Seminal Works: Paul Mahoney Uncovers Hidden Side of Financial Regulation

Professor's Work as a Securities Lawyer Led Him to Question Regulation's Intent
Paul Mahoney
February 6, 2017

U.S. securities regulation is supposed to protect the interests of the public from nefarious behavior by investment bankers. But University of Virginia School of Law professor and former dean Paul G. Mahoney has dedicated much of his scholarship to showing just how misguided this idea is.

Mahoney first challenged the concept of regulation as preserving transparency and the rights of consumers in “The Political Economy of the Securities Act of 1933,” published in 2001 in the peer-reviewed Journal of Legal Studies.

The article was one of several studies of New Deal securities reforms Mahoney conducted that combine close reading of the historical record with creative empirical analysis of the limited market data available from the 1920s and 1930s.

The article is a public-choice analysis of the first of the New Deal financial reforms. Public choice theory argues that regulation is produced by the mutual self-interest of legislators and private-sector interest groups and tends to benefit the regulated industry by raising barriers to entry or otherwise reducing competition.

“The Securities Act had been long considered a counterexample,” Mahoney said. “Before this article, scholars uniformly described the Securities Act as an example of public-spirited regulation that protected investors from the misleading practices of investment bankers.”

The article, however, shows that the Securities Act was designed to, and did, have a substantial and detrimental effect on competition among investment banks. Its principal beneficiaries were large, established, wholesale investment banks that lost market share throughout the 1920s to newer, nimbler, vertically integrated investment banks that combined wholesaling and retailing. Those losses of market share were reversed after the Securities Act was enacted and many of the upstart firms disappeared.

How the article came about:

“During my time in practice, securities lawyers spent an enormous amount of time advising companies and investment banks about the Securities Act’s ‘gun jumping’ prohibition,” Mahoney said. “The basic idea is that when a company plans to offer its securities to the public, the statute limits what it can say prior to filing a registration statement.

“This always struck me as an exceedingly odd feature of something that is called a ‘full disclosure’ statute. Indeed, the more I thought about it, the more I became convinced that academic lawyers, economists and historians who wrote about the Securities Act had missed the point. The statute wasn’t interesting because it requires disclosures — companies have always made disclosures when they sell stock. It was interesting because of its secrecy provisions, which were something entirely new. But why were they there?

“Then I ran across the records of a trade group for the investment banking association from the 1920s. And here they were talking about gun jumping, a full five years before the Securities Act was in existence. And then I understood what was going on. Underwriters wanted everyone in a syndicate to begin selling at exactly the same time to reduce the risk that one investment bank would poach another’s customers. But they had no practical way to enforce it. Congress could do it by making it illegal to release information about the offering or to agree to sell the securities before the lead underwriter gave the go-ahead. Broadly speaking, that’s what the Securities Act did.

“My research on this article persuaded me that no matter how sensible and public-regarding is the big picture objective of a statute or regulation, if you give me input into the technical details of how it is implemented, I can make out like a bandit,” Mahoney said. “That has been an important theme in my work since then.”

Key lines from the article:

  • “The Securities Act … made it possible for a lead underwriter to provide distributing houses with detailed information about a pending issue secure in the knowledge that the latter could not agree to sell securities until the official offering date. The Act also assured the absence of retail solicitation prior to the offering date by suppressing preoffering publicity.”
  • “One important consequence was to protect high-prestige wholesale investment banks, and the retail dealers who sold on their behalf, from competition by integrated wholesale/retail investment banks that gained market share in the late 1920s.”
  • “Unlike many regulatory statutes, [the Securities Act] has been largely untouched by claims that it raises entry barriers or enforces cartel agreements among members of the regulated industry. Yet a closer look at the statute … shows that even the Securities Act was a likely source of rents for the firms it subjected to regulation.”

Why the work matters:

Yale Law School professor John Morley, a former UVA Law faculty member, said Mahoney’s work stands the test of time and inspired his own scholarship.

“Paul’s article is the definitive treatment of the politics behind the Securities Act of 1933. But more than that, it’s a roadmap to understanding the content and politics of all financial regulation. Before Paul’s article, everyone took it as an axiom that securities regulation was about disclosure and transparency. The law’s purpose, it seemed clear, was to force companies to open up to the public. But Paul showed that securities law was also secrecy. Though it sometimes forced companies to disclose, at other times it forced them not to. This insight was transformative — it flipped the logic of securities regulation upside down. But even more important was Paul’s development of an explanation. Paul showed that the securities acts served the interests of industry, rather than the public. This called the entire regulatory regime into question and opened up a whole methodology for understanding how and why financial regulation comes into being. Paul later used the article as the foundation of a book ["Wasting a Crisis: Why Securities Regulation Fails"] that provides a masterly and devastating critique of American financial regulation. This is why Paul’s article is the only academic article I assign to students in my securities regulation classes at Yale — it’s all they really need, because it cracks open the entire field.

“The methods in Paul’s article were especially important for me. I first read the article soon after I graduated from law school, when I was still a research fellow and before I had any scholarly ideas of my own. I found the article as I was flipping through old issues of academic journals in search of ideas I could use to generate my own research agenda. I was so inspired by Paul’s article and its method that I decided to take the same method and apply it to another New Deal securities statute — the Investment Company Act of 1940. As in Paul’s study of the Securities Act, I found that the Investment Company Act served the interests of the industry, rather than the public, though in slightly less worrisome ways. That study then set me on the path to what has become a whole research agenda about investment company regulation, much of it animated by the political sensibility I learned from Paul.”

The Seminal Works series explores key scholarship by UVA Law faculty that has changed how we think about the law.

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