Commentary: A Sorry Legacy the Street Can't Shake

The pattern: A disgrace, a crackdown, then little real change

By Gary Weiss

It made headlines around the country. The New York State Attorney General took action against an entrenched practice on Wall Street--illegal conduct involving the stocks of the leading companies of the day. Wall Street seethed with resentment at what appeared to be politically motivated grandstanding.

The above event was taken right from the headlines--of Jan. 5, 1978. The attorney general was Louis J. Lefkowitz, not Eliot Spitzer, and his target was the American Stock Exchange, not analysts.

It's scandal time on Wall Street. Again. If brokerage industry scandals seem to happen over and over again--the names of the players changed, but the playbook intact--there's a good reason. They do. And that's important to keep in mind as the daily headlines unfold over Wall Street's latest moral crisis. Recurrent scandals are a part of the fabric of the Street, a product of halfhearted regulation and deeply ingrained industry practices that often go unchecked for years.

Historians say a distinct pattern has evolved since the 1930s: scandal, usually a byproduct of a bull market, followed by a sometimes overzealous crackdown, followed by a return to business as usual under the eyes of lax regulators. "What you have here is an institutionalized structure feeding on itself--slippage between the rules as written and the rules in practice," says Dale A. Oesterle, a University of Colorado law professor and critic of Wall Street's regulatory structure. In this view, the securities industry's system of self-regulation feeds the scandal-crackdown cycle.

It's surely no secret that there are no new Wall Street scams--just dusted off old ones. That is evident by perusing Wall Street tell-all books that have long since turned yellow with age. One of them that could have been written yesterday--but was published in 1932--was High and Low Financiers, an exposé of "some notorious swindlers and their abuses of our modern stock-selling system." The book recounts one instance in which the long-defunct brokerage Hadley & Co. took a huge position in the shares of an aircraft company and then issued the 1929 version of a strong buy--with 1990s-style price targets. Alas, "the actual condition of the company while these glowing descriptions were being broadcast was rather sad," said the authors. Sound familiar?

In reaction to such abuses, lawmakers passed the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1934 act, which created the self-regulation system in effect to this day, was a compromise between New Deal reformers and the Street. The newly created Securities & Exchange Commission was in overall charge, but most regulation and rulemaking was left in the hands of the exchanges.

The system has worked well--when the Street wants it to work well. But all too often, "abuses of our modern stock-selling system" go undetected and unpunished until it is too late. Critics say industry regulators are far too reactive and don't effectively prevent scandal. "The regulators have been slow to anger. They don't jump up and take action until there's a reason to notice," said John Herzog, a veteran Wall Street exec and chairman of New York's Museum of American Financial History.

Wall Streeters have a way of shrugging off the best their regulators have to offer. A good example can be found in the controversy that arose in the '90s concerning price-fixing on the Nasdaq Stock Market. After years of complaints that market-makers colluded to fix prices, the Justice Dept. brought suit. One result was a set of new order-handling rules designed to get customers fairer prices. But an SEC study in 2000 found what then-Chairman Arthur Levitt called an "alarming failure" to abide by those rules.

Other examples abound of Wall Street thumbing its nose at regulators. Penny stock scandals of the 1980s resulted in an uproar--and passage of sales practice rules governing shares trading at less than $5. But the rules were evaded or ignored, and the microcap scandals of the 1990s were the result. In the end, federal prosecutors--not the regulators--proved the undoing of the microcap crooks.

Law enforcement also brought down the other scoundrels of the 1980s. The insider trading scandals, and the prosecution of Mike Milken, generated daily headlines and destroyed Drexel Burnham Lambert. But insider trading continues to dog the markets. Likewise, the Lefkowitz assault on Amex traders was quickly forgotten, and new scandals beset the Amex and NYSE in the late 1990s.

A cycle of scandals doesn't have to be a permanent feature of the Wall Street landscape. Not if the SEC more actively enforces securities laws and relies less on the self-regulatory organizations, often justly criticized as too sympathetic to the Street. And if the SEC won't step in--well, there's always the state regulators. Spitzer is following a tradition that may result in feelings of déjà vu--but that doesn't make it any less necessary.

Senior Writer Weiss has written extensively about Wall Street scandals.

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