UNITED STATES v. MORGAN

118 F. Supp. 621 (S.D.N.Y. 1953)

MEDINA, Circuit Judge.

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PART I

The Investment Banking Business

It would be difficult to exaggerate the importance of investment banking to the national economy. The vast industrial growth of the past fifty years has covered the United States with a network of manufacturing, processing, sales and distributing plants, the smooth functioning of which is vital to our welfare as a nation. They vary from huge corporate structures such as the great steel and automobile companies, railroads and airlines, producers of commodities and merchandise of all kinds, oil companies and public utilities, down to comparatively small manufacturing plants and stores. The variety and usefulness of these myriad enterprises defy description. They are the result of American ingenuity and the will to work unceasingly and to improve our standard of living. But adequate financing for their needs is the life blood without which many if not most of these parts of the great machine of busines would cease to function in a healthy, normal fashion.

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While the complaint alleges that the syndicate system was invented at or about the time of the Anglo-French Loan in 1915 by the defendants and their "predecessors," it has been conclusively established, as already stated, that the syndicate system as a means of issuing and distributing security issues was in use at least as early as the 1890's; and in this early period price maintenance was to some extent used, as it was appreciated even in those days that the problem of placing upon the market a large bulk of new securities required careful management and planning lest the very quantity involved should depress the price and make distribution within a reasonable time difficult if not impossible.

The present method for issuing and distributing new security issues thus has its roots in the latter part of the nineteenth century. It is the product of a gradual evolution to meet specific economic problems created by demands for capital, which arose as the result of the increasing industrialization of the country and the growth of a widely dispersed investor class. It was born in large part because of, and gradually adapted itself to, conditions and needs which are peculiar to the business of raising capital.

I. Prior to the First World War

Prior to the year 1900, the large majority of industrial and business units which existed in this country were small in size and their capital needs were small; use of the corporate form was not widespread. There was no substantial and widely scattered class of persons with surplus savings who sought promising investment opportunities. A large part of the capital needed came from abroad.Securities sales operations were conducted principally by selling agents who sold on a commission basis, and more often than not it was the issuer who bore the risk of how successfully and how quickly the required funds would be obtained.

The evolution of the investment banking industry in the United States is illustrated by the early phases of the development of two of the defendant investment banking firms, Goldman, Sachs & Co. and Lehman Brothers.

Goldman, Sachs & Co. traces its origin back to the year 1869, when Marcus Goldman started a small business buying and selling commercial paper. In the year 1882, he was joined in that business by Samuel Sachs, and at that time the firm, which had been known as Marcus Goldman, became M. Goldman & Sachs. In the year 1885, when additional partners joined the firm, the firm became Goldman, Sachs & Co., and has continued as such from then on to today. At that time, it was very difficult for small manufacturers and merchants to get capital with which to operate, so Goldman, Sachs & Co. developed the business of buying their short-term promissory notes, thus furnishing them with needed capital, and selling these notes to banks or other investors. This commercial paper business prospered and continued to expand in the 1880's and 1890's, and, by the time of the year 1906, when the opportunity first arose for Goldman, Sachs & Co. to underwrite some financing for United Cigar Manufacturers, now known as the General Cigar Company, the firm had established many contacts all over the country with merchants and manufacturers. During this period, also, partners of Goldman, Sachs & Co. took frequent trips to Europe, because at that time it was difficult to raise capital for American enterprises in the financial markets of this country, and they entered into arrangements with European bankers, whereby they would lend money in this country for their account.

Likewise, the firm of Lehman Brothers traces its ancestry back to about 1850. Since then, a series of partnerships, formed from time to time upon the withdrawal or death of partners or the addition of new ones, has conducted business under the name of Lehman Brothers. The firm had prospered greatly as "cotton bankers," and, years before the turn of the century, it had established its headquarters in New York City.

In the late 1890's and the early 1900's, the prime securities were railroad bonds and real estate mortgages. The public utilities business had not as yet achieved great importance, and, consequently, public utility securities were generally looked upon with disfavor. Railroad and public utility financing was handled by a small number of firms. The railroad financing was done to a considerable extent by Kuhn, Loeb & Co., J. P. Morgan & Co., Vermilye & Co. and August Belmont; and a large percentage of the capital was furnished by French and German underwriters. The public utility financing was done to a large extent by Harris, Forbes & Co., which had become a specialist in the securities of companies providing power and light. Harris, Forbes & Co. was becoming known as an underwriter which understood and knew how to solve the problems of those companies, and had the knack of raising capital for the growing industry. There was an open field in certain light industrial and retail store financing which had been neglected or overlooked.

After the beginning of this century, as family corporations grew larger and needed more capital for expansion, or when the head of a family died and money was needed to pay inheritance taxes, it became increasingly apparent that commercial paper, which was short‑term money, was insufficient to meet the capital requirements of those small enterprises. At about this time, Goldman, Sachs & Co., desirous of entering the business of underwriting securities, conceived the idea of inducing privately owned business enterprises to incorporate and to launch public offerings of securities. In the early 1900's it was considered undignified to peddle retail store securities, but Goldman, Sachs & Co. believed that, with the growth in size of family corporations and other privately owned business enterprises, there would be a market on a national basis for their security issues. The problems involved in offering securities to the public, where no securities were previously outstanding in the hands of the public, were new and difficult of solution, and different from the problems involved in the underwriting of bonds of a well known railroad. The sale of retail or department store securities required a different market.

When the opportunity arose in the year 1906 for Goldman, Sachs & Co. to underwrite the financing of United Cigar Manufacturers, it was unable to undertake the entire commitment alone, and could not get the additional funds which it needed to underwrite from commercial banks or other underwriters, as they would not at that time underwrite this type of securities. Henry Goldman prevailed upon his friend Philip Lehman of Lehman Brothers to divert some of his capital from the commodity business and to take a share in the underwriting. The result was that the two firms, Goldman, Sachs & Co. and Lehman Brothers, became partners in the underwriting of the financing of United Cigar Manufacturers. When the opportunity arose in that same year for Goldman, Sachs & Co. to underwrite the financing of Sears, Roebuck & Co., it was perfectly natural for it again to turn to Lehman Brothers for assistance, and the two firms became partners in that enterprise. Thus it was through this oral arrangement between two friends, Henry Goldman and Philip Lehman, through this informal partnership, that Goldman, Sachs & Co. was able to obtain the capital which it needed to underwrite these two security issues in the year 1906. Without such capital, it would have been unable to enter the business of underwriting securities. The events which occurred in the year 1906 set the pattern for subsequent financings which Goldman, Sachs & Co. underwrote prior to the First World War. In the period from the year 1906 to the year 1917, although Goldman, Sachs & Co. occasionally underwrote financings with other partners, notably Kleinwort Sons & Co., merchant bankers of London, its principal partner was Lehman Brothers.

These two firms, as partners or joint adventurers, continued to act together thereafter underwriting securities of clothing manufacturers, cigar manufacturers, department stores and merchants, and the kind of businesses that most investment bankers, who were interested only in the securities of heavy industrials, railroads and to some extent public utilities, would not touch. The two firms began to cultivate acquaintances and build up relationships with securities dealers in other parts of the country who could market in their respective cities or towns the type of securities in which the two firms were particularly interested; and, as their reputations grew, they began to underwrite securities in the industrial field. They added to their staffs persons who were experts on merchandising and retail store methods, and they developed the business of selling their services to family and other privately owned enterprises.

While the evidence is not explicit on the point it would seem reasonable to assume that, prior to World War I, the firms interested in the securities of railroads, public utilities and heavy industries were establishing similar contacts, building up similar staffs of experts in their particular fields and otherwise doing whatever they could to enhance their reputations in their own specialities.

In the period from the year 1906 to the year 1917, Goldman, Sachs & Co. and Lehman Brothers together underwrote the financings of many enterprises which had a small and humble beginning, but which later grew to very great size, among them being United Cigar Manufacturers, Sears, Roebuck & Co., B. F. Goodrich Company, May Department Stores Company and F. W. Woolworth Company. Many of the business concerns whose securities were underwritten by Goldman, Sachs & Co. and Lehman Brothers during this period were houses with which Goldman, Sachs & Co. had previously had commercial paper transactions. As Goldman, Sachs & Co. and Lehman Brothers were better known at the time than many of the business enterprises whose securities they underwrote, investors bought the securities to some extent in reliance on their reputation.

There thus grew up between these two firms an informal, oral arrangement whereby they, as partners or joint adventurers, purchased security issues directly from issuers, and divided equally the profit which was realized from their sale.

There was then no network of securities dealers throughout the country, such as there is at the present time. In or about the year 1905 or 1906, there were only about five investment banking houses which had a national distribution system for securities: Lee Higginson & Co.; N. W. Harris & Co.; N. W. Halsey & Co.; Kidder, Peabody & Co.; and William Salomon & Co. Investment banking houses such as J. P. Morgan & Co., Kuhn, Loeb & Co., and William A. Read & Co. were underwriters of securities primarily in the New York market. Up to about the year 1912 or 1915, there were approximately only two hundred and fifty securities dealers in the entire United States, most of whom were concentrated in the eastern and middle eastern parts of the country. It was not until the time of the launching of the Liberty Loan in the year 1917 that we find a large number of independent dealers engaged in the business of distributing securities throughout the country.

As there was no network of securities dealers on a nation wide scale, the underwriters sold as many securities as they could directly to individual investors, and the sale of security issues generally was not completed rapidly. For example, it took Goldman, Sachs & Co. and Lehman Brothers three months to sell the Sears, Roebuck & Co. security issue which they underwrote in the year 1906, and, in many other instances, it took the underwriters much longer to complete the distribution of security issues. The personnel of the distributing organizations was small, and their operations were concentrated in the eastern and northeastern parts of the country. The purchase and banking groups were characteristically organized to last for a period of one year, and the manager had broad powers to extend the period. This power to extend was frequently exercised by the manager; there are records of such groups continuing from two to five years or longer. Investment banking firms kept lists of investors, and, whenever they underwrote a security issue, they would go directly to the investors and try to sell them that particular security.

This method of distribution was adequate for the sale of a limited number of security issues to a limited investing public; it was wholly inadequate for a later time when new security issues were to follow each other in rapid succession, since the slowness of distribution of a greatly increased volume of securities required excessively large capital resources on the part of the originating banker and the purchase and banking groups for the purpose of carrying the securities. Accordingly, it is interesting to observe that, as an incident of the long periods of distribution, the investment banker's "spread," that is, the difference between the price paid to the issuer for the security and the price received for it from the investing public, was larger during this period than in later years.

Prior to World War I, the United States was a debtor and not a creditor nation. Investment banking firms in this country turned to Europe to find wealthy individuals and other investment bankers who would be willing to share the risk and underwrite the security issues of business enterprises in the United States. European investment banking firms also sold to investors in Europe the securities of American business enterprises. Among some of the European investment banking firms to which Goldman, Sachs & Co. and Lehman Brothers turned to during this period were Kleinwort Sons & Company, Helbert, Wagg & Russell and S. Japhet & Company, all of London, Labouchere Oyens & Company, of Amsterdam, and others in Berlin and Zurich. Goldman, Sachs & Co. had established business relationships with all of these investment banking firms prior to the year 1906, when it was anxious to enter the international banking business in order to be able to furnish its American clients with letters of credit and foreign exchange. All of these contacts became very useful when Goldman, Sachs & Co. entered the investment banking business.

With this background, it is easy to see that many of the issuers, especially those whose securities were not well known to the public, leaned heavily upon the sponsorship of the investment banking firms under whose auspices the securities were sold. Issuers invited partners or officers of investment banking firms to serve on their boards of directors, in order to interest investors in their securities. Some of the prospectuses, which in those early days were little more than notices, stated that a partner or officer of a particular investment banking firm would go on the board of directors of the issuer whose securities were being offered to the public for sale. Investment bankers sometimes asked to be put on the boards of directors of issuers in order to know how they were managed and to protect the interests of the investors to whom they had sold the issuer's securities. Since the investment bankers sponsored the securities and lent their names to their sale, they felt a certain obligation to the investors to whom they sold the securities to see to it that the issuers did not adopt any policies or engage in any practices which would impair the value of those securities. This was especially important in connection with foreign investors.

Another development which was to have repercussions later on arose out of the difficulty of obtaining underwriters to share the risk. Thus it was that, prior to World War I, it was not unusual to find officers, directors and shareholders of issuers made participants on original terms in the underwriting of security issues; and investment bankers approached wealthy friends and other moneyed individuals, who were willing to take the risks involved, and asked them to participate. Commercial banks also took participations in substantial amounts.

In the period under discussion, it was common for an investment banker to purchase an entire issue directly from the issuer at a stated price, and that banker alone would sign the purchase contract with the issuer. Generally, the investment banker's agreement to purchase represented a firm obligation. This investment banker would then immediately organize a larger group, composed of a limited number of investment banking firms, which was sometimes called a "purchase syndicate," whereby he would, in effect, sub-underwrite his risk by selling the securities which he had purchased alone from the issuer to this larger group, at an increase or "step‑up" in price. The investment banker who purchased the entire issue directly from the issuer was known as the "originating banker" or "house of issue." The originating banker became a member and the manager of the "purchase syndicate." Goldman, Sachs & Co. is said to be one of the first investment banking firms to develop this method of underwriting securities; and, although this method may have been developed to underwrite the securities of the smaller, less well-known industrial enterprises and of the family concerns which were for the first time launching securities for sale to the public, other investment bankers used the same method to underwrite the securities of large industrial enterprises, railroads and utilities. As business enterprises in this country grew in size, and as the amounts of capital required by these enterprises became larger, sometimes a second group, more numerous than the "purchase syndicate," would be formed in order to spread still wider the risk involved in the purchase and sale of the securities. The "purchase syndicate" would then sell the securities which it had purchased at an increase in price from the originating banker to this second larger group, which was sometimes called a "banking syndicate," at another increase or "step-up" in price. The originating banker and the other investment banking firms, which were members of the "purchase syndicate," usually became members of the "banking syndicate" and the originating banker became its manager. The transfer of the securities to the "purchase syndicate" and then to the "banking syndicate" was practically simultaneous with the original purchase of the securities from the issuer by the originating banker.

Even at a time before there was any delegation of powers to any particular one of the original purchasers, according to the testimony of Harold L. Stuart of Halsey, Stuart & Co., "there was an agreement between the houses to buy them and to sell them and to maintain a price" which was even then called a "public offering price."

Stuart also described the first syndicate in which his firm participated, which was a $10,000,000 issue of First Mortgage Bonds of the Commonwealth Edison Company in December, 1908. There were two managers who were paid a fixed fee, an equivalent of the present day management fee, and the two managers had broad powers. Sales through the manager pro rata for the accounts of the members of the syndicate and also sales of non-withdrawn bonds on behalf of the syndicate members through dealers and directly to institutions and other buyers were contemplated. Further details appear in the syndicate agreements of certain issues of bonds of the Pacific Gas & Electric Company and United Light & Railways Company in 1912 and 1913.

From all the above it is evident that the various steps which were taken, including use of the purchase and banking groups above described, were all part of the development of a single effective method of security underwriting and distribution, with such features as maintenance of a fixed price during distribution, stabilization and direction by a manager of the entire coordinated operation of originating, underwriting and distributing the entire issue.

This evolution of the syndicate system was in no sense a plan or scheme invented by anyone. Its form and development were due entirely to the economic conditions in the midst of which investment bankers functioned. No single underwriter could have borne alone the underwriting risk involved in the purchase and sale of a large security issue. No single underwriter could have effected a successful public distribution of the issue. The various investment bankers combined and formed groups, and pooled their underwriting resources in order to compete for business. These groups of investment bankers were not combinations formed for the purpose of lessening competition. On the contrary, there could have been no competition without them. Unless investment bankers combined and formed such groups there would have been no underwriting and no distribution of new security issues. Perhaps the English system, which seems superior in the view of some, has many advantages. But the investment banking business in America grew and developed and prospered according to an indigenous American pattern.

The most significant fact about the period prior to World War I is that in it will be found the beginnings, the seeds as it were, from which in the course of time and by a gradual and traceable evolution there grew the elaborate and effective modern methods by which investment bankers, skilled in the application of their special techniques, perform the integrated services by which they earn their livelihood.

Thus in these early times we find investment bankers employing trained experts who spend much of their time developing plans and designing the set-ups of issues of securities which will be especially suitable for the needs of a particular issuer, at a particular time and under particular circumstances.

We find groups forming for the purposes of competition, sometimes small groups developing into larger ones. And we find the already well developed shaping up of the syndicate system, with features of price maintenance and stabilization and broad powers delegated to the managers in connection with distribution and otherwise, not as a means of merely merchandizing securities, as one would buy and sell hams and potatoes, as suggested by government counsel, but rather as a means of integrating the steps of purchase and distribution necessary to the attainment of the ultimate goal of channeling the savings of investors into the coffers of the issuer as a single unified, integrated transaction. No longer does the issuer bear the risk alone and distribute its securities by agents selling on a commission basis. The pattern of performing a series of interrelated services by the investment banker, including the formulation of the plan and method to be pursued in raising the money, the undertaking of the risk and the distribution of the security issue as a whole, has already emerged.

II. Between World War I and the Securities Act of 1933

The aftermath of the war was a period of over-production and mal-distribution accompanied by a sharp decline in the prices of commodities. A nation at peace could not absorb all the products of an economy, which, but a short time before, had been geared for the effective waging of war. Many business enterprises were faced with the problem of reorganizing in order to get their operations back on a profitable basis. By the year 1923, however, the nation's economy had recovered from the "commodity or inventory panic," and business enterprises began to enjoy more prosperous conditions.

In the following decade there was an unprecedented expansion of industrial and business enterprises, an increase in the number and geographical distribution of investors; and the use of the corporate form was adopted more and more widely. As domestic business units increased in size and number, the demands for investment capital reached a magnitude never before experienced. The United States had become a creditor nation; and, for the first time, foreign governments, foreign municipalities and foreign corporations turned to this country to raise capital from private American investors. Those investment banking firms which were dependent upon European capital for their underwriting strength went into eclipse and other banking investment firms came to the fore.

J. P. Morgan & Co. was the leading firm. But all the great publicly owned banks were in the investment banking business, first for their own account and later indirectly through either subsidiary or affiliated corporations formed for the purpose. Dillon Read, Lee Higginson, the old Kidder Peabody and Blair appear to have been perhaps the best known names in all-around business. Kuhn Loeb together with J. P. Morgan & Co. were leaders in railroads, in which field older firms such as Speyer, J. & W. Seligman, and Ladenburg Thalmann were also important. Bonbright, Harris Forbes, Halsey Stuart and Coffin & Burr were leaders in public utilities. Lehman and Goldman Sachs were leaders in merchandising and other fields. The largest distributing firms were those particularly connected with the banks, such as National City, Guaranty and Chase. But a number of other banks were active, such as First National, Bankers Trust, the principal banks in Boston, Chicago, Cleveland and Pittsburgh, and others. Among other firms then in existence but appearing less frequently were E. B. Smith, C. D. Barney, White Weld, Blyth Witter, Stone & Webster, Field Glore, Hallgarten and Brown Brothers.

Security issues followed one another in rapid succession and, whereas before World War I an issue of one million dollars was considered large, in the middle 20's issues of twenty and twenty-five million dollars were by no means unusual.

The impact of these economic forces upon the investment banking industry was precisely what one would have expected. The number of underwriters in the syndicates increased, in order both to spread the risk and to effect a widespread and rapid distribution of the securities to the public. Even so the problems of distribution became so complicated that it became customary to form an additional group called a "selling syndicate" or "selling group." The new "selling syndicate" was much larger and more widely dispersed than the purchase and banking groups had been.

There were three types of these selling syndicates throughout this period. While they represented successive steps in the development of investment banking, and while there were shifts in the type that was most extensively used, all three were used throughout the 1920's.

The first type was known as the "unlimited liability selling syndicate." In this group, each member agreed to take a pro rata share in the purchase of the security issue by the selling syndicate from the previous group, at a stated price, and to take up his share of any unsold securities, which remained in the syndicate at the time of its expiration. The syndicate agreement stated the terms upon which the offering to the public was to be made. Each member was given the right to offer securities to the public, and he received a stated commission on all confirmed sales. However, regardless of the amount of securities which he sold, he still retained his liability to take up his proportionate share of unsold securities. The undivided syndicate combined selling with the assumption of risk; therefore, both houses with distributing ability and houses with financial capacity, but without distributing ability, were included in the syndicate. Usually, a banking group was not organized where this type of selling syndicate was to be used. The purchase group sold the security issue directly to the selling syndicate.

The dealers who did the actual selling of the securities objected to the "unlimited liability selling syndicate," as they were compelled to take up in their proportionate shares the securities, which the other dealers, who were members of the selling syndicate, were unable to sell. Consequently, the second type of selling syndicate, which was known as the "limited liability selling syndicate," subsequently was developed. This syndicate operated in much the same manner as the undivided syndicate, except that the obligation of each member was limited to the amount of his commitment, and, when he distributed that amount, he was relieved of further liability. Each member retained his proportionate liability for the costs of carrying the securities, shared in the profits or losses of the trading account, and was liable for such other expenses as occurred after the purchase from the purchase or banking group. A banking group was usually organized where the "limited liability selling syndicate" was to be used.

The "limited liability selling syndicate" gradually evolved into the third type of selling syndicate, which was simply known as the "selling group." The "selling group" differed from the "limited liability selling syndicate" in that its members relieved themselves of all liability for carrying costs, the trading account and other expenses. Each member of the "selling group" was concerned only with expenses connected with the actual retail distribution of securities. The financial liability of the member was restricted to selling or taking up the amount of securities for which he subscribed. Usually, a large banking group was organized where the "selling group" was to be used. The banking group took over the liability for carrying costs, the trading account and other expenses.

The size and makeup of the selling syndicates varied with the circumstances of the particular security issue. Among the important factors, which were considered in the selection of dealers, were the size of the security issue, the type and quality of the security, the size and nature of the class of investors to whom the distribution was to be made, and the ability of a dealer to distribute securities of a particular type. All of these factors were considered in the selection of underwriters and dealers for the formation of the underwriting syndicates and selling groups.

In all of these types of selling syndicates, the members acted as principals, and not as agents of the manager, in distributing securities to the public. The syndicate agreement specified the price at which the securities were to be sold, and it was a violation of the agreement for a member to sell at any other price. The manager traded in the open market during the period of distribution in order to maintain the public offering price. Through such stabilizing operations, the manager sought to prevent any securities, which had been sold by dealers, from coming back into the market in such a manner as to depress the public offering price. It was felt that with respect to the securities which appeared in the market, the members of the selling syndicate had not performed their function of "placing" with investors, for which they were paid a selling commission; and, consequently, "repurchase penalties" were provided for, whereby the manager had the right to cancel the selling commission on the sale of those securities which he purchased in the market at or below the public offering price. Under most agreements, the manager had the option of either cancelling the selling commission on the sale of the securities, or of requiring the member who sold the securities to take them up at their cost to the trading account. Records of the serial numbers of securities were kept, and the securities which appeared in the market were thus traced to the dealers who sold them. Stabilizing operations and the repurchase penalty were used in all of the three types of selling syndicates which prevailed throughout this period. However, where a "selling group" was used, it became more and more common practice to restrict the re-purchase penalty to the cancellation of commissions.

The operations of the "selling syndicate" like those of the pre-war withdrawing subscribers, dealers and selling agents, were directed by the manager whose general supervisory function over the whole machinery of purchase and distribution was continued. Even in the earlier period provisions for maintenance of the public offering price by persons to whom title had passed had been included in some agreements.

As testified by Harold L. Stuart "you simply had to have such a clause in order to make this business function in putting the securities on the market," because "there were many ways that shrewd people could beat the game and spoil the putting of any security issue on the market unless you did this."

A significant development and one quite in keeping with the economic conditions above referred to, is that the periods for distribution became much shorter than they had been in the period prior to the war. Usually the life of the syndicate was designated as from thirty to sixty days, with a provision for earlier termination or for extension not exceeding a like period by the manager. As a matter of fact, however, the periods of distribution were generally much shorter.

The "market out" clause was evidently developed somewhere in the neighborhood of 1914 or 1915, and its use was fairly general at an early date. As the amounts of capital required by business enterprises became larger, and the number and size of securities issues greatly increased, the problems with which investment bankers were confronted, in connection with the underwriting of security issues, multiplied. Extensive investigations had to be conducted into the affairs of a business enterprise, and studies made of its financial structure and capital needs, at considerable expense to the investment banker, before that banker would undertake the risk and underwrite the securities of that enterprise. In this connection, investment banking firms were compelled to bring into their organizations individuals who had new types of specialized knowledge and experience; so that they gradually built up teams of specialists, who were experts in the different fields in which their respective investment banking firms underwrote securities.

Throughout this period prior to 1933, officers and directors of issuers continued to be made participants on original terms in the underwriting of the security issues of those issuers and other moneyed individuals also continued to participate. This was the much criticized "gravy train" about which much was heard in the early stages of the trial. The practice seems to have gradually disappeared in the course of time, due perhaps to the fact that the investment bankers in adequate numbers became available as underwriters and the liability provisions of the Securities Act of 1933 made such opportunities for profit less attractive. In any event, government counsel now agree that this issue is out of the case.

While there were some instances in the earlier period of a purchase by the members of a banking syndicate in severalty, the more usual legal form in which the transfer was made from the issuer to the participating underwriters in the decade now under consideration was a joint or joint and several purchase.

More important than any of the other developments between World War I and the passage of the Securities Act of 1933 was the effect of the unprecedented era of expansion upon the participation of the great banking institutions and their affiliates. As the need for vast amounts of new capital for expansion, plant construction and the establishment of thousands of new enterprises made increasing demands for new money, the banks and their affiliates became increasingly interested in managing and participating in the various underwritings. While the evidence in this case relative to the pre-Securities Act period is far from complete,there is ample documentary evidence to show that many of the banks became directly interested through their bond departments and many others formed affiliates, as above stated. J. P. Morgan & Co., the First National Bank and the Bankers Trust Company and many others in New York City, as well as large banking institutions in Chicago, Cleveland and other cities did a large investment banking business. The National City Company, the Guaranty Company and Chase Securities Corporation, affiliates of the National City Bank, the Guaranty Trust Company of New York and the Chase National Bank were in the investment banking business in a big way. The National City Company as of December 31, 1929, had a capital of $110,000,000. On the same date the capital of the Chase Securities Corporation was over $101,000,000. The economic power of these huge aggregations of capital vis-a-vis the relatively small capital of issuers was a factor of no mean significance in the period just before the great depression. There was an additional leverage in the multiplicity of banking functions which could be placed at the disposal of issuers. Added to this was the vast influence and prestige which must have made itself felt in a variety of ways. Issuers were dependent upon these great banking institutions in a way which finds no parallel in the relations between issuers and investment bankers in the period subsequent to the passage of the Banking and Securities Acts.

Before it became necessary by law to choose between commercial banking on the one hand and investment banking on the other, many of these great banking institutions were private banking houses under no statutory duty to make the disclosures required of national banks and others and this, coupled with the lack of legal requirements for disclosure of relevant facts connected with security issues, helped to make the period under discussion what has been described in the trial as an era of "dignity and mystery." In such an atmosphere it seems altogether probable that, wholly in the absence of any conspiratorial combination, issuers felt a strong inclination to continue to bring out issue after issue with the same bankers. Indeed, it is probably not too much to say that many issuers took pride and satisfaction from the very circumstance of their connection with these giants of American finance. Such sponsorship of an offering of securities to the public was of real value.

In any event, these great banking institutions and their affiliates were doing a huge investment banking business, and they were using the money of their depositors as well as their own resources to underwrite one security issue after another.

Some of the evidence which goes back to this earlier period leads to the suspicion that with reference to one or two particular issuers there may have developed some arrangement or combination of participants, continuing throughout a number of successive issues, which might, taken in isolation and separately, have constituted violations of the Sherman Act. At this late date, after practically all of those personally concerned have died and the files and other documentary evidence are no longer available, no adjudication of the legality of such isolated transactions is possible, nor is such adjudication requested by the government. Some references have been made in the evidence to contracts with a few issuers by which an investment banker was given "preferential rights"; and Harold L. Stuart testified that he tried to get such contracts whenever he could. They seem to have been ineffectual, however, and have long since gone out of use, due at least to some extent to the disapproving attitude of the SEC. In any event, I cannot find that they were sought or used to any extent by the defendants in this case.

III. Further Developments 1933-1949

Following the Armstrong Insurance investigation in 1905 and Governor Hughes' Committee Report in 1909 there had been other investigations which covered activities of investment bankers. The Pujo investigation was conducted in 1912 and 1913, the Utility Corporation inquiry by the Federal Trade Commission started in 1928; and these were followed by a long series of hearings, under the auspices of various committees of the Congress, which resulted in the Banking Act of 1933 (known also as the Glass‑Steagall Act), the Securities Act of 1933 and the Securities Exchange Act of 1934. From December 10, 1931 through February 1932 the Senate Committee on Finance pursuant to the Johnson Resolution undertook to investigate the flotation of foreign bonds and other securities in the United States. Perhaps the most important of these investigations was the Gray‑Pecora investigation of the Senate Committee on Banking and Currency which began on April 11, 1932 and continued through May 4, 1934.

In this chronological survey of the history and development of the investment banking business it will suffice to say that these statutes, together with the Public Utility Holding Company Act of 1935 and the Maloney Act, effective June 25, 1938, which added Section 15A to the Securities Exchange Act of 1934, and authorized the organization of the National Association of Securities Dealers, Inc. (NASD), under the supervision of the SEC, which followed, effected changes of the most radical and pervasive character; and these changes were made with a complete and comprehensive understanding by the Congress of current methods of operation in common use in the securities issue business, such information having been made available in the course of the investigations to which reference has just been made.

Institutions which had previously engaged both in commercial and deposit banking on the one hand and investment banking on the other were required to elect prior to June 16, 1934, which of the two functions they would pursue to the exclusion of the other. This resulted in the complete elimination of the commercial banks and trust companies from the investment banking business; and the various bank affiliates were dissolved and liquidated.

The elaborate procedures which now became necessary in connection with the sale of new issues of securities were at first implemented by the Federal Trade Commission and then, upon the creation of the Securities and Exchange Commission, transferred to it. The regulation of the securities business which followed with such salutary and beneficial results has been one of the significant developments of our time. The era of "dignity and mystery" was over.

When we come to discuss the syndicate system and its operation, it will be appropriate to treat in some detail the various applicable provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934, with their respective amendments, and also the numerous regulations, interpretations and releases of the SEC relative thereto. For the sake of continuity and clarity, however, this brief recital of the development of the investment banking business will be continued in order to furnish general background.

Security issue financing was relatively inactive as the result of the great depression, up until about the end of 1934. Thereafter, except for an occasional falling off in the depression of 1937 and in the early years of World War II, the needs of industry kept the demand for new capital at a high level. The reduction of interest rates as the result of government manipulation brought about refundings on a large scale and further refundings continued in volume as interest rates continued to fall. The size of issues increased. An issue of $5,000,000 was considered small. In this period there were 155 issues of $50,000,000 and larger; 559 issues of $20,000,000 and larger and over 1,000 issues of $10,000,000 and larger.

Due largely to the impact of the income and inheritance tax laws, the importance of the individual as an investor diminished and there was an extraordinary and continued growth in the size and investment needs of large institutional investors such as life and casualty companies, savings banks, investment trusts, pension funds, universities, hospitals and fraternal orders. Perhaps the most significant change of all was caused by the withdrawal from the field of investment banking of the capital funds of the commercial banks and their affiliates, which had previously been among the foremost managers and underwriters of security issues. As already stated, investment banking firms could participate in and manage underwritings only with their own money. As of the end of 1949 only 7 of the defendant firms had a capital of 5 million dollars and larger, 8 a capital of between 2 and 5 millions and 2 a capital of between 1 and 2 millions. Nor could any of them use all of their capital or borrowing power for underwritings, as each was engaged in other activities which tied up a part of their capital funds and they were all subject to certain regulations of the SEC and the various exchanges which promulgated rules and regulations affecting the amount of capital available for underwriting.

The Revenue Act of 1932, which became effective on June 22, 1932, for the first time imposed a tax on the transfer of bonds, * * * . A transfer tax on stocks had previously been enacted in 1914; but in 1932 this tax was greatly increased in amount, * * * . Section 11 of the Securities Act of 1933 imposed on each underwriter a civil liability, for any omission or misstatement of a material fact in the registration statement, equal to the entire amount of the issue. By later amendment in 1934, Title II, Sec. 206 (d) of the Securities Exchange Act of 1934, this liability was changed to "the total price at which the securities underwritten by him and distributed to the public were offered to the public." 15 U.S.C.A. § 77k(e). The liability thus defined plus the transfer taxes made it necessary for the underwriters to abandon the purchase of security issues jointly or jointly and severally, and resulted in the purchase by the various underwriters in severalty, which has been the prevailing method ever since. Otherwise an underwriter might still be liable under Section 11 of the Securities Act of 1933, as amended, for the entire amount of the issue. Significantly, since the 1933 Act, the underwriters still frequently take title jointly or jointly and severally when the security is a municipal or other issue not subject to the Securities Act of 1933.

The old banking and purchase syndicates with the "step-up" of earlier days which had been gradually going out of vogue, now completely disappeared. The form in which underwriting transactions commonly took place from the passage of the Banking and Securities legislation up to the present time is that of a purchase or "underwriting agreement" between the issuer and the underwriters represented by the manager, and an "agreement among underwriters."

The substance of the entire transaction is substantially what it was before. The manager, like the originating banker or manager in the previous periods, handles the negotiations with the issuer and supervises the whole process of underwriting and distribution. The management fee of today is not a new development either in form or in purpose after the Securities Act of 1933, but is the direct equivalent of the management fee paid by the members of the syndicate to the manager for his services in pre-1933 financings, where the syndicate either purchased directly from the issuer or from a prior "original purchaser."

Dealer and group sales are still made, under the authority of the manager who directs the entire process of distribution. But the change in the character of the investing public and especially the development of institutional investors on such a large scale and the impact of regulation by the SEC and of the Securities Act of 1933, the Securities Exchange Act of 1934 and the organization and functioning of the NASD, brought about a gradual decrease in the use of selling group agreements, especially in issues of the higher grades of debt financing and preferred stock. It is worthy of note that in performing his function of making sales for the accounts of the underwriters both to dealers and to institutions the manager sells "out of the pot." In other words, he does not allocate particular bonds to particular underwriters but simply sells "bonds" and does not allocate numbers to any participant until the time comes for delivery of securities to the purchasers. In accordance with the trend of the previous period spreads are gradually becoming smaller and smaller; and the maximum life of the syndicates is now 15, 20 or 30 days, although in some cases the maximum period may be longer, and it is not unusual to find clauses authorizing the manager to extend the period with or without the consent of a certain proportion of the underwriters. Price restrictions may, however, be removed earlier than the actual termination date of the syndicate, and as a practical matter they are generally terminated within a few days after the offering.

Stabilization provisions have become commonplace pursuant to statutory provisions and administrative regulations and interpretations relating to their use. While the authority to stabilize is generally given, it is only in relatively few cases that the authority has been exercised.

The use of "penalty clauses" has varied and the same is true of the use of price maintenance clauses. This subject will be discussed in greater detail when we come to the portion of this opinion devoted to syndicates. But it is well to bear in mind throughout that the entire pattern of the statutory scheme above referred to, as implemented by the various rules and regulations of the SEC and the rules of Fair Practice of the National Association of Securities Dealers, Inc., approved by the SEC pursuant to legislative authority, contemplates the sale of each security issue at the public offering price proposed in the prospectus and set forth in the registration statement as finally made effective by the SEC. Having proposed and tendered a security issue to the public at the public offering price, it is not strange that those who propose to sell the entire issue at this public offering price should be required to make a bona fide attempt to do so. Otherwise,the elaborate statutory provisions relative to "the public offering price" would be meaningless. Nor, under these circumstances, should one wonder that some investment banking houses continued to use price maintenance clauses while others did not.

In the previous period a few issues were brought out by public sealed bidding and there were some private placements. In the present period public sealed bidding transactions very greatly increased due to the adoption by the SEC in 1941 of Rule U‑50, in connection with all security transactions of companies affected by the Public Utility Holding Company Act of 1935 and to the ruling in 1944 of the Interstate Commerce Commission, requiring all debt issues of railroads to be sold at public sealed bidding.

Due in part to the registration provisions of the Securities Act of 1933, but also in large measure to the increase in the number of institutional investors and their particular requirements, private placements grew by leaps and bounds.

In 1937 the $48,000,000 Convertible 3 1/2s of the Bethlehem Steel Corporation which came out on September 8, 1937 and the $44,244,000 issue of 5% Convertible Preferred Stock of the Pure Oil Company on September 3, 1937 were conspicuously unsuccessful and many of the underwriters suffered serious embarrassment. Repercussions were felt throughout the entire investment banking industry; and thereafter the number of underwriters in practically every syndicate was largely increased in order to spread the risk more widely.

The period 1933‑1949 is the critical period in this case, as it includes the years immediately prior to the filing of the complaint in October, 1947.

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In this last and final period the Securities and Banking Acts, the numerous and detailed rules and regulations of the SEC, the multiplicity of forms, prospectuses and registration statements which were required to be prepared and filed, and the organization and operation of the NASD, all had a profound effect upon the investment banking business. But none of these developments altered the basic function of the syndicate operation as a unitary, integrated means of underwriting and distributing a security issue, under the direction of a manager. This remained fundamentally the same as it was in the beginning. Such changes as had taken place from first to last were the normal and natural reactions of business men with common problems, to the course of economic events and the legislation which has been described.

IV. How the Investment Banker Functions

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The types of issues, methods of raising money and the general apparatus of finance which I am about to relate are the ABC's of investment banking, known to every investment banker but not to others.

The problem before an issuer is in no real sense that of selling a commodity or a manufactured article. In essence what the issuer wants is money and the problem is how and on what terms he can get it. Basically, it is simply a question of hiring the money.

Thus a knowledgeable issuer, and most of them are definitely such, will scan the possibilities, which are more numerous than one might at first suppose. The available types of transactions include many which may be consummated by the issuer without using any of the services of an investment banker. In other words, the raising of a particular sum may be engineered and consummated by the executive or financial officers of an issuer according to a plan originated and designed by them; and this may be done after prolonged collaboration with one or more investment bankers, whose hopes of being paid for the rendition of some sort of investment banking services never reach fruition. Thus the necessary funds may be raised by:

1. A direct public offering by the issuer without an investment banker. 2. A direct offering to existing security-holders without an investment banker.

3. A direct private placement without an investment banker.

4. A public sealed bidding transaction without the assistance of an investment banker.

5. Term bank loans, commercial mortgage loans, leasebacks and equipment loans by commercial banks, life insurance companies and other institutions.

Where the services of an investment banker are used, the typical transactions are even more varied. The principal ones are:

1. A negotiated underwritten public offering.

2. An underwritten public offering awarded on the basis of publicly invited sealed bids, an investment banker having been retained on a fee basis to shape up the issue.

3. A negotiated underwritten offering to existing security-holders. Here the investment banker enters into a commitment to "stand by" until the subscription or exchange period has expired, at which time the investment banker must take up the securities not subscribed or exchanged.

4. An underwritten offering to existing security-holders awarded on the basis of publicly invited sealed bids, an investment banker having been retained on a fee basis to render the necessary assistance.

5. A non-underwritten offering to existing security-holders, with an investment banker acting as agent of the seller on a negotiated basis.

6. A private placement with an investment banker acting as agent of the seller on a negotiated basis.

There are many and sundry variations of the types of transactions just described, depending on the designing of the plan, the amount of risk-taking involved and the problems of distribution; and these variations are reflected in the amount of compensation to be paid to the investment banker, which is always subject to negotiation. And it is worthy of note that, where the services of an investment banker are availed of in the preparation of an issue for publicly invited sealed bids, then pursuant to SEC, ICC and FPC rulings, the investment banker who has rendered financial advisory services for a fee cannot bid on the issue.

Moreover, the static data reveal numerous instances where combinations of these types of transactions are used. The avenues of approach to the ultimate goal of hiring the money on the most advantageous terms, and in ways peculiarly suited to the requirements of the particular issuer at a given time and in a certain state of the general securities market, are legion. And issuers, far from acting in isolation, are continually consulting and seeking advice from other qualified financial advisers such as their commercial bankers and others. Sometimes an issuer knows pretty well in advance which type of transaction it wishes to use. More often this is not determined until every angle has been explored. In either event, the methods to be followed present a complex series of possibilities, many of which involve intricate calculations of the effective cost of the money and a host of other features affecting the capital structure of the issuer, plans for future financing, problems of operation of the business and so on.

Generally the money is needed for a special purpose at a particular time, which may or may not be determined at the will of the issuer. Examples are: for expansion, the building of a new plant, the purchase of existing facilities, the scrapping of one set of elaborate and costly machines and their replacement by others more efficient and up-to-date, or for refunding. Often it is deemed important by the management that there be a wide distribution of the securities or that they be placed with investors in a particular geographical locality or among those who utilize the services of the issuer or purchase its products. When good will is involved or favorable treatment of existing security-holders is desired, the issuer may have sound reasons for not wishing to obtain the highest possible price for the issue.

If a given type of transaction is tentatively selected, the issuer has before it an almost infinite number of possible features, each of which may have a significant bearing on the attainment of the general result. The method to be pursued may be through an issue of bonds or preferred or common stock or some combination of these. If a debt issue is contemplated there are problems of security and collateral, debentures or convertible debentures, serial issues, sinking fund provisions, tax refund, protective and other covenants, coupon rates and a host of other miscellanea which may affect the rating (by Poor's or Moody's, Fitch or Standard Statistics), or the flexibility necessary for the operation of the business and the general saleability of the issue in terms of market receptivity. These details must each be given careful consideration in relation to the existing capital structure and plans for the future. If equity securities seem preferable on a preliminary survey, the available alternatives are equally numerous and the problems at times more vexing. What will do for one company is not suitable for another, even in the same industry. At times prior consolidations and reorganizations and an intricate pattern of prior financing make the over-all picture complicated and unusually difficult. But in the end, sometimes after many months of patient effort, just the right combination of alternatives is hit upon.

The actual design of the issue involves preparation of the prospectus and registration statement, with supporting documents and reports, compliance with the numerous rules and regulations of the SEC or ICC or FPC and the various Blue Sky Laws passed by the several States. In view of the staggering potential liabilities under the Securities Act of 1933 this is no child's play, as is known only too well by the management of issuers.

This hasty and far from complete recital of available alternatives will suffice to indicate the milieu in which the investment banker demonstrates his skill, ingenuity and resourcefulness, to the extent and to the extent only that an issuer wishes to avail itself of his services. It is always the hope of the investment banker that the issuer will use the full range of the services of the investment banker, including the design and setting up of the issue, the organization of the group to underwrite the risk and the planning of the distribution. If he cannot wholly succeed, the investment banker will try to get as much of the business as he can. Thus he may wind up as the manager or co‑manager, or as a participant in the group of underwriters with or without an additional selling position; or he may earn a fee as agent for a private placement or other transaction without any risk-bearing feature. Or someone else may get the business away from him.

Thus we find that in the beginning there is no "it." The security issue which eventuates is a nebulous thing, still in futuro. Consequently the competition for business by investment bankers must start with an effort to establish or continue a relationship with the issuer. That is why we hear so much in this case about ingenious ways to prevail upon the issuers in particular instances to select this or that investment banking house to work on the general problem of shaping up the issue and handling the financing. This is the initial step; and it is generally taken many months prior to the time when it is expected that the money will be needed. It is clear beyond any reasonable doubt that this procedure is due primarily to the wishes of the issuers; and one of the reasons why issuers like this form of competition is that they are under no legal obligation whatever to the investment banker until some document such as an underwriting agreement or agency contract with the investment banker has actually been signed.

Sometimes an investment banking house will go it alone at this initial stage. At times two or three houses or even more will work together in seeking the business, with various understandings relative to the managership or co-managership and the amount of their underwriting participations. These are called nucleus groups. Occasionally one comes across documents pertaining to such nucleus groups which seem to contemplate the continuance of the group for future business, only to find that in a few weeks or less the whole picture has changed and some realignment of forces has taken place.

The tentative selection of an investment banker to shape up the issue and handle the financing has now been made; and there ensues a more or less prolonged period during which the skilled technicians of the investment banker are working with the executive and financial advisers of the issuer, studying the business from every angle, becoming familiar with the industry in which it functions, its future prospects, the character and efficiency of its operating policies and similar matters. Much of this information will eventually find its way in one form or another into the prospectus and registration statement. Sometimes engineers will be employed to make a survey of the business. The investment banker will submit a plan of the financing, often in writing; and this plan and perhaps others will be the subject of discussions. Gradually the definitive plan will be agreed upon, or perhaps the entire matter will be dropped in favor of a private placement, without the services of an investment banker. Often, and after many months of effort on the part of the investment banker, the issuer will decide to postpone the raising of the money for a year or two.

In the interval between the time when the investment banker is put on the job and the time when the definitive product begins to take form, a variety of other problems of great importance require consideration. The most vital of these, in terms of money and otherwise, is the timing of the issue. It is here, with his feel and judgment of the market, that the top-notch investment banker renders what is perhaps his most important service. The probable state of the general security market at any given future time is a most difficult thing to forecast. Only those with ripe trading experience and the finest kind of general background in financial affairs and practical economics can effectively render service of this character.

At last the issue has been cast in more or less final form, the prospectus and registration statement have been drafted and decisions relative to matters bearing a direct relation to the effective cost of the money, such as the coupon or dividend rate, sinking fund, conversion and redemption provisions and serial dates, if any, are shaped up subject to further consideration at the last moment. The work of organizing the syndicate, determining the participation positions of those selected as underwriters and the making up of a list of dealers for the selling group or, if no selling group is to be used, the formulation of plans for distribution by some other means, have been gradually proceeding, practically always in consultation with the issuer, who has the final say as to who the participating underwriters are to be. The general plans for distribution of the issue require the most careful and expert consideration, as the credit of the issuer may be seriously affected should the issue not be successful. Occasionally an elaborate campaign of education of dealers and investors is conducted.

Thus, if the negotiated underwritten public offering route is to be followed, we come at last to what may be the parting of the ways between the issuer and the investment banker - negotiation relative to the public offering price, the spread and the price to be paid to the issuer for the securities. These three are inextricably interrelated. The starting point is and must be the determination of the price at which the issue is to be offered to the public. This must in the very nature of things be the price at which the issuer and the investment banker jointly think the security can be put on the market with reasonable assurance of success; and at times the issuer, as already indicated in this brief recital of the way the investment banker functions, will for good and sufficient reasons not desire the public offering price to be placed at the highest figure attainable.

Once agreement has been tentatively reached on the public offering price, the negotiation shifts to the amount of the contemplated gross spread. This figure must include the gross compensation of all those who participate in the distribution of the issue: the manager, the underwriting participants and the dealers who are to receive concessions and reallowances. Naturally, the amount of the spread will be governed largely by the nature of the problems of distribution and the amount of work involved. The statistical charts and static data indicate that the amount of the contemplated gross spreads is smallest with the highest class of bonds and largest with common stock issues, where the actual work of selling is at its maximum. While no two security issues are precisely alike and they vary as the leaves on the trees, it is apparent that the executive and financial officers of issuers may sit down on the other side of the bargaining table confidently, and without apprehension of being imposed upon, as data relating to public offering prices, spreads, and net proceeds to issuers from new security issues registered under the Securities Act of 1933 are all public information which are publicized among other means by the wide distribution of the prospectuses for each issue.

And so in the end the "pricing" of the issue is arrived at as a single, unitary determination of the public offering price, spread and price to the issuer.

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