[As longtime LHB readers know, I post here the essays I research and write for my exam in American Legal History, which principally treats the years 1898 to 1962. The first treats some topic in the history of regulation that we did not cover in class but which raises analogous issues, especially judicial review of agency adjudications. For earlier ones, start here. This year's was on blue-sky laws, with just a glimpse of New Deal securities regulation and the Hughes Court. DRE]
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| Joseph Dolley (wiki) |
Shortly after 1900, Joseph Dolley, Kansas’s state banking commissioner, noticed that the state’s residents, dissatisfied in an inflationary time with the interest on savings accounts in commercial banks, were purchasing the exceedingly dubious securities of newly formed corporations, “beautifully engraved or lithographed certificates of stocks and bonds, which soon proved to be worthless.”
The common law already proscribed fraud, the affirmative misstatement or active concealment of facts, but a common-law cause of action was not much help to buyers of stocks and bonds. With “cunning innuendo,” dealers tiptoed up to the line of fraud without crossing over. Individuals could not afford the cost of proving the falsity of claims about the condition of business entities incorporated elsewhere. Further, as a judge observed, courts could act only after the fact; a common-law cause of action could “in no wise act as a preventative.”
Thus, to save Kansas’s widows and orphans from throwing their money away on securities backed by nothing more than “so many feet of blue sky,” in 1911 Dolley persuaded the state legislature to pass the first of what became known as “blue-sky laws.” Before the nation’s major investment banks knew it, half the states had adopted a similar one by 1913. Almost all states had some kind of blue-sky law by 1931.
Defenders of blue-sky laws acknowledged that Americans’ “inheritance from our Anglo-Saxon origin” included the principle that an “individual citizen shall regulate his own affairs with the least government possible.” Even so, individuals did not have “untrammeled liberty” to do what they pleased, because their liberty was “limited by the rights of others and by the public welfare.” The state could pass laws to promote the public welfare even if they “circumscribe[d] the freedom of contract.” And although the state could not prohibit honest businesses, it could subject them “to such a degree of control as may be necessary to ascertain that [their transactions were not of] a fraudulent character.” That is, it could make even an honest business bear “some burdens in order that dishonest business may be regulated or entirely prohibited.”
Not only could the state legitimately regulate sales of securities, proponents argued; it should. “Modern conditions have become so complex that it is not only impracticable but even impossible for the investor to investigate the merits if any” of many securities, a treatise writer claimed. Because only “the most skillful and informed” could evaluate securities, “the doctrine of caveat emptor” did not apply. An Iowa judge agreed. Blue-sky laws were needed “to protect the humble, honest citizens of the state, unlearned in the intricacy of business affairs as being conducted at this day, from being plundered and despoiled of their small earnings” by the “unscrupulous, cunning and deceitful.” Such investors “could not afford to go to the expense of having an independent audit and appraisal made, even if they had thought of such a thing.”
Blue-sky laws took several forms. Almost all states passed “dealer-licensing” acts, which required dealers of stocks, bonds, and other securities to obtain licenses, which they could keep only so long as a designated government official found that they were not of “bad business repute.” But almost all states also passed “specific-approval” acts, which required blue-sky administrators to assure themselves of the legality of particular issues of securities. “First-generation” specific-approval acts, including the original Kansas statute, required issuers to show that a stock or bond would provide investors with a “fair return.” Thus, as Stuart Banner has observed, “before anyone could sell stock in Kansas, they would have to persuade Joseph Dolley and his staff that the stock was a sound investment.”
Investment bankers quickly mounted a political and legal campaign against the “first-gen” specific-approval laws. All investments entailed risk, they observed. Further, no state official could predict whether new business ventures would produce “a fair return.” They countered that the real purpose of the laws, as Nebraska’s blue-sky administrator incautiously said, was to create legal obstacles to sales within a state of the securities of “any eastern financial house.”
The investment bankers successfully challenged the first-gen laws in a series of lawsuits in Federal District Court. The Doyle decision, for example, involved a Michigan law that empowered a commission to forbid the sale of securities if it thought that a company’s business plan was not “fair.” “Broader and vaguer language could not be chosen,” the federal judge protested. The law “subjects to the practically uncontrolled discretion of the Commission every issue or general sale of stocks, bonds, or securities hereafter to be made in Michigan.” In response to such decisions, Michigan and other states adopted “second-generation” specific-approval acts, under which officials could only prohibit the sale of securities if they were fraudulent–with “fraud” defined in traditional, common-law terms. Even Kansas replaced its first-gen law with a second-gen one.
But if the investment bankers hoped to restore laissez faire in all its rigor, they failed. In Hall (1917), and two companion cases, with only Justice McReynolds dissenting, the Supreme Court rejected various constitutional challenges to dealer-licensing and second-gen specific-approval statutes. Such laws did not violate the liberty of contact guaranteed by the Due Process Clause of the Fourteenth Amendment, Justice McKenna wrote for the majority. Although the “essence of liberty” was “freedom of conduct,” sometimes that freedom had to “yield to the public welfare.” In Hall, McKenna specifically defended Ohio’s dealer-licensing law, under which dealers had to persuade the blue-sky administrator that they were of “good business repute.” The dealer argued that this language vested the administrator with “purely personal and arbitrary power.” McKenna disagreed. “Reputation and character” may be hard to define, he allowed; still, many administrative agencies found facts under comparably open-ended standards. Besides, “the statute provides for judicial review.”
In Hall, judicial review took the following form. A dealer who had been denied a license filed a petition in the Court of Common Pleas for the county containing Columbus (Ohio’s state capital) detailing his qualifications and asking for a reversal of the denial. The blue-sky administrator then filed an answer stating his grounds for denying the license. Thereafter, the case proceeded as “usual in civil actions.”
In most other states, a different, more administrative procedure prevailed. Dealers who were denied a license or whose securities were deemed fraudulent received a notice to that effect and a hearing before the blue-sky administrator. At the hearing, the dealer could be represented by an attorney. Testimony was taken for the record, and witnesses were subject to cross examination. Then the administrator made the statutorily required finding–say, that the dealer was of bad business repute or that one of his transactions was fraudulent.
Dealers who lost before the administrator could appeal to a state appellate court. In Abrams (1922), an intermediate appellate court overturned the order of California’s blue-sky administrator suspending a dealer’s license on the ground that a security he offered was fraudulent. The court first faulted the administrator because his notice to the dealer “contained no charges of any nature and nothing from which [the dealer] could ascertain what he would be required to defend.” The court then conducted its own review of the record and found that the evidence–a single witness’s testimony–did not establish that any of the dealer's statements were false or that anyone had relied upon them. In reaching its conclusion, the Court invoked a common-law principle: whoever “seeks relief from fraud must allege it and prove it by clear and satisfactory evidence.”
As blue-sky administrators perfected their procedures, reviewing courts treated their findings of fact more deferentially. In Hardstone Brick (1928), for example, the Minnesota Supreme Court upheld the blue-sky administrator’s finding that the sale of stock for a brickmaking company whose incorporators had no experience in the business “would operate as a fraud on the purchasing public.” Although not all of the evidence the administrator heard would have been admissible in a jury trial, the Court saw “ample evidence” in the record sustaining the administrator’s finding. Similarly, in Investment Reserve (1927), the Michigan Supreme Court upheld the refusal of a blue-sky administrator to license the sale of bonds because he found, after, “a full and protracted hearing,” that they were “likely to work a fraud upon the public” for two specific reasons. If the record contained “evidence tending to support the [administrator’s] conclusion,” the Court announced, “its order is not to be disturbed, unless the evidence is found overwhelmingly convincing to the contrary. We cannot so find in this case.”
The greater deference of courts did not alarm major investment bankers, however, because by the end of the 1920s they had already persuaded state legislatures to write exemptions covering their securities into the blue-sky laws. For example, securities that were already listed on a stock exchange were exempt, as were those of businesses regulated by public utility commissions or by federal banking regulators. In 1911, Dolley had promised that his blue-sky law would keep “Kansas money for Kansas investments.” By 1929, blue-sky laws seemed to be doing almost the opposite. Only novice entrepreneurs or small businesspeople, it seemed, had their securities rejected. Critics charged that the blue-sky laws had made it “impossible for young industries to finance themselves” and claimed that they were allowing “big interests” to “monopolize” American industry.
Some wondered if the laws were doing anything at all. “The effectiveness of blue-sky laws depends absolutely on the vigilance, the energy, and intelligence of their administrator,” a commentator observed, but many administrators lacked sufficient training in finance. In Nebraska, for example, the job of administering the state’s blue-sky law fell to the same official who inspected rights of way for the state railroad commission. Even competent administrators could be turned out of office if a new governor needed to make a patronage appointment. Bribery scandals embarrassed administrators in several states. Almost all administrators lacked adequate funding. In some states, administrators gave up investigating dealers and simply asked them to provide letters of reference.
The Stock Market Crash of 1929 renewed calls for the federal regulation of securities. The version adopted during the Hundred Days, the Securities Act of 1933, differed significantly from blue-sky laws. Drafted by Felix Frankfurter’s proteges and defended by Frankfurter himself, the act did not require an official to determine whether a security was fraudulent. Instead, it required an issuer of a new security to file a registration statement disclosing many facts about the business entity with the FTC (originally) or (from 1934 on) the Securities Exchange Commission. No security could lawfully be sold until the registration statement took effect, which happened twenty days after the issuer filed the statement, unless the SEC acted first. The SEC did so by commencing proceedings to issue a “stop order” on the grounds that the registration statement contained untrue statements of material facts or omissions of material ones.
In 1935, J. Edward Jones filed a registration statement for a kind of security called a trust certificate which gave investors a share in the royalties from certain oil wells. Nineteen days after the filing, the SEC notified Jones that it was commencing proceedings for a stop order and issued a subpoena requiring him to bring financial records to a hearing. Before that hearing could take place, however, Jones withdrew his registration statement. The SEC insisted on the proceeding nonetheless and sued to enforce the subpoena. The case arrived at the Supreme Court in 1936, the same term in which the Court struck down the AAA in United States v. Butler and a state minimum wage law for women in Morehead v. New York ex. rel. Tipaldo.
Lawyers in the office of Solicitor General Stanley Reed feared that the Court would invalidate the Securities Act on constitutional grounds, but when it announced its 6-3 decision, in an opinion by Sutherland from with Brandeis, Cardozo, and Stone dissented, its grounds were procedural. Jones had an unqualified right to withdraw his registration statement, the Court ruled, and, after he withdrew it, the SEC could no longer subpoena his records.
The SEC’s power over Jones could not be greater than that “exercised by judicial tribunals of the land under similar circumstances,” Sutherland announced. Plaintiffs in federal courts had the unqualified right to dismiss their complaints unless the defendant would be prejudiced–which, Sutherland claimed, was not true for the SEC in Jones’s case. The SEC’s “wholly unreasonable and arbitrary” position, he charged, would subject Jones to “the mere will of an official” rather than “the standing law as a rule of human conduct.” Administrative agencies were necessary, but they must not be “permitted gradually to extend their powers by encroachments–even petty encroachments–upon the fundamental rights, privileges, and immunities of the people.” If agencies were so permitted, Sutherland warned, Americans would ultimately “become submerged by a multitude of minor invasions of personal rights,” and government would cease to be “one of laws.” Sutherland saved his worst epithet for last: The SEC’s continued enforcement of its subpoena was on a par with the “intolerable abuses of the Star Chamber.”
“Sutherland writes as though he were still a United States Senator, making a partisan speech,” Felix Frankfurter complained. That Chief Justice Hughes joined Sutherland’s opinion, Frankfurter added, was “saddening and incomprehensible.”
[Sources. Primary: John M. Elliott, Annotated Blue Sky Laws of the United States (W.H. Anderson, 1919); James A. Gross and Richard W. Brown, “Administrative Powers under Blue Sky Laws,” St. Louis Law Review 16 (1931): 141-147; Keyes
Winter, “State Regulation of Corporations by Policing Securities,”
Annals of the American Academy of Political and Social Science 129
(1927): 149-155; “The Control Exercised over the Issuance of
securities under the Nebraska Blue Sky Law,” Nebraska Law Bulletin 11
(1932): 148-175. Secondary: Jonathan R. Macey and Geoffrey P. Miller, “The Origin of Blue Sky laws,” Texas Law Review 70 (1991): 347-397; Daniel Stephen Holt, “Acceptable Risk: Law, Regulation, and the Politics of American Financial Markets, 1878-1930 (Ph.D. diss, University of Virginia, 2008); Stuart Banner, Speculation: A History of the Fine Line between Gambling and Investing (Oxford University Press, 2017).]
