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A Magazine of Ideas

The Uses of Scandal

Tuesday, May 21, 2013

One of the greatest uses of scandal is to vividly demonstrate what new laws are needed and to create the political conditions to get them enacted.

Washington is suddenly awash with major scandals. The IRS has been caught abusing its powers regarding conservative organizations. The AP had its phone records seized without a court order. The White House explanation for the Benghazi attack has been shown to have been a tissue of lies made for political purposes. There might well be more scandals to come. The Environmental Protection Agency, for instance, has reportedly been routinely waiving the substantial fees to fulfill Freedom of Information Act requests for liberal organizations but not for conservative ones.

This has produced, naturally, a cacophony of talk among the chattering classes, much of it basically gossip. And there’s nothing wrong with that. To gossip, after all, is to be human. We are the most social species on the planet, and the doings of our fellow creatures are thus always of great interest. And when those doings transgress societal norms — in other words, become a scandal — well, people will talk. But the amount of talk is directly proportional to the square of the social status of the people involved.

To be frank, other than those directly involved, no one much cares if a bank clerk in some small town dips into the till. But in 1938, when Richard Whitney, the former president of the New York Stock Exchange and perhaps the most famous broker of the time, was found to have embezzled money from his customers, his clubs, the New York Stock Exchange, and even from his wife’s trust fund, the uproar was huge. “Wall Street could hardly have been more embarrassed,” the leftist magazine The Nation gleefully reported, “if J. P. Morgan had been caught helping himself from the collection plate at the Cathedral of St. John the Divine.”

District Attorney Thomas E. Dewey arrested Whitney personally (having made sure beforehand that reporters and photographers would be present) and 6,000 people later turned out in Grand Central to watch Whitney board the train for Sing Sing prison.

Likewise, a bank clerk cheating on his wife is not big news. A president of the United States doing so, and with a White House intern, resulted in the biggest sex scandal in American history.

There is not much to be learned from these sorts of scandals, however, other than the already well-attested truths that men are not angels and that boys will be boys.

The Erie Wars

But there are also scandals that are very useful indeed, for they point out vividly where reform is needed and powerfully help bring it about. Consider one of the great Wall Street scandals of the 19th century, remembered as the Erie Wars.

The Civil War had caused Wall Street to explode in size as the government’s need for money resulted in a breathtaking rise in the national debt, from $64.8 million in 1860 to $2.7 billion in 1866. Further, the demand for war materiel caused a great expansion of manufacturing. The securities issued by companies to pay for new plants were traded on Wall Street. What didn’t keep pace were the rules and regulations needed to keep Wall Street honest. Before the war, the Street, although by far the largest financial market in the country, was still a small and provincial place, where everyone knew everyone and peer pressure kept things under control.

Scandal cannot do its job unless the media decide that the situation is, indeed, a scandal.

But the war transformed Wall Street into the largest securities market in the world after London. The old ways of policing didn’t work anymore. The result was a few years of capitalism red in tooth and claw.

The federal government was not thought to have any role in regulating securities markets at this time and the New York state and city governments were sunk in a cesspool of corruption not seen before or since. In 1868, the state legislature actually passed a law that effectively legalized bribery. “No conviction,” the law read, “shall be had under this act on the testimony of the other party to the offense, unless such evidence be corroborated in its material parts by other evidence.” In that pre-electronic age, that meant that as long as the public official took his bribe in private and in cash, he could not be convicted.

The judiciary was little better. The great diarist George Templeton Strong, a lawyer himself, wrote that “The Supreme Court [the lowest court for serious cases in New York’s topsy-turvy judicial nomenclature] is our Cloaca Maxima, with lawyers for its rats.” The judges, elected since the 1840s, were dependent on the political machines for support and were often more adept at politics than at the law. They too were easily and often bribed. “In New York,” Fraser’s Magazine explained to its English readers, “there is a custom among litigants as peculiar to that city, it is to be hoped, as it is supreme within it, of retaining a judge as well as a lawyer.”

And Wall Street itself was largely unregulated. The New York Stock Exchange was not the only exchange by any means. The Open Board of Brokers, which had come into existence in 1862 to meet the greatly increased business demand, actually had a larger volume than its older and more prestigious rival. And securities were also traded on the Curb, as the informal stock market that ran — with no formal rules whatsoever — on Broad Street during trading days was called. (The Curb market formally organized and finally moved indoors in the 1920s; in the 1950s, it changed its name to the American Stock Exchange.)

As a result, people could do pretty much as they pleased, and many did. Three of these were Daniel Drew, Jim Fisk, and Jay Gould. Drew, over 70, had been a Wall Street fixture — indeed a legend — for years. He had long served on the board of the Erie Railway and speculated endlessly in Erie securities, often while being the Erie’s treasurer. The newspapers dubbed him the “speculative director.” Gould and Fisk, in their early thirties, were, like so many, new to the Street.

The Erie had long been the wild man of New York railroading, instigating frequent rate wars among other things. Cornelius Vanderbilt, recently named president of the New York Central, wanted to bring it under control. He owned enough stock to be able to have one of his own men elected to the board and he got a promise from Daniel Drew, an old friend as well as frequent antagonist, to behave himself. Gould and Fisk were also elected to the new board.

But Drew was soon playing games with Erie stock again and the Commodore decided that the only solution was to buy control of the Erie. To make this easier, he had a judge named George Barnard — according to one contemporary, “a Tammany helot, numbered among the Vanderbilt properties” — issue an injunction. It forbade the Erie from converting any of its large issues of convertible bonds into stock and enjoined Drew personally from “selling, transferring, delivering, disposing of or parting with”6 any Erie stock in his control. Vanderbilt thought he had his old friend legally hogtied.

He was wrong. New York comprised eight judicial districts, but the authority of the judges in each district ran to the borders of the state. And any judge could issue orders in any case, even one before another judge. Drew simply had one of the Erie’s upstate judges suspend Vanderbilt’s man on the board, Frank Work, while another judge, in Barnard’s district, issued an injunction forbidding the board from doing any business without Frank Work being present.

What is needed is a spark, something so outrageous that the scandal suddenly becomes overwhelming and reform follows.

Still another judge, named Gilbert, sitting in Brooklyn, ordered the Erie to continue converting bonds into stock on demand. Drew, Fisk, and Gould, therefore were in a nearly perfect legal situation. As a writer of the time explained, “Since they were forbidden by Barnard to convert bonds into stock and forbidden by Gilbert to refuse to do so, who but the most captious could blame them for doing as they pleased?”

Vanderbilt sent his brokers into the market to buy all the Erie stock they could. First on the New York Stock Exchange and then on the Curb, the brokers made enormous purchases. But at the same time, Jim Fisk dropped off for sale 50,000 new shares of Erie stock, freshly converted from bonds, at the brokerage house of William Heath and Company.

“If this printing press don’t break down," Fisk remarked, “I’ll be damned if I don’t give the old hog all he wants of Erie.” Later, another freshly minted batch of 50,000 shares was also thrown on the market. Fearing, correctly, that the exchanges would declare this stock not to constitute good delivery — i.e. the exchanges wouldn’t recognize it as legitimate Erie stock — they hastened to convert the proceeds into cash and soon had $7 million of the Commodore’s money in a carpet bag.

At the end of the day, the Commodore and his allies owned almost 200,000 shares of Erie. But was that a majority of the stock, and thus enough to control the company? No one, except perhaps Drew, Fisk, and Gould, knew. The next morning, Vanderbilt had Barnard issue arrest warrants for the entire Erie board and Barnard sent the sheriff to execute the warrants.

Alerted, the board fled. A broker reported in his memoirs, published only two years later, that a policeman on the beat outside the Erie headquarters “observed a squad of respectably dressed, but terrified looking men, loaded down with packages of greenbacks, account books, bundles of papers tied up with red tape, emerge in haste and disorder from the Erie building. Thinking perhaps that something illicit had been taking place, and these individuals might be plunderers playing a bold game in open daylight, he approached them, but soon found out his mistake. They were only the executive committee of the Erie company, flying the wrath of the Commodore, and laden with the spoils of their recent campaign.”

Gerrymandering is not permitted in any other country in the democratic world and yet it flourishes here because the media have not brought it to public attention.

The board decamped to New Jersey, safely beyond the reach of Judge Barnard’s writs. The two sides were at a standoff, with the Erie board members holding the Commodore’s money while he had only worthless stock, but with Vanderbilt in possession of New York, while the board was exiled to New Jersey.

The newspapers, needless to say, had a field day reporting all this. Harper’s Weekly, in May 1868, reported that the Erie war had “entirely superseded public interest in the impeachment of the president” going on in Washington just then.

An epic bribery contest in the state legislature, where the legislators, “flocked to Albany like beeves to a cattle-mart,” Fraser’s Magazine reported. “All were for sale, and each brought a price proportioned to his weight."

Eventually the Commodore cut a deal. He and his allies would be made whole, Drew would resign from the Erie board and take no further part in the company’s management, and Gould and Fisk would become president and treasurer respectively of the Erie. The 100,000 shares of stock were sold over the next few months in order to pay back Vanderbilt. The only losers were the legitimate shareholders of the Erie, who saw their equity in the company diluted by about 40 percent. The company, meanwhile, had “a very well-dusted treasury,” according to Jim Fisk.

Time for Reform

While the public had been vastly entertained by these shenanigans, the brokers on Wall Street realized that this was no way to run a stock market. Brokers, unlike speculators such as Drew, Fisk, and Gould, made their living by small commissions on many stock trades. If Wall Street couldn’t provide some certainty as to what buyers were getting, business would go elsewhere.

By the end of the year, the New York Stock Exchange and the Open Board had each instituted new rules that required that listed companies maintain open registries of their securities and give 30 days' written notice of any new issues planned. The Erie refused to comply and was delisted from both exchanges, but was still traded on the Curb.

A bank clerk cheating on his wife is not big news. A president of the United States doing so, and with a White House intern, resulted in the biggest sex scandal in American history.

The following year, the two exchanges merged under the name of the New York Stock Exchange and the merged entity was now large enough to dominate the Street. It soon required that listed securities be sold only on the exchange, where the exchange could keep an eye on things. Brokerage firms, which had previously often operated independently, found that they needed to belong to the exchange if they were to be more than a bucket-shop operation. And companies of any size found they needed to be listed. The Erie grudgingly complied with the new rules and was relisted on the NYSE in September 1869. Wall Street, thanks to the Erie Wars, now had an effective policeman on the beat.

The lawyers, meanwhile, moved to clean up the legal system and in 1870 founded the New York Bar Association to police both lawyers and the system, an idea soon copied elsewhere. But there was only so much they could do while those who made law — the legislators — remained corrupt. They flatly refused to reform a system that was so personally profitable.

The Tweed Courthouse Scandals

Again, scandal made reform possible. A new county courthouse, located just north of City Hall, was budgeted at $250,000 when construction began in 1859. By the time it was finished, this modest structure had cost, as near as anyone could figure out, about $12 million. One plasterer, Andrew Garvey, “the prince of plasterers” was paid $133,187 for two days’ work, according to the Times; a carpenter was paid $360,747 for a month’s work. Folding chairs were purchased at the cost of hundreds of dollars each.

By way of comparison, the vast Houses of Parliament in London, which cover eight acres and had been built in the 1840s to house in splendor the central political institution of the most powerful country in the world, cost only $10 million.

(At least New York got quality. The courthouse is one of the finest examples of the Victorian Anglo-Italianate style in the country. Long neglected, it was beautifully restored a few years ago and now houses the city’s Department of Education.)

The war transformed Wall Street into the largest securities market in the world after London. The old ways of policing didn’t work anymore.

In 1871, a disgruntled city employee sent the New York Times copious evidence of the bribes and kickbacks that had gone on in building what has always been informally called the Tweed Courthouse, after “Boss” William M. Tweed who headed Tammany Hall. Thanks to the merciless cartoons of Thomas Nast, he had become the symbol of municipal corruption. When the Times began to publish the details, the public exploded in anger and probity swept through New York politics like measles through a second-grade class.

Tweed was arrested and held on $1 million bail (promptly supplied by Jay Gould and others). Peter Sweeney, the city chamberlain, citing health reasons, went to Canada in December. Members of the legislature lost their seats in the next election by the dozen, and the Republicans, promising a thorough housecleaning, took the majority in both houses. In 1874, an amendment specifying what was needed to obtain a conviction on a charge of bribery was added to the state constitution, where it was safely beyond the reach of the legislature.

The new bar association petitioned the new state legislature to impeach the corrupt judges and donated $30,000 to cover the costs. Two, John H. McCunn and George Barnard, were impeached and removed from office. Justice Albert Cardozo resigned rather than face impeachment. (His son, Benjamin, would devote his life to redeeming the family name in the law, becoming one of the U.S. Supreme Court’s greatest justices.)

New York would never come to resemble Plato’s republic, but the reforms brought about by the Erie Wars and the Tweed courthouse scandals helped to ensure that it would be the dominant financial center of the country and then the world right up to the present time.

*  *  *

It was the New York brokers’ sense of self-preservation that drove the reforms on Wall Street in the late 1860s, but it was public outrage that made the politicians see the light and begin to clean up government. That had only recently become possible, for until the 1830s the mass media did not exist and it was the mass media that made public opinion a powerful force in the politics of democratic states.

Before the days of mass media, what we would regard as gross corruption was simply business as usual. In 1799, Aaron Burr, then a New York state assemblyman, was pushing for a charter for a company that was ostensibly to provide potable water in Manhattan, whose ground water had become badly polluted. But his real object was to establish a bank. Into the bill to charter a water company, Burr slipped a provision allowing the company to use any surplus capital “for any legal purpose.”

Six months later, long before the company had laid a single length of pipe, it opened a bank. When Burr stepped down three years later — by this time he was vice president of the United States — he owed the bank $64,903.63, a moderate fortune at the turn of the 19th century. (The bank, by the way, is still with us, today known as Chase Manhattan.)

Similarly, in the 1830s, Daniel Webster, a highly paid lawyer as well as a U.S. senator, sent a law client a bill for $500 for services rendered — a bill that was promptly paid. The service in question was a provision in a law the effect of which was to move the client’s case from the Alabama courts, where he had little chance, to federal court, where his chances were much better. Again, this was business as usual in the 1830s. Today it would land a senator in jail and members of Congress have had to devise other ways — campaign contributions, for instance — to be sure of getting a quid for their quo.

Front-Page News: The Politically Independent Newspaper

The 1830s also saw a revolution in the newspaper industry. New steam-powered presses greatly increased the speed of printing, lowering the cost per copy. Equally important, a genius named James Gordon Bennett founded the New York Herald in 1835. Before the Herald, most newspapers had either been overtly political, pushing one party and denigrating the others, or restricted to one form of news, such as shipping or financial news.

Bennett had a different idea. He created a politically independent newspaper that covered all aspects of the new, modern age then aborning. The Herald was the first general newspaper to print a weather report, stock market report, or sports news, or to use an illustration. Bennett invented the idea of foreign correspondents and was the first out-of-town editor to employ a regular correspondent in Washington. He even invented the word leak in its journalistic sense.

The judges, elected since the 1840s, were dependent on the political machines for support and were often more adept at politics than at the law. They too were easily and often bribed.

The Herald was an almost instant success and its formula was widely copied, indeed it became universal. By the 1850s, the daily newspaper, wrote the North American Review, had become “one of those things which are rooted in the necessities of modern civilization. The steam engine is not more essential to us. The newspaper is that which connects each individual with the general life of mankind.” The newspaper also connected the ordinary people to the doings of their government in a fundamentally new way. And they often didn’t like what they saw.

In the mid-1850s, the reports of William Russell to the Times of London from the Crimean War, via the newly invented telegraph, helped powerfully to bring down the government of Prime Minister Lord Aberdeen. His reporting on the appalling conditions in which the soldiers often lived, the murderously inadequate treatment of the wounded, and the sheer incompetence of much of the leadership of the British army also brought about major reforms.

The ancient practice of officers buying their commissions ended and promotion became much more based on performance rather than wealth. Florence Nightingale established the profession of nursing to care for the wounded. Russell’s reports of army bungling even produced a classic of English poetry, Tennyson’s “Charge of the Light Brigade.”

Lord Aberdeen’s demise was the first time that a government had fallen because of public pressure brought about by news coverage. It would not be the last by any means. Lord Macaulay had dubbed the press the “fourth estate of the realm” in 1828, but it was only in the 1850s that that estate truly became a major player in the world of politics.

In this country, an endless series of government scandals, local, state, and federal, have rocked the nation courtesy of the press. The Crédit Mobilier scandal erupted in the 1870s when the board of the Union Pacific Railroad, largely funded by federal funds and land grants, formed a construction company, gave it a fancy French name, and then hired their own company to build the railroad at wildly inflated prices. It is said that they paid $72 million to build a railroad that was worth only $53 million.

To make sure Congress didn’t object, the directors invited members to invest in the stock of Crédit Mobilier, offering to let them pay for it out of future dividends. Since the quarterly dividends were often more than the par value of the stock, they got it effectively for free. When the scandal became public, however, one-third of the members of Congress lost their seats in the 1872 election.

Many politicians found their careers in ruins thanks to Crédit Mobilier. (But not Representative James Garfield, one of those named in the scandal. He denied involvement and went on to be elected president eight years later.) But none went to jail because the law, lagging behind inventive individuals, did not cover the situation. Had Crédit Mobilier simply given the congressmen cash (or even stock) in exchange for a blind eye to what was happening, that would have been bribery. But by having them “pay” for the stock out of dividends, no crime was committed.

Harper’s Weekly reported that the Erie war had ‘entirely superseded public interest in the impeachment of the president’ going on in Washington just then.

This is one of the greatest uses of scandal: it demonstrates what new laws are needed and creates the political conditions to get them enacted. And this is not just in politics. As industrial capitalism developed in the second half of the 19th century, the American economy was transformed. Manufacturing before the advent of the railroad had been necessarily local and the companies therefore small. But as railroads spread and hugely lowered the cost of transporting goods long distances, nationwide markets were created. To serve these large markets and achieve economies of scale allowing them to sell at lower prices, companies of national size with sometimes tens of thousands of employees and millions of dollars in annual revenues quickly evolved.

What evolved much more slowly was the regulatory apparatus necessary to keep the new economy operating in the public interest, even as it piled up unprecedented fortunes for the new capitalists of the Gilded Age. What were perceived as scandals often helped focus public, and therefore political, attention on areas where rules needed to be created.

Standard Oil went from being one oil company among hundreds to having an effective monopoly on an ever-increasingly important commodity within a decade after its formation as a corporation in 1870. It also quickly became the archetype of overweening corporate power as it made its founders rich beyond imagination. One highly effective way it achieved this power was to guarantee minimum shipments on railroads in exchange for undisclosed rebates on freight rates, giving Standard a huge competitive advantage. But Standard Oil would also secretly get the railroads to agree to pay them rebates on their competitors’ oil as well.

This allowed Standard to give these competitors a choice: sell out to Standard at a price Standard set (always a fair price, however, at least by Standard’s calculation) or be driven into bankruptcy by high transportation costs.

Such concentrations of economic power increasingly seemed to many to be dangerous and over a period of about 25 years such laws as the Sherman and Clayton Antitrust Acts banned such combinations in restraint of trade and secret dealings and the federal government began to enforce the laws vigorously. It was an effective, if not perfect solution to excessively concentrated economic power.

But sometimes the solutions brought about by these economic “scandals” were much less successful. Consider railroads, the dominant industry of the late 19th century. On runs where railroads competed, such as between New York and Chicago, served by the New York Central, the Pennsylvania, and the Erie, prices were kept low by frequent rate wars as the various railroads fought for business. Often these rate wars resulted in operating at a loss, and the railroads would form cartels to try to stabilize freight rates. But the cartels would always break down as one member of the cartel went for market share.

However, many customers were not on the trunk lines, where competition was fierce, but on the branch lines where the railroads had a monopoly on overland transportation. The railroads could — and mostly certainly did — charge high prices on these branch lines. This perfectly logical exploitation of monopoly power naturally infuriated the farmers and small merchants who were exploited. Their complaints were picked up by the newspapers and means were sought to bring the abuse to an end, among them the formation of the Granger movement.

Before the days of mass media, what we would regard as gross corruption was simply business as usual.

When state governments proved unable to effectively deal with the problem, the federal government finally stepped in, thanks to several Supreme Court decisions. In 1889, it created the Interstate Commerce Commission to regulate railroad pricing. It was the wrong solution. A simple law requiring railroads to have uniform pricing throughout their systems would have ended the abuse on the branch lines.

But the ICC quickly evolved into a government-run cartel, one that didn’t break down. The result was higher prices and a stagnant industry. Trucking was brought under the purview of the ICC in the 1930s and airlines under their own cartel, the Civil Aeronautics Board, as well. It would be the 1970s before competition was restored to American transportation, resulting in greatly lowered transportation prices and thus lower costs for most goods.

Today’s Scandals

Scandal produces solutions, but not necessarily the right solutions. Still, by shining the spotlight of public attention on a situation, scandal at least forces that situation onto the public agenda.

But scandal cannot do its job unless the media decide that the situation is, indeed, a scandal.

While earmark abuse in Congress grew by leaps and bounds over the last 15 years and several members of Congress went to jail because of it, the media chose to treat these as individual scandals involving individual congressmen such as Duke Cunningham and Bob Ney. In fact they were a systemic problem in Congress and only when a public outcry arose did Congress change its ways.

Similarly, scandals in tort law have been treated as individual transgressions, not as a fundamental problem with how tort law has developed in this country in the last 40 years. Recently, three of the most prominent and economically successful tort lawyers in the country, Richard Scruggs, William Lerach, and Melvin Weiss were all serving substantial sentences in federal penitentiaries for conduct committed in the course of practicing law. And yet the media has not connected the dots.

Gerrymandering, which effectively disenfranchises millions of people by guaranteeing the election of candidates of one party in many legislative districts, should be a huge scandal in a country that prides itself on not only being a representative democracy but having invented representative democracy. Gerrymandering is not permitted in any other country in the democratic world and yet it flourishes here because the media have not brought it to public attention.

At some point they will, just as they will with a tort law system that serves only tort lawyers and with earmarks that waste public money in order to re-elect members of Congress. What is needed is a spark, something so outrageous that the scandal suddenly becomes overwhelming and reform follows.

In the 1860s, gross abuses of the law and fiduciary obligations to stockholders were thought to be just business as usual on Wall Street. That is, until the board of directors of one of the country’s largest corporations stuffed $7 million in stolen cash into a carpet bag and fled across the Hudson River one step ahead of the sheriff.

As a new spate of scandals develops in Washington, one hopes that lessons will be learned and reforms instituted. What will be the sparks that set off scandals that lead to the reform of equivalent abuses we have now? I don’t know, but I do know it is going to be a lot of fun to read about them. For scandal is not only useful, it is highly entertaining.

John Steele Gordon has written several books on business and financial history, the latest of which is the revised edition of Hamilton's Blessing: The Extraordinary Life and Times of Our National Debt.

FURTHER READING: Gordon also writes "Reforming the Law," "Congratulations! You Have Arrived at the Greatest City on Earth," and "The Personal Income Tax at 100." Michael Barone comments "Benghazi, IRS Scandals Constitute Politics by Other Means" and  Peter J. Wallison notes "President Obama’s White House Counsel Knew about the IRS Targeting Weeks before the President."

Image by Dianna Ingram / Bergman Group