Regulation of the London Stock Exchange

Share Trading, Fraud and Reform 1914–1945

Chris Swinson

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351706209
• Edition: 1
• Topic: Economics
• Subtopic: Economic History
• Index: Economics

In 1914, the notion of statutory regulation of trading in shares was anathema to both the Government and the London Stock Exchange. By 1945, a statutory scheme of regulation had been introduced. This book serves to:

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• Track the steps by which this outcome came about,

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• Explain why the Exchange felt obliged in the process to abandon long-cherished policies,

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• Analyse the forces which led to it, and

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• Account for the form in which it was implemented.

Throughout the period, the attitudes of both the Stock Exchange and Government were affected by widening interest in share ownership, the increasing tendency for business interests to look to the Exchange for long-term finance, and the increasing challenge of financing the Government's expenditure. At a disaggregated level, the market was able to respond to changing circumstances taking advantages of opportunities and weaknesses. At an aggregated level, the Exchange was not able to foresee the implications of change or to forestall unfortunate consequences. This exposed the weakness of the criminal justice system and its failure to serve as a deterrent for abuse.

This study, the only book to take full account of the documents held by the National Archives in relation to the Bodkin Committee, examines the stages by which share trading in the United Kingdom came to be a statutorily regulated activity and by which the London Stock Exchange moved from being antagonistic towards public regulation in 1914 to lobbying in 1944 for the new scheme to be implemented.

1
Introduction

On 22 May 1946, a block of shares in St Helena Gold Mines Limited was placed on the London Stock Exchange. The price approved by the Exchange’s New Issues Sub-Committee was 52s 6d. Interest was so great that by 1000 hours, the shares were trading at prices over £5 and ended the day at 4⅛ to 4½, falling subsequently to 3½.¹

It was immediately rumoured that the shares had been ‘rigged’:² a rumour that became the subject of a disciplinary inquiry by the Exchange. The outcome was that the senior partner of the brokers responsible, Keith, Bayley & Rigg, was suspended for two years and six jobbers who had made substantial profits received lesser punishments. For some members, these punishments were not sufficient. J&A Scrimgeour wrote to the Stock Exchange Council suggesting that action should have been taken against the broking firm as a whole and not simply its senior partner:

The times are difficult and the difficulties will not be alleviated by timid measures, neither can we expect the prestige of the Stock Exchange to be enhanced until full measures for the protection of the public, and members generally, are adopted.³

Scrimgeours’ interest in the public’s protection was shared by the council, which had asked the brokers’ senior partner whether:

the public, in order to obtain an interest in the shares, had to pay a premium to Keith, Bayley & Rigg and their friends of £2 a share.⁴

The senior partner agreed and went on to express his regret for the ‘grave discredit’ this had brought to the Stock Exchange.

For a member whose memory extended to trading on the Exchange before the 1914–1918 war, such an interest in the protection of the public would have seemed remarkable. Market rigs had been mounted before, and had been punished,⁵ but on the grounds that rigs disadvantaged fellow members of the Exchange, not that they abused members of the public. In effect, between 1914 and 1946 there had been a sea change in the Exchange’s thinking and in its practice. Whereas in 1914, the Exchange was solely concerned with overseeing the integrity of relationships between its members, by 1946, with government encouragement, the Exchange had accepted responsibility for protecting the interests of the wider investing public.

At the time, some commentators recognised the scale of the change that had occurred, for in June 1945, The Economist observed that:

All these changes add up to an altered mentality among brokers … which prefers reasonable, but secure, profits to long risks with the alternative of brilliant success or equally striking failure.⁶

Subsequent commentators have referred to the same changes, although describing them in different ways. Michie (1999, pages 326–327) refers to a state of uncertainty after the end of the war and to the Exchange’s need to secure a rapid return to peacetime trading conditions. Kynaston (2001, pages 30–31), dealing with a broader canvas, refers to concern among members that the Exchange had become a public institution rather than a private club that existed to facilitate its members’ trading. Both largely attribute the changed circumstances to the economic effects of the 1939–1945 war and to the effect of controls implemented during the war. Doubtless the effect of the war was extensive, but it cannot account for the fact that the key legislation underpinning the regulation of share trading was passed in 1939 before the commencement of the war and manifestly not in contemplation of the onset of war.⁷ Further, the legislation was brought into force in 1944, before the end of the war, as the Board of Trade acquiesced to lobbying by the Stock Exchange which had traditionally opposed such legislation.

This study examines the nature of the change in the regulatory arrangements for share trading that occurred between 1914 and 1945.

The study suggests that the Stock Exchange and the government faced five challenges posed by a change in the character of the demand for and supply of securities that had begun to be apparent before 1914. The investing community expanded to include many first-time holders whose holdings tended to be small: too small for the traditional relationship between stockbroker and client to be economically viable. Such holders either sought security through institutional intermediaries, partly encouraged by tax considerations, or traded without professional advice becoming prey to unscrupulous traders.

At the same time, vendors of shares increasingly saw the market not as a means by which to dispose of ownership but as a source of finance because of a decline in corporate profitability together with higher tax rates restricted businesses’ ability to finance investment by retention of profit. This trend was reinforced by tax reforms which tended to favour companies whose shares were traded on a recognised stock exchange.⁸

As this was happening, the political environment also changed. During the 1914–1918 war, the role of government had become more important and its demands for financial support more insistent. At the end of the war, the political system had become more pluralist, with a greatly enlarged electorate, for the first time including the working class, bringing forward a Labour Party suspicious of business privilege with a burgeoning range of pressure groups representing workers and manufacturers.

The main question posed by these changes was whether it would be possible for the Exchange to preserve its independence of state control.

The outcome would depend upon four other challenges, the first of which was whether investors alone should be responsible for managing their own risks: caveat emptor. This principle was the foundation of the Exchange’s relationship with members. Implicit in this approach was the assumption that clients had both the experience and, where necessary, the access to advice to enable them to manage their risks. As the market welcomed a larger number of smaller investors who had savings to invest but neither the experience to assess and mitigate their own risks nor the access to necessary advice, at what point would caveat emptor become an impractical and untenable principle?

The second challenge was to self-regulation as an organising principle for bodies such as the Exchange. To deal with changing circumstances, any organisation must be able to identify challenges and to face them successfully. In the case of the Exchange, self-regulation had been viewed as essential for the well-being of members, to the extent that the grant of a royal charter had been resisted because it would have involved oversight by the Privy Council. As the underlying assumptions were challenged, how successfully would the Exchange manage its responses?

The third challenge was to the criminal justice system. Beyond the London Stock Exchange and the provincial stock exchanges, share trading could take place free from regulation other than the constraint of criminal law and prosecutions. Would the criminal justice system provide an adequate response to abuse of unsuspecting investors in off-market transactions?

The fourth challenge was to the government’s management of the financial system and the financing of its expenditure. Between 1914 and 1918, rather than relying solely on taxation, the government chose to meet a large part of the cost of prosecuting the war by raising loan issues that were traded through the Exchange, a studiously independent organisation. What measure of influence or control did the government need to achieve its own policy objectives?

By 1945, the answers to these questions had become clear. The London Stock Exchange had largely been able to preserve the appearance of independence, but after the twin crashes of 1929, it had been necessary to abrogate the principle of caveat emptor. The Stock Exchange had eventually been able to act with determination to defend the principle of self-regulation. The criminal justice system had failed to meet the challenge of abusive share pushers. The government had concluded that it could achieve its objectives through influencing rather than controlling the Exchange.

At no point in the period with which this study is concerned was the regulation of share trading a prime concern of the politicians involved in considering these issues. It waxed and waned in importance in their eyes in proportion to its perceived relevance to the achievement of other objectives. Politicians were prepared to compromise in implementing proposals for regulation of share trading once the objectives of prime concern to them appeared within grasp. In November 1914, the government responded to the imperative need to finance the war by agreeing that its interest in controlling new issues and share trading should be achieved by means of the Exchange’s own regulations. In February 1919, the government was forced into an ignominious abandonment of proposals for extended capital controls. In 1938, this led to acceptance of the Stock Exchange’s conditions for acceptance of the statutory scheme. These compromises were accepted even though they were known to embed weaknesses in regulatory arrangements which in due course led to calls for further reform.

The study also shows how, in the 1920s and 1930s, reliance solely upon the criminal justice system as a means of regulating abusive share trading, especially abusive trading outside recognised exchanges, became untenable. It may have been thought credible in the previous century, but by the 1930s such narrow reliance coupled with the widening public interest in share ownership was exposing to abuse a section of the public that was ill-fitted to protect itself. Regulation that depended upon post facto punishment and in many cases upon private prosecution did not serve to deter, eliminate or avoid the social damage caused by the abuse.

In other respects, prosecution proved more effective. The prosecution of Clarence Hatry in 1930 distracted attention from the causes of the collapse of many companies floated in the 1928 boom and enabled the Exchange to engage in a discreet reform of its new issue practices. The Royal Mail trial in 1931 initially appalled the City which sympathised with the plight of the defendants; but served as a warning. If in regulating itself, the City’s rules became too far removed from the requirements of public law and public expectation its independence would be curtailed. By 1940, reform of the rules of disclosure in accounts had become inevitable.

That the Exchange could deal successfully with the weaknesses in systems and behaviour demonstrated so powerfully in 1929 can be attributed to two factors: the leadership of the Governor of the Bank of England and the blindingly obvious risk that the Exchange’s independence would be lost. Confident in wider City support and the support of members, the self-regulatory Exchange was able to move boldly in a manner it did not demonstrate at any other point in the period covered by this study.

Chapters 2 to 5 describe the development of the share trading environment between 1914 and 1945, beginning in Chapter 2 with a brief outline of the economic environment. In Chapter 3, the developing changes in the demand for securities are charted, followed in Chapter 4 by an analysis of the supply of securities for trading in the Exchange’s market. These developments were to affect demand for the services of the Exchange’s members and the market’s vitality: trends which are examined in Chapter 5.

Against this background, the development of a regulatory framework for the Exchange and for share trading more generally is analysed in Chapters 6 to 12.

Chapter 6 describes the developments that occurred during the 1914–1918 war from the initial imposition of new issue controls in January 1915 to their removal in 1919. Created by an agreement between the Stock Exchange and the Treasury which was enforced solely through the Stock Exchange’s own rules, the controls proved dysfunctional because they did not apply to off-market transactions. The incentive to enter into transactions off-market which were not permitted on-market ultimately undermined the controls’ purpose and frustrated the Exchange’s members who had been happy to see controls introduced in January 1915 as a means of restoring their livelihood. In 1919, members saw the abolition of controls as vital to restoring the economic rents of membership. Others suggested that some continuing control would be desirable to avoid the abuse of the new class of inexperienced investors. In the event, the Treasury’s attempt in January 1919 to impose permanent controls was to prove a humiliating failure. In returning to ‘business as usual’, caveat emptor remained a guiding principle.

The end of hostilities in November 1918 was accompanied by hope that commercial life would return to normality and prosperity. For a while, trade and the stock markets boomed. But there was also uncertainty about how the transition to a peacetime economy would be managed and whether markets which had been lost during the war could be recovered. In the event, the transition proved troublesome and markets were not recovered so that the post-war boom was followed by a crash in 1920. Slowly, business recovered, leading to a further boom in 1928.

As years passed, deeper uncertainties emerged. War had exposed the inefficiency of many old industries and had given fresh impetus to new technologies. The character of the investing public had been changed as had the risk appetite of many investors. Government expenditure, even when reduced in 1920, was at a higher level than before 1914 and required a higher level of taxation. Thus, attitudes towards investment were changing, with a search for higher returns within acceptable levels of risk and volatility. Sustained returns based on continuing relationships came to be more valued than short-term, speculative gains.

These circumstances challenge...