Too Big To Fail or Too Hard To Remember: James M. Landis and Regulatory Design

by Justin O'Brien

This year marks the fiftieth anniversary of the death of James M. Landis, one of the most pivotal entrepreneurs in regulatory history. A key architect of the Securities and Exchange Commission, established eighty years ago, and former Dean of Harvard Law School (1937-1946), Landis and his conception of regulatory purpose has largely been relegated in part because of an investigation into his personal tax affairs that did much to besmirch his legacy. In advance of a major panel discussion at Harvard Law School on November 24, 2014, Justin O’Brien evaluates the abiding strength of the approach to regulatory design advanced by Landis, drawing on a major article on “too big to fail” just published in Law and Financial Markets Review and his monograph The Triumph, Tragedy and Lost Legacy of James M Landis (Hart Publishing, 2014).

“One grasps for shadows the better to comprehend sunlight. One reaches into the past, more clearly to know today and tomorrow. It is the privilege of all who care about education to test the depth and quality of that shadow for there, perhaps more than anywhere, one must try to pierce the brilliance of continuing dawns,” noted James M. Landis, the Chairman of the Securities and Exchange Commission, in a speech delivered at the Catholic University of America in March 1937. Landis, one of the most pivotal figures in establishing and legitimating external oversight of the capital markets, was at the time ruminating whether to return to the academy. An outsider, born in Tokyo in 1899, Landis had risen to the apex of bureaucratic power. There he had put into practice the ideas that animated the progressive jurist Louis Brandeis, for whom he had clerked after graduating from Harvard Law School. His public service for the Roosevelt administration, his connections in both Washington and New York, and his preference for evidence over unsubstantiated assumption had guided initial success, including at Harvard itself, where he became a tenured professor in 1929. Not surprisingly, Harvard’s law faculty as well as the university itself was keen to see his return to Cambridge to navigate the relationship between Washington and the country’s pre-eminent legal educational establishment, not least because of the rapid expansion of the federal bureaucracy.

As a legislative scholar, draftsman and regulator Landis knew few equals, then or since. While other prominent members of the informal Brains Trust that provided advice to Roosevelt were better known at the time, none—with the exception of William O. Douglas, a mercurial self-promoter who inveigled his way to the SEC and from there to Supreme Court though the patronage of Landis—had such pronounced influence in regulatory policy. Four years on the frontline of at times vicious battles over whether and how to impose restrictions on freedom to contract in capital markets had, however, taken its toll. The SEC, the agency Landis had been instrumental in designing, had survived Supreme Court challenge, notwithstanding criticism from the bench that its methods risked application of unaccountable and arbitrary power. It was an accusation that Landis treated with barely disguised contempt when in a major speech in Chicago just ten days before the Catholic University address he accused a majority of the Supreme Court of “writing their own individual economic prejudices and predilections into the fabric of constitutional law.” Such trenchant criticism of the highest court in the land reflected intellectual bravery. It showed willingness to engage in partisan disputes in equal measure. It also reflected a personal commitment to the praxis between cutting edge academic research and policy development. For Landis in 1937, a further tactical and strategic challenge remained unresolved: how and through what mechanism to institutionalize the ideational gains of the New Deal?

The challenge consumed him as he oscillated between the academy and regulatory and private practice over the next three decades. It was a quest that was to prove his personal undoing. In 1963, Landis was publicly humiliated in the Federal Court of the Southern District of New York, where he was convicted and sentenced to one-month’s imprisonment for failing to file income tax returns. Commuted to forced hospitalization on the orders of Chief Justice Sylvester Ryan, the ruling sent an unambiguous message that none could be held above the law. The case and its handling had profound political implications for the Kennedy administration, which had mandated a substantial reorganization of regulatory agencies as a result of specific recommendations made by Landis to the president-elect in December 1960. In prosecuting the architect of the New Deal for what amounted to a misdemeanor, the Department of Justice felt it had little choice. Landis was to become a victim of political expediency. An already brittle personality cracked under the strain. Landis entered a downward spiral into alcoholism and depression. His personal and professional life disintegrated. Despite the suggestion by Chief Justice Ryan that Landis could once more aspire to greatness, the judge was no doubt aware that the defendant would probably never recover. He never did. A year later he was dead, found floating in his swimming pool three weeks after being suspended from legal practice. The tragedy was complete.

Landis was the critical architect of the Securities Act (1933), governing new issuance, and the Securities Exchange Act (1934), which extended regulatory oversight to existing securities and mandated associational governance with the exchanges through the establishment of the SEC. He served on the agency’s inaugural board, becoming its second chairman with the public endorsement of his predecessor. Integrating enforcement with attempts to guide industry towards socially beneficial outcomes, Landis never saw the regulatory agency’s role as solely that of policing. He maintained that administrative law could, should and did perform a crucial task in operationalizing initial democratic choices and subsequent political mandates. At the same time, he was profoundly aware of the challenge of ensuring appropriate accountability mechanisms, the failure to attend to which would leave the entire project subject to judicial criticism.

Through a combination of tactics and strategy, there can be no questioning his mercurial shrewdness in establishing and legitimizing the regulatory state. There is much to be gained in revisiting that agenda in order to deal with existing problems in regulatory design in the capital markets. A critical factor in the recent Global Financial Crisis was the provision of a de facto guarantee to institutions deemed too big to fail. It remains one of the thorniest issues in capital market governance. Despite the depth of proposed reform measures, coordinated at the global level by the Financial Stability Board, the political economy questions at the domestic level remain unresolved. Mark Carney, Governor of the Bank of England and the head of the Financial Stability Board, set out a progress report at the 2013 G20 Summit in St. Petersburg. Much, he claimed, had been achieved but more was required in order to allow for the orderly resolution of systemically important financial institutions. These remained too inter-connected, too complex, and subject to “worryingly large differences” in the nature and quality of internal risk models. With remarkable understatement, Carney argued that “our work is not yet completed. It is crucial that the G20 stay the course in implementing reforms in a consistent manner.” It will be a pivotal component of the upcoming G20 leaders summit in Brisbane this November.

These problems are, however, not new. As in so many other areas of financial regulation, there is much to digest from the lessons of history. Faced with the problem of regulating “too big to fail” in the 1930s, the United States was faced with a similar existential question. Then the problem was the interdependence between investment banking and the electricity and gas markets. The lack of coordination applied at the state-federal rather than the international level. Radical change then, as now, was equally bitterly opposed by industry. It was to spawn one of the most sustained and vicious lobbying campaigns in history. Crucially, however, it was a battle in which the investment industry worldview was faced down and, ultimately—if only temporarily—defeated. It is a lesson that we do well to remember, as well as the central role of James M. Landis in guiding the success of the strategy. What becomes clear from this reevaluation is the importance of a strong normative underpinning, informed by adroit administrative tactics, effective litigation strategy and resolute political backing. All three, necessary for transformative change, were instrumental in securing the passage in August 1935 of the Public Utility Holding Company Act, the most far-reaching piece of legislation passed in the New Deal.

The legislation built on the formal separation of commercial and investment banking and the introduction of a disclosure regime in the issuance of new securities and trading of publicly traded companies. It went much further, however, in its recognition that some industries are so important and potentially so destabilizing that disclosure was an insufficient regulatory tool. By forcing the dissolution of highly leveraged corporate structures that relied on the capital markets for their rationale and expansion, the legislation was the most ambitious attempt to steer the direction and purpose of not just the electricity and gas sectors but also the power of finance to dictate public policy. Its purpose was to eliminate unfair business practices and abuses by closing down dispersed entities that evaded state oversight. They were blamed for putting corporate profits ahead of reliable electricity services. They were also seen as having privileged speculation over sustainable investment. The goal, therefore, was as much to redirect capital market practice as it was designed to keep the lights on and prices low. Unprepared to countenance the implications of the changes, the financial industry used the battles over the Public Utility Holding Company to undermine the operation of the entire disclosure regime.

The primary logic and justification of the draft legislation focused on the fact that the utilities were engaged in interstate commerce. It placed oversight with the Securities and Exchange Commission precisely because the primary problems identified were not operational but in the financial instruments that held them together. The purpose was to trade provision of a license to operate within contiguous borders in return for formal regulated oversight, restrictions in financial chicanery and capped pricing. The holding companies themselves were to be abolished if no economic purpose could be found to justify ongoing existence. This became known as the death sentence clause. Opponents, including Wendell Wilkie, a future Republican presidential candidate, warned of a process of nationalism by default as a “great bureaucracy in Washington [that] will be regulating the internal affairs of practically all utility operating companies in the United States.”

The House of Representatives wanted the death sentence to be commuted if determined by the SEC to be in the national interest. For the architects of the legislation, as well as for senior echelons at the SEC, which was required to administer it, such an extension of discretion, while superficially attractive, would be disastrous. It was a view endorsed by Landis, who was soon to assume the chairmanship and thus carry ultimate responsibility for its implementation. Landis saw inevitable court challenges and ongoing political controversy attach to such discretion.

The SEC was bombarded with lawsuits even before the act became operational. Landis and the SEC were caught in an impossible position, which could not be resolved without judicial determination. On the one hand, opposition from the utilities and the finance industry that facilitated their expansion undermined the agency’s capacity to secure consent for other aspects of its attempts to recalibrate the capital markets. On the other, any aggressive move on the broader enforcement agenda risked causing further alienation. Landis, in a pattern that was to be replicated throughout his tenure at the SEC and beyond, combined tactical and strategic tactics. Each was based on the acquisition of detailed empirical evidence. Notwithstanding the pressures and the goading, he refused to expose the agency to easy judicial challenge by precipitate action. His primary modus operandi, informed by political realities, was to exude reasonableness. This is not to say that Landis was cowed.

Surrounding himself with the top legal minds in the country, he mapped out a strategy to reduce the perception of arbitrariness within the SEC and at the same time paint the opposition in the Public Utilities Holding Company Act as, at best, duplicitous. It was now an imperative for the SEC to seize the initiative by developing a test case narrowly enough drawn to limit Supreme Court disproval. To do so it needed to divert attention from the more controversial aspects, such as the application of the corporate death sentence. Its test case would focus judicial determination on whether the SEC had the right to demand registration under the interstate commerce provision of the constitution. Secondly, it needed to ensure that its choice of opponent was sufficiently important to capture the attention of the industry as a whole. As Landis recalled, “we came to the conclusion that, let’s pick a big one, a top one, take a big one and topple that one, and then the little ones would fall into line.”

The legal team found its target in Electric Bond & Share, one of the largest utility companies in the country. As part of Landis’s twin-prong strategy of engagement and guile, he personally oversaw the registration negotiations with Electric Bond & Share, attending meetings with its executives in the week prior to the registration deadline of December 1, 1935. Following Electric Bond & Share’s inevitable failure to register, Landis pounced with alacrity. He directed his field staff to file a pre-arranged suit in the prestigious Southern District of New York, then as now the most important securities law jurisdiction in the country. As the legal challenges and counter-challenges meandered their way through the court system, the political mood darkened. Roosevelt captured what was at stake with a particularly strident call to arms delivered in the final days of the 1936 election campaign. The fiery rhetoric retains its power to shock:

For twelve years this Nation was afflicted with hear-nothing, see-nothing, do-nothing Government. The Nation looked to Government but the Government looked away. Nine mocking years with the golden calf and three long years of the scourge! Nine crazy years at the ticker and three long years in the breadlines! Nine mad years of mirage and three long years of despair! Powerful influences strive today to restore that kind of government with its doctrine that that Government is best which is most indifferent. For nearly four years you have had an Administration which instead of twirling its thumbs has rolled up its sleeves. We will keep our sleeves rolled up. We had to struggle with the old enemies of peace—business and financial monopoly, speculation, reckless banking, class antagonism, sectionalism, war profiteering. They had begun to consider the Government of the United States as a mere appendage to their own affairs. We know now that Government by organized money is just as dangerous as Government by organized mob. Never before in all our history have these forces been so united against one candidate as they stand today. They are unanimous in their hate for me—and I welcome their hatred. I should like to have it said of my first Administration that in it the forces of selfishness and of lust for power met their match. I should like to have it said of my second Administration that in it these forces met their master.

There could be no doubt that in Landis, along with his collaborators Ben Cohen and Tommy Corcoran, Roosevelt had found advisors capable of traversing the political and judicial stages, most notably in the presentation of oral arguments to the Supreme Court on the Electric Bond & Share Case. Writing to Landis in November 1937, Cohen acknowledged Landis’s process in making the SEC as small a target as possible. “It really was a cooperative victory and no little credit belongs to you for the effective manner in which you kept the Commission from being involved in any threats of enforcement. It did require a great deal of self-restraint on the part of the Commission.” The feeling was mutual. Oral arguments on the Public Utility Holding Act were heard in February 1938, with Ben Cohen and Robert Jackson, soon to be elevated to the Supreme Court, representing the government. While the jurisprudential turn of the previous year gave the strategists room for confidence, they could take nothing for granted. When the Supreme Court handed down its decision in April 1938, Landis was effusive in his praise for the diffident but brilliant Cohen. “You certainly deserve congratulations,” he wrote “for I doubt whether the annals of the Supreme Court history would show any case better presented than you presented the Bond and Share case. And more than that, you can now feel great pride in your own draftsmanship for your technique in this respect was no less a basis for the victory than your spoken arguments. I just wanted you to know that I take my hat off to you with the deepest respect.” In reply Cohen again acknowledged the tactical guile in litigating the case. “It was a truly cooperative endeavor and that is why it succeeded so well. And not a little credit belongs to you for the admirable restraint you showed under the provocation of the enemies’ fire.”

The importance of the case was that it gave the SEC the authority to begin enforcing the Public Utility Holding Company Act in all of its dimensions, a task which was entrusted to William O. Douglas. For Douglas there was early recognition that the changed dynamics of the Supreme Court as well as careful preparation had provided him with a once-in-a-lifetime opportunity. In typical fashion he seized it with gusto but he could not have achieved his goal without the patience of Landis in embedding the administrative process in American political life.

It is in this context that the abiding strength (and limitations) of the Landis approach to governance, which combines elite wisdom and capacity to both capture and utilize populist sentiment, becomes clear. At the heart of the compromise lies an uneasy compact on how to evaluate expertise. In the initial framing, this was conceived as the remit of impartial career-driven bureaucrats, prepared to forgo personal material advancement in exchange for societal improvement. The critical flaw pivots on what happens when claims to expertise are evaluated according to different criteria. It could only achieve its dominance because of the extraordinary political circumstances of the time. The unresolved question was what to do with this power. Here too, we see evidence of a coordinated approach built on gaining consensus rather than the imposition of externally generated dictates. Notwithstanding his own complex character, Landis became a beacon. It is a beacon that still burns brightly.