§ 2.1.1

• Jurisdiction: Arizona

§ 2.1.1 A Century Without Securities Regulation

In 1800, the American economy had yet to industrialize. Most Americans still lived on farms or in small towns.⁴³ But in the 1830s the industrial revolution galvanized the country.⁴⁴ By 1868, the U.S. economy had become the world's largest.⁴⁵

As the economy grew, new businesses and securities markets developed. The corporate form emerged as the preferred way for businesses to raise and manage capital.⁴⁶ The New York Stock Exchange established itself, and other securities markets in which stocks and commodities were publicly traded appeared.⁴⁷ New technology like the ticker tape made it possible to easily follow stock prices and sparked public interest.⁴⁸ In the 1870s bucket shops appeared in which people could bet on stock and commodity prices.⁴⁹ None of this investment activity was regulated.

Securities laws had yet to appear. Neither a federal counterpart to the Securities and Exchange Commission nor state securities regulators existed.⁵⁰ And the stock exchanges operated without rules to deter manipulation.⁵¹ The idea of government regulation to protect investors or tame the country's stock exchanges was foreign to nineteenth-century lawmakers.⁵²

The lack of regulation had predictable results. In the 1860s and 1870s Cornelius Vanderbilt, Jay Gould, and other Wall Street titans regularly manipulated the price of publicly traded stocks.⁵³ In one notorious stock-market corner, Vanderbilt nearly bankrupted the New York City council, which had tried to ruin him with excessive regulations regarding the Harlem Railroad.⁵⁴ Western railroad companies in the nineteenth century were highly leveraged companies that issued stocks and bonds without disclosing that they depended on continued borrowing from new investors to stay in business.⁵⁵ The result was widespread defaults on railroad bonds and huge price declines on railroad stocks.⁵⁶

In Arizona, stock schemes were enough of a problem that a proposed constitution in 1891 included provisions aimed at schemes by wildcat corporations.⁵⁷ Two decades earlier, California adopted constitutional provisions that were designed to curb wildcat schemes in gold-mine stocks.⁵⁸ Stock schemes in Arizona almost invariably involved securities issued to finance mining properties. Promoters freely exaggerated their mine's success in newspaper accounts, advertisements, and brochures.⁵⁹ Persuading well-known people to serve as directors and obtaining endorsements by mining experts was also common.⁶⁰ Prospectuses were used, but they were not written as disclosure documents.⁶¹ Their purpose was to induce sales by reassuring and exciting investors about potential profits.⁶² Even if the promoters were honest, their prospectuses and marketing techniques would be considered misleading by today's standards.

The mining prospectuses tended to follow the same general approach.⁶³ They estimated future profits,⁶⁴ promised high dividends,⁶⁵ and occasionally asserted that the dividends or purchase price was guaranteed in some way.⁶⁶ They normally described the company's mines as located in an area that had proven success.⁶⁷ Production figures were often listed to give the appearance of a proven mine or going concern.⁶⁸ In Arizona, where Apaches were a problem, assurances that the Indians were not a threat were sometimes made.⁶⁹ And invariably, the prospectuses used the names of mining engineers, well-known people, or both, to enhance their credibility.⁷⁰

Prospectuses issued by Seven Stars Gold Mining Company show how deceptive these prospectuses could be. During 1892 and 1893, Seven Stars' promoters distributed nearly 400,000 of the company's prospectuses in the U.S., England, and Scotland.⁷¹ Seven Stars' prospectuses claimed ownership of a producing gold mine and six other sites in Yavapai County's Eureka Mining District. The primary mine was described as "one of the richest and most extensive gold mines in the world."⁷² Investors were told that $2 million in gold was in "sight, ready to remove" and that for an estimated $100,000, another $3 million in ore could be reached.⁷³ For $5 a share, investors were "guaranteed" dividends "payable quarterly in gold, of 15 percent, per annum."⁷⁴ Quotes from mining experts gushed that when developed the mine would be "one of the most remarkable mines in the West," "one of the most valuable that it has ever been my fortune to know," and one that has "fully proved to be of immense value."⁷⁵ A schedule purported to show a track record for the mine by summarizing smelter deliveries and prices paid.⁷⁶

As it turned out, Seven Stars did not even own the mining properties that the prospectus described.⁷⁷ A class action was filed in Yavapai County.⁷⁸ The case eventually went to the Arizona Supreme Court and then to the U.S. Supreme Court. In affirming dismissal, the U.S. Supreme described Seven Stars' prospectuses as "full of exaggerated and delusive statements [that] were undoubtedly a gross fraud upon persons who took stock upon the faith of their exuberant promises."⁷⁹

It was not unusual to find public officials hawking mining schemes.⁸⁰ Before he was appointed Arizona's territorial governor in 1878, John Charles Fremont had a long history of participating in speculative mining and railroad ventures.⁸¹ In the 1870s, he was tried in absentia in France and convicted of fraud in swindling investors of roughly $6 million.⁸² In office, he used his position to promote his mining interests. In one legislative session, he approved a territorial lottery and obtained a $2000 appropriation to finance a trip to Washington D.C. regarding the Gila River Indian Reservation.⁸³ While in the East, he resolved the reservation issue, sold lottery tickets, and found eastern investors for mining stock he was promoting.⁸⁴ An Arizona newspaper reported that he made "bar'ls of money" selling mining interests.⁸⁵

Countless other examples could be given of securities transactions in the 1800s in which securities prices or investment information was manipulated or misrepresented almost at will.⁸⁶ The point, though, is that nineteenth-century securities markets, as well as the issuers, investment banks, and promoters who sold securities, were not restrained by securities regulators or securities laws. Laws requiring securities sellers to disclose adverse financial information and other material risks before selling securities did not exist. Market manipulation, deceptive prospectuses, false financial statements, and suppression of material information went unchecked except for an occasional criminal prosecution or civil action for common-law fraud.⁸⁷ Public protection through securities regulators and securities laws requiring registration, licensing, and disclosure were...