(Courtesy Library of Congress )
Investment companies took root in countries where a middle class, flush with capital but lacking financial expertise, sought secure investments. The wealthy had long used trusts to capitalize a single firm and to influence its management. “Investment trusts,” pioneered in Great Britain in latter half of the 19th century, enabled the less affluent to sink capital into a range of assets selected by advisors, with diversification, rather than control, being the means of ensuring steady earnings. A late 19th century boom and bust left investment trusts with a dubious reputation, but they survived and came to America.
About 140 investment trusts were founded in the United States between 1921 and 1926. Like their European predecessors, most were “closed-end” trusts: they contained a pool of assets of different types, and if an investor wished to exit, he had to sell his trust shares on the market just as if they were stocks and bonds. Most were sold by New York-based banks or brokerages that promoted the ability to manage their funds. The unit investment trust, which contained a fixed set of securities and required no management, appealed to those skeptical of the claims of brokers and content to let the initial selection of securities dictate returns. A face-amount certificate company offered investors of limited means the ability to make installment payments in return for receipt of their capital, presumably with interest, later.
Yet another alternative was the “open-end” trust. The pioneer open-end investment companies were established by people who took the idea of trusteeship quite seriously. They were all founded in Boston, where the responsibility of preserving old merchant fortunes for future generations had traditionally fallen to individuals rather than corporations. State Street Investment Corporation, for example, was directed by Paul Cabot, bearer of one of the oldest Brahmin names. These trusts were open-end because they allowed their shareholders an exit, guaranteeing to redeem shares at a daily or twice daily-established “net asset value.” In order to provide that exit for existing investors, open-end funds always had to be prepared to sell shares to new investors.
All of these investment companies allowed average investors to diversify their holdings at a fraction of what it would have cost to invest in the market through stocks and bonds. But each came with its own liabilities as well, with the sharpest contrast being between closed-end and open-end trusts.
Of the two, open-end trusts were safer—they had more transparent capital structures, stricter custodial arrangements, and the promise of redemption at net asset value (NAV). The hazards open-end funds posed to investors resulted from the ability—and necessity—to constantly sell shares. Fund managers, for example, could sell to themselves when the market was going up and pocket the day’s profit. When redemptions rose, open-end managers resorted to high-pressure sales and misleading literature to attract new purchasers. To pay for this sales burden, open-end funds charged a markup or “sales load.”
The greater hazards of closed-end trusts stemmed from their lack of transparency. They were easily manipulated by the bankers and brokers who operated them for their own, rather than their investors, benefit. Closed-end trusts were often “leveraged,” containing senior securities for insiders and junior securities for the public, with all of the fluctuation in value coming out of the junior shares. Many open-end administrators provided only a general description of their investment strategies—which could be changed without notice—and used their funds to unload worthless stocks that were a drag on the bank’s or brokerage’s own books. Sales loads could be as high as 20 percent.3
Still, boom times could make any kind of investment trust appear to be foolproof, and an alarming number of ill-informed investors were rushing into an ever-growing market. In 1927 the predecessor to Standard & Poor’s warned of the “the ever-swelling flood” of investment trusts, concluding that while some were “competent and expertly managed,” others “were rigged up chiefly for sales purposes and to take advantage of the growing interest in investment trusts.”4 A number of states and cities agreed, launching high-profile investigations. But by 1929 new investment trusts were being created at the rate of nearly one every day and Paul Cabot warned that unless the industry learned from the example of the British boom and bust “we shall inevitably go through a similar period of disaster and disgrace.”5
When the market crashed Americans had about $2.6 billion sunk mostly in closed-end investment trusts. The share price of one of the largest, United Founders, dropped from 75 in 1929 to 1 and 3/8ths in 1931. Although the Investment Bankers Association hoped to burnish its image by pushing for the new name “investment company,” the damage caused by trusts manipulated for the good of the trustees was easy to see. The New York Stock Exchange, which had resisted listing investment trusts until mid-1929 (and then only under restrictions), imposed new requirements for independent directors. Although the problems with investment companies had come up in the hearings that led to the 1933 Securities Act and the 1934 Exchange Act, Congress opted to focus on shortcomings in corporate disclosure and conduct of exchanges first.
However, it appeared that the public was, to some extent, watching out for itself. The popularity of closed-end funds plummeted. Some disillusioned investors gravitated toward unit investment trusts, but far more opted for open-end investment companies. These Boston-based firms gained an even greater advantage over the closed-end funds after obtaining favorable treatment in the 1936 Tax Reform Act. Prior to 1936 returns from investment companies were taxed three times: once when the corporation invested in made a profit, again when the fund received its share, and a third time when the shareholder received his. The Boston firms successfully obtained “conduit treatment” providing single taxation for customers of open ended firms, called “mutual investment companies” in the 1936 legislation.6 Within a few years that lobbying ability would again be put to use, for the Securities and Exchange Commission was then preparing the way for investment company regulation.
The effort began in mid-1935, when Section 30 of the Public Utility Holding Company Act directed the SEC to undertake an investment trust study. Congress gave the SEC a year and a half: it took more than four. Supervised by SEC Commissioner Robert Healy, it was a star-crossed study: Director Paul Gourrich resigned for health reasons, and Study Chief William Spratt died midway through his work. The effort was also complicated because the investment company industry remained in flux during the late 1930s—in a sense the regulators were aiming at a moving target. But the chief explanation for the delay was that, as Healy put it, “the size and the problems of the industry proved to be much larger or more complicated than either we or Congress evidently anticipated.”7
To conduct the study the SEC assembled a sizeable staff of accountants and investment company veterans who prepared questionnaires and collated replies from 700 firms and 400 investment advisors. Field studies covered about 100 active investment companies and another 60 that had since been acquired. The SEC also conducted public examinations of 250 investment companies with $10 million or more in assets. The effort yielded 33,000 pages of transcripts, 4,800 exhibits, and a multi-volume report. The main report was submitted to Congress in four parts. Six supplemental reports followed. Perhaps the study’s most striking finding was its assessment of the damage: between the mid-1920s and March 1940 about 1,300 investment trusts had been formed—only about 650 remained in existence. All told U.S. investors had lost about $3 billion of a total $7 billion investment.8
By the spring of 1940 the SEC had drafted a bill, and Congress initiated hearings. But the legislation which Healy insisted would “promote the dignity of investment trusts” was denounced by the industry which had cooperated in the study but been excluded from the drafting.9 Paul Cabot called it “a bill that would burn down the barn to kill the rats.”10 Despite the rhetoric, it was clear that the industry was amenable to regulation in some form, so legislators sent both sides back to the table to frame a compromise bill.
Thanks to the Great Depression and public indignation, the reformers had the upper hand in shaping earlier securities legislation, but by the time the long investment trust study was over, the New Deal was as well. As Alfred Jaretzki Jr., who represented the New York-based closed-end investment trusts put it, legislation “would not have been passed by Congress in 1940 except for the active collaboration of the investment companies.”11 Still, the industry had two reasons to compromise: first, they could not be sure that the legislative momentum would stall if this thrust was turned back, second, all investment companies had been tarnished by the excesses of the 1920s, so leaders believed that only reform would enable the funds to recover. Closed-end fund officials also hoped that the law would help them gain back ground lost to the open-end funds.
So, with Warren Motley, lawyer for the Boston open-end funds, Jaretzki hammered out a compromise with the Commission. SEC staffer Harry Heller recalled “many sleepless nights of preparation and discussion at Washington’s Carlton Hotel” in mid-1940.12 Once the regulators and industry participants settled on a compromise, both houses of Congress unanimously approved the bill.
Enacted August 22, the Investment Company Act of 1940 greatly increased financial and administrative transparency for all investment companies, requiring SEC registration, disclosure of finances and investing policies, prohibition of changing investment policies without shareholder approval, and a minority of independent board members (no more than 60 percent of whom could be an “investment adviser of, affiliated persons of an investment advisor of, or officers or employees of” a registered investment company). The 1940 Act also remedied long-standing problems of inequitable capitalization among closed-end funds by prohibiting senior stock and enabling the SEC to bring legal action against inequitable arrangements regarding mergers and recapitalization. The Act restricted the sales excesses of open-end funds by prohibiting dealers from trading against their own investment companies and by allowing the National Association of Security Dealers to require repricing of shares at certain times during each day.
Still, Jaretzki believed that the industry was in fact the prime beneficiary of the 1940 Act, unusual praise for a bill that was much more dense than its predecessors. The 1933 and 1934 Acts sketched out a broad regulatory regime, leaving the SEC to draft rules that would make them operative. The 1940 Act was much more specific, detailing the regulatory regime itself through what the SEC called “affirmative statutory requirements or prohibitions.” As a result, the Commission’s future work under the 1940 Act would consist less of writing new rules than exercising its wide-ranging exemptive authority. As a later study put it, “the Act defines an investment company broadly and then exempts or excludes various specific types of companies that fall within the general definition of the Act.”13
The investment trust study had also looked, as an ancillary matter, at those who sold investment company shares, and resulting report was a 1939 study on “Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services.” Provisions stemming from that research were included in Title II of the bill which became the Investment Advisers Act of 1940. This Act did away with performance fees for retail investors (arrangements in which compensation was tied to investment returns which regulators believed encouraged advisers to gamble with client money), required disclosure of interest in transactions executed for clients, and prohibited the assignment of contracts without customer consent. The key provision, however, was a tried and true disclosure requirement—with limited exceptions for advisers working only for investment and insurance companies, doing business in a single state and advising on securities not traded on national exchanges, or those working for an exclusive clientele of less than 15 investors – all investment advisers had to register with the SEC.
(3) Alfred Jaretzki, Jr., “The Investment Company Act of 1940, Washington University Law Quarterly, April 1941, 303-47, see page 306.
(4) Standard Trade and Securities Service, Vol. 45, No. 4, July 5, 1927, Edgar Higgins Papers, Harvard Business School Archives, Box 2.
(6) Memo to SEC Commission from John Hollands on investment company taxation, July 10, 1941.
(8) Release - Senator Wagner Introduces Investment Trust Legislation, March 14, 1940.
(10) Michael R. Yogg, Passion for Reality: The Extraordinary Life of the Investing Pioneer Paul Cabot (New York, 2014), 95.
(11) Alfred Jaretzki, Jr., “The Investment Company Act of 1940, Washington University Law Quarterly, April 1941, 303-47, see page 303.
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