federal Trade Commission.

Three weeks later the Banking Act of 1933 forced the separation Pecora's National City material had made concrete: commercial banks were given a year to divest their securities affiliates, and the wall between deposit-taking and underwriting stood for sixty-six years. Whether the affiliates had in fact sold worse securities than independent houses became a live empirical question decades later, and the answer from the data is not the one the hearings implied — bonds underwritten by bank affiliates in the 1920s defaulted at lower rates than those underwritten by independent investment banks (Kroszner and Rajan, 1994). Congress in 1933 was legislating against a conflict of interest it had watched described under oath, not against a default rate it had measured.

The Securities Exchange Act of 1934, signed on 6 June, did the structural work. It created the Securities and Exchange Commission, moved administration of the 1933 Act to it, required registration of exchanges and of listed companies, mandated periodic reporting, gave the Federal Reserve authority over margin requirements, and outlawed the manipulative devices — wash sales, matched orders, pool operations — that the hearings had catalogued issue by issue. Richard Whitney's New York Stock Exchange fought the bill through the spring of 1934 and won concessions on self-regulation; the same exchange president was in Sing Sing four years later for stealing from customers' accounts.

Pecora was sworn in as one of the Commission's first five members on 2 July 1934, under a chairman, Joseph P. Kennedy, whose own fortune had been assembled partly through the pool operations the new agency was to police. He served six months and left in January 1935 for a seat on the New York Supreme Court, disappointed by the pace and by the appointment he had not received.

What the Record Settled

Roughly a third of the securities outstanding in the United States in 1933 had been issued in the previous decade, much of it sold by institutions whose own files showed they knew better. That asymmetry, rather than any single villain, is what the hearings documented. Vincent Carosso's history of American investment banking notes how thoroughly the profession's own defenders had relied, before 1933, on the claim that reputation alone disciplined underwriters (Carosso, 1970). The National City bond files retired the claim.

Writing in 1939, Pecora put the mechanism plainly: "Legal chicanery and pitch darkness were the banker's stoutest allies." The chicanery survived; his committee mostly took away the darkness, by requiring that facts already known inside the firm be written down where a buyer could read them. That is why the reforms of 1933 and 1934 were built on disclosure and registration rather than on approval or licensing, and why a disclosure regime devised for a market of pool operators and bucket shops still governs an electronic one.

The broader wave carried further than securities law. The collapse of Ivar Kreuger's match empire in March 1932 and the audit that followed it supplied the argument for independent certified accounts, which the 1933 Act made compulsory. Samuel Insull's utility pyramid, examined in a parallel Federal Trade Commission inquiry, produced the Public Utility Holding Company Act of 1935.

Norbeck's committee had been convened to find the men who sold America short. It found instead the men who had sold America the securities, and the difference between those two investigations is the difference between a search for scapegoats and a functioning regulatory state. Pecora's fee for the work came to less than a single day's interest on the Peruvian bonds his questioning had exposed.