Financier J.P. Morgan deserved his nickname ‘Jupiter'. In the late 19th and early 20th century he was a godlike force presiding over the control and financing of large blocks of corporate America. Early in his career J.P. worked with his father, Junius. Both were financiers but they sat on opposite sides of the Atlantic — Junius in London and J.P. in New York. They acted as the conduit for the flow of money from English investors to capital-hungry American industrialists and railroad entrepreneurs. The US needed capital to tap its resources, produce its steel and build its factories, railroads, bridges and ships. But as America's wealth grew, so too did its capacity to fund its own expansion. At the start of J.P.'s career, London was the financial capital of the world; by its end New York wore the crown.

J.P. Morgan's career was at its zenith at the dawn of the 20th century. As already mentioned, it was he who orchestrated the first billion-dollar float, US Steel. Larger blocks of capital were needed to fund the creation of ever-larger companies, which meant this period saw a shift from private to public ownership of US enterprise. It was a new age — the age of share ownership by the common people.

This shift meant that manager and owner were no longer necessarily the same person. It created the need to establish effective lines of communication between those running the companies and those who owned them, namely the shareholders. But these lines of communication were slow to be established.

It wasn't the lack of a financial language that was preventing companies from reporting to their shareholders — the tools to facilitate this communication already existed. Double entry bookkeeping, the accounting method underlying today's financial reports, had been developed in Italy during the 15th century. No, the problem was attitudinal, one centred in America's boardrooms. Directors chose to behave more like owners of the business than employees of the shareholders. They welcomed shareholder capital but resented any form of accountability. The following statement made by the president of the American Sugar Refining Company, Henry O. Havemeyer, shows how management felt at the time:

Let the buyer beware. That covers the whole business. You cannot wet-nurse people from the time they are born until the day they die. They have got to wade in and get stuck and that is the way men are educated and cultivated.¹⁰⁸

J.P. Morgan's berating of a railroad president of the time shows Havemeyer wasn't the only director or president who thought like this. In reminding a company president that it was wrong to refer to the company's railroads as his own, Morgan bellowed: ‘Your roads! Your roads belong to my clients!'

Around this time, however, the New York Stock Exchange became increasingly aware of the need to keep shareholders better informed. In 1895, only six years prior to the record-breaking US Steel float, it proposed what was then a radical idea — that companies distribute annual earnings reports to shareholders. But a proposal in the absence of legislation remained just a proposal. Compliance rates remained low, with companies offering many excuses for not publishing reports. A couple of the better ones of the day were that:

• in making their affairs known companies would ‘lay their trade secrets before competitors'¹⁰⁹
• stockholders should be wholly satisfied in receiving regular dividends and that financial disclosure would likely subject the directors to ‘annoying inquisitions from tax gatherers'.¹¹⁰

The debate regarding the need for improved financial reporting gained momentum as the new century unfolded. Henry Clews, an influential broker at the time, was an early advocate of reform, and his calls were increasingly backed by some of the more ethically minded financiers. But it takes massive shifts in public opinion for real reform to occur, and there's nothing like a full-blown financial crisis to heighten public opinion. There were two substantial crises around this time — the 1907 Panic and the 1929 Crash.

Government inquiries invariably follow crashes. When the public loses money you can be sure there will be a loud cry for the scalps of insider traders and morally corrupt brokers and bankers. In the wake of the 1907 Panic it was the Pujo Committee hearings of 1912. Louis D. Brandeis chronicled the investigation in his 1914 book Other People's Money. Brandeis saw the solution to financial excess as enhanced disclosure: ‘Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.'¹¹¹

But it took yet another crash, two decades later, before Brandeis's sentiments would be embodied in law. The principal reforms coming out of the Pujo Committee hearings were the banking reforms associated with the establishment of the Federal Reserve. It wasn't until the aftermath of the 1929 Crash that financial reporting standards were substantially improved.

The period leading up to the 1929 Crash was an extremely interesting time. Like all boom times it was a period marked by excess, easy money and dubious moral behaviour. To gain an insight into that behaviour let's have a look at a couple of the principal corporate villains of the 1920s, Ivar Kreuger and Charles E. Mitchell.

THE MATCH KING

Ivar Kreuger emerged, over the course of the 1920s, as one of the most respected and profiled business moguls in the world. His friends included movie stars and presidents. His companies supplied nearly 70 per cent of the world's demand for matches. His empire included gold and mining interests, telecommunications and vast timber plantations. He owned real estate portfolios on both sides of the Atlantic. His companies provided loans to governments across Europe and South America. And where did he get much of the money for the corporate acquisitions and government loans? From the US equity markets. That's right. To Kreuger a dollar was a dollar no matter where it came from. Whether it came from bona fide business profits or the pockets of new investors, he looked upon every dollar as the same — his.

Clearly not everything in Kreuger's empire was as it appeared to the outside world — his wealth was in fact a mirage. Kreuger's house of cards had been built on the back of Wall Street's lax reporting standards. He'd tapped the equity markets for millions of dollars yet had provided little to no information about his companies' financial affairs. What Kreuger failed to produce in financial disclosure he more than made up for in charm and persuasion. He had the press, the public and the partners at stockbroker Lee, Higginson & Co. convinced he was the safest bet on Wall Street. In reality he was busy shuffling money from one subsidiary to another in a desperate attempt to keep his corporate raft from sinking. It was largely a Ponzi scheme.^a

The Match King kept both his broker and his investors happy by confident reassurance and a succession of new capital raisings. His eventual demise came after the 1929 Crash. As Buffett likes to say, ‘only when the tide goes out do you discover who's been swimming naked'. Kreuger committed suicide just before news of his scam became public. The New York Times had this to say five years after his suicide:

From the record of falsehood and betrayal with which Kreuger besmirched the very pillars of finance in the leading countries of the world has come, particularly in the United States, the erection of new safeguards for investors. In our Securities Act are to be found preventives whose origin is to be traced definitely to the Kreuger experiences.¹¹²

So Kreuger was a big player. A government-generated report that preceded the Securities Act of 1933 devoted more than 250 pages to him, and some historians have said his activities were a major contributor to the 1929 Crash. But it would be wrong to blame the Crash solely on Kreuger.

As an aside, it's interesting to compare Kreuger with Australian-born Tim Johnston, of Firepower fame. It seems that similar scams can be replayed to a different generation. In the early 2000s Johnston tried playing the same games Kreuger had 80 years earlier. Johnston claimed to have developed a pill that, when added to engine fuel, resulted in the dual benefits of reduction in fuel consumption and reduction in harmful emissions. He claimed to have multimillion-dollar contracts to sell his wonder pill around the world. None of it was true. The pill was less than useless and sales were close to nonexistent. Yet his persuasive charms had investors, politicians and government authorities around the world chasing him with investment dollars. Before his scam was exposed he'd duped them of more than $100 million.

But there's one thing that eluded Johnston: in the absence of scientific proof of the pill's efficacy or of audited financial statements proving his claimed sales revenues, he couldn't float Firepower on any stock exchange. Unlike 80 years earlier, when Kreuger was operating, the stock market's regulatory authorities had presented a strong barrier against unscrupulous behaviour.

POST-CRASH WALL STREET

When America was rocked by the 1929 Crash, stories started to emerge of the corporate excesses of the pre-Crash era. And while rising share prices had cloaked much of the morally questionable behaviour of the Roaring Twenties, the world was now a different place. Answers were demanded, scalps were sought — and solutions were needed. The time was ripe for legislative change.

The Committee on Banking and Currency was charged with delivering answers to those demanding to know what had happened in the 1929 Crash. But after 12 months it had come up with next to nothing and the hearings were due to be shelved. Even the incoming President, Franklin D. Roosevelt, a strong advocate for social and economic reform under the banner of the ‘New Deal', had little interest in the committee continuing its investigations. That all changed in the early months of 1933.

In what were thought to be the dying days of the inquiry, a new Chief Counsel was appointed, Ferdinand Pecora. The press quickly picked up on the penetrating and aggressive courtroom style of the brilliant young Sicilian-born lawyer. His questions were probing, the disclosures more revealing. The inquiry quickly found its way onto the front pages of newspapers around the nation. Pecora single-handedly revived interest in the inquiry and as a result it was extended 14 months into Roosevelt's first term. Pecora exposed a culture of self-interest and moral corruption firmly embedded in the psyche of Wall Street's banking elite. The nation was shocked by the magnitude of the self-enriching deals, that the perpetrators denied any feelings of guilt and that the deals were all carried out behind a cloak of non-disclosure. Pecora's first scalp was Charles ‘Sunshine Charley' Mitchell, the Chairman of National City Bank (now Citibank). Before Pecora exposed his activities, Mitchell had been one of the most respected bankers in the country.

Pecora uncovered City Bank's ‘morale loans'. The bank's president, Gordon Rentschler, told the inquiry how the loans had worked. Like other investors who held stock on margin, many of City Bank's senior executives were exposed to mounting margin calls in the wake of the 1929 Crash. Indeed many faced financial ruin, so the bank's board offered each a financial lifeline. It authorised that large, unsecured, interest-free loans be advanced to the bank's top 100 executives. The board justified the loans as ‘protecting such officers in the present emergency, and thereby sustaining the morale of the organization'. Hence the name ‘morale loans'.

The loans were financed by shareholders, without their knowledge. Most of the executives were either unable to repay the loans or looked upon their repayment as optional. Only about 5 per cent were ever paid back. To avoid public disclosure the bad loans were shifted into an affiliate, the National City Company. Not surprisingly, this company never disclosed its annual income statements.

The National City Company was used to hide other dirty linen as well. The bank had suffered substantial losses on a Cuban sugar investment several years earlier, and Mitchell was responsible for both the failed deal and the subsequent cover-up. The $25 million financial hole was plugged with money from a public equity raising. Subscribers had no idea that half the $50 million they put up was being used to cover the loss; they assumed the money was being used for new investment. Pecora's revelations demonstrated to the nation that reporting standards required a major overhaul.

Pecora also painted a picture of City Bank as a high-pressure securities shop offloading second-rate stocks and bonds to unsuspecting investors. The man in the street, previously ignored by the broking industry, had been increasingly tapped for the speculative dollar during the course of the Roaring Twenties. And this was in no small part due to Mitchell. No stock was too overpriced and no bond was too risky for Sunshine Charley's boys to push onto innocent clients. His trained team of commission-driven brokers didn't feel the need to operate under the principle ‘buyer be informed'; rather, they operated on caveat emptor — that is, ‘buyer beware'.

Interestingly, just 18 months prior to the Pecora hearings one of City Bank's bond salesmen, Julian Sherrod, released a book that described the bank's high-pressure sales techniques. Unemployed and bankrupt, Sherrod wrote his book, Scapegoats, to generate sufficient dollars to put food on his family's table. In it he described the moral decay that infected Wall Street's financial institutions. While he was clearly describing the activities of City Bank and Mitchell, he never actually named them in his book.

SHIFTING EMPHASIS ON THE MEANS OF VALUATION

Julian Sherrod had also observed a shift in how company valuations were being presented in prospectuses. Values were no longer measured in terms of cold, hard assets but rather as multiples of potential earnings. A number of businessmen and investors (Cornelius Vanderbilt and J.P. Morgan among them) had adopted this method of valuation many years earlier. In 1910 Louis Guenther had described this change of emphasis when he wrote of departing from ‘our more conservative methods of basing the capital on physical assets … Instead, the earnings possibilities of a corporation are capitalized'.¹¹³ But even by the 1920s not everyone had come to accept this method of valuation. Sherrod was among them, as the following quote from Scapegoats shows:

I have always had the feeling that the offering of 850 000 shares in Dodge Brothers Inc. Preference Stock (no par value) ushered in the Belshazzar era of finance. There is one thing about that deal which I have always admired. The Merchants just came right out and in the face of the circular stated in plain English that it was practically all what we call ‘Water'. Here is the statement:

‘The capital stock of the company (no par value) will be issued almost entirely against the established earnings power, which is not assigned a value in the balance sheet.'

Sherrod went on to say:

That is one of the frankest and most honest statements I have ever seen in a circular. Then on the back of the circular is a balance sheet which shows you are buying nothing but goodwill and going concern value.^b

After the Crash, but before he lost his job, Sherrod attended a conference organised for City Bank salesmen. He tells us that the Chairman, Charles Mitchell (the man Pecora grilled during the post-Crash hearings), addressed the sales team. He talked about the company's opaque affiliate, National City Company. Remember, this was the company that didn't report and had been used to hide the morale loans and Mitchell's failed Cuban sugar investment. Sherrod recalls Mitchell's words from his address at that sales conference:

One reason the Security Company does not publish a statement is that earnings fluctuate widely and the Management feels that the stock should not zigzag with earnings.

Of course this was a ridiculous justification. The second reason he offered was much closer to the truth:

Another reason is that ‘We wash our dirty linen on the back porch rather than on the front porch'.¹¹⁴

Sherrod's book sold well, but it didn't produce anywhere near the impact the nation's newspapers later did. Their front pages carried the unfolding revelations of the Pecora-led commission 18 months after Sherrod's book was released. Pecora's findings were so damning that Mitchell resigned as chairman of City Bank within days of the ordeal. In a short time Pecora had exposed Mitchell for hiding huge financial losses from the bank's shareholders, paying himself and fellow directors undisclosed and overly generous bonuses, and failing to pay personal capital gains taxes. Remember that as the nation listened to these stories it was suffering its most crippling depression in decades. The public were screaming for change, and the politicians had to respond.

With public anger aroused by the Pecora-led inquiry, real reform could begin. Until then less than one-third of companies listed on US exchanges published quarterly reports, and a third of companies didn't publish any reports at all. The Securities Act of 1933 laid out a bevy of financial disclosure requirements with the aim of making corporate activities more transparent. No longer could the directors of a listed company say to the shareholders, ‘Just trust us.'

The disclosure requirements spelt out in the Securities Act were a big leap forward, but they didn't end the problem. Mandatory disclosure can never protect against fraud. And, as the relatively recent Enron, WorldCom and Madoff scandals remind us, there remains a risk in accepting financial accounts at face value.