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Reinventing the rationale for market intervention

Welcome to part two of Back to the Future. Through the Securities and Exchange Commission, James M. Landis helped legitimise the authority of the state to intervene in capital markets, despite a judiciary…

The battle over regulation of capital markets seemed over by 1937: but by the global financial crisis in 2008, separation of the corporation and the capital market was no longer assured.

Welcome to part two of Back to the Future. Through the Securities and Exchange Commission, James M. Landis helped legitimise the authority of the state to intervene in capital markets, despite a judiciary deeply uncomfortable with its methods.

Professor of Law at the University of New South Wales, Justin O'Brien writes that it was an approach that typified the Roosevelt’s New Deal: yet why did this legitimacy evaporate during the global financial crisis?

This is an edited extract of the article, which is available in full here.


When considering the crisis afflicting the Anglo-American model of capitalism, the search for a credible and effective approach to regulatory reform necessitates going “back to the future”.

When Joseph Kennedy left the board of the Securities and Exchange Commission (SEC) in 1934 he interrupted the first James M. Landis press conference by calling out “Good-bye Jim. Good luck to you. Knock ‘em over.”

As history shows, it was a task Landis took to with gusto. For the progenitors of the administrative state the aim was not to operate within accepted paradigms — legal, institutional and theoretical — but to destabilise them by creating an alternative reality; one that legitimated state intervention. Extending far beyond the narrow realm of banking and securities regulation, the New Deal was designed to recalibrate society itself.

The debates that the New Deal engendered were as much political as judicial, practical as theoretical. They took place in the context of domestic industrial and financial failure and looming conflagration in Europe – the rise of the Soviet Union, the emergence of Fascism in Italy and Nazism in Germany.

The self-proclaimed crusade brought the administration into immediate and repeated conflict with the Supreme Court over what constituted or should constitute the appropriate balance between individual rights and public duties.

The judicial repositioning in turn, was played out in the context of rising unemployment, an increasingly disputatious labour environment and a deepening recession. In ruling flagship programs, such as the National Recovery Authority and Agricultural Adjustment Act, unconstitutional the Supreme Court sharpened an existential dispute that dated back to its 1905 decision to strike down state-based working hour restrictions in New York bakeries on the basis that it was “unreasonable, unnecessary and arbitrary interference with the right and liberty of the individual to contract”. By 1937 it was clear that Roosevelt had had enough of recalcitrant judges.

In the 1936 presidential campaign he had promised to deal with court activism and the threat he deemed it to hold to the functioning of the democratic order. In his second “fireside chat” following re-inauguration, broadcast on March 7, 1937, he reiterated the campaign promise and announced a plan to dilute the poison by expanding the number of judges on the Supreme Court.

To generate support for this goal, Roosevelt turned to James M. Landis. Landis was the critical figure in the academic and policy debates over the rise of the administrative state. Steeped in the administrative process as both an academic and policymaker, as early as 1930 he had dismissed juridical restrictions on agency discretion as little more than an attempt to curtail the legitimate exercise of public power for the public good.

Roosevelt’s New Deal was designed to recalibrate society. Flickr/

Asked by his long-term confident Felix Frankfurter to help the Roosevelt administration transform an initial election pledge to regulate securities in 1932 to credible legislation, Landis began a commute from Cambridge to Washington that was to transform the governance of Wall Street and American society through the auspices of the Securities and Exchange Commission.

Putting into practice the ideas developed in his innovative course on legislation at Harvard, he became one of the most significant policy actors of his generation (and arguably in the history of regulatory design).

Landis had stewarded the agency through early legitimacy and accountability firefights with the financial sector, showing as much acumen in navigating the complexity of political contingency and judicial gamesmanship as in legislative drafting. Although the enforcement methods used by the SEC, for example, had come under attack from a Supreme Court and a legal profession deeply troubled by the expansion of the administrative state, it had been deemed constitutional, if potentially dangerous.

Landis endorsed wholeheartedly the president’s proposal to inject new blood into the court, dispensing with any pretence that the move was designed to enhance the efficiency of court business. Instead, the unalloyed political reality was presented in forceful terms: “the issue is not one of the Constitution but an issue of men whose interpretations of that document makes it a straitjacket upon our national life”.

Although the plan to stack the court was not followed through, it marked a defining moment in New Deal politics. It marked the point that the court finally recognised the legitimacy of administrative power.

Throughout his career Landis was determined to ensure flexibility without subjecting the agency to accusations of economic or ideological bias.

It remains the defining text of administrative rule. In his book, The Modern Corporation and Private Property (1932), Landis' book argued regulatory lawmaking as an essential pre-condition for democracy.

There was considerable judicial dismay at SEC enforcement methods.

In a critical passage Landis argued “if the doctrine of the separation of power implies division, it also implies balance, and balance calls for equality.” The creation of administrative power may be the means for that balance, so that paradoxically enough, though it may seem in theoretic violation of the doctrine of the separation of power, it may in matter of fact be the means for the preservation of the content of that doctrine.

For Landis, therefore, the rise of the administrative state was an exercise in modernisation, legitimated by “the inadequacy of a simply tripartite form of government to deal with modern problems”.

What becomes clear is that the battle over the authority to intervene was fought and won by 1937. Moreover, deference to agency power has long been recognized in cases that date back to the 1940s and where definitively ruled upon in 1984 in the landmark Chevron ruling. Prior to the Supreme Court’s decision in Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., judicial deference to agency interpretations was based on pragmatism.

Courts would give deference to agency interpretations depending upon “the thoroughness evident in [the agency’s] consideration, the validity of its reasoning, its consistency with earlier and later pronouncements, and all those factors which give it power to persuade, if lacking power to control.”

Additionally, courts looked to see if the agency, opinion had “warrant in the record and a reasonable basis in law.” Accordingly, while some deference was accorded to agencies, the amount of deference varied considerably, based on the facts surrounding the interpretation. Chevron changed the basis for deference. It laid out a two-step process for determining the validity of an agency’s statutory construction.

First, if the intent of Congress in enacting a statute is clear, then the court must ensure that the agency has given effect to the unambiguously expressed intent of Congress. If, however, a statute is silent or ambiguous with respect to the specific issue, then a court must apply a second step and ask whether the agency’s interpretation is based on a permissible construction of the statute.

In developing its two-step framework, the court articulated three reasons to justify its decision to defer to the agency: implicit delegation, agency expertise, and political accountability.

First, with respect to the “implicit delegation” rationale, the court reasoned that with the power to administer a congressionally-created program comes the power to formulate policy and make “rules to fill any gap left, whether implicitly or explicitly, by Congress.

“When Congress explicitly leaves a gap for an agency to fill, the agency’s interpretation controls, so long as it is not arbitrary, capricious, or manifestly contrary to the statute. And when delegation is implicit, "a court may not substitute its own construction of a statutory provision for a reasonable interpretation made by the administrator of an agency.” This interpretation effectively expanded the powers of legitimate agency lawmaking.

Second, while the Court had previously alluded to “agency expertise” in the decisions of Skidmore and Hearst, in Chevron it clarified that “[j]udges are not experts,” at least not in these technical areas. Agency personnel are highly qualified to make technical determinations and are charged with making these determinations. Regardless of whether Congress actually intended to delegate to the agency, it simply makes sense to defer to such expertise.

Third, the court was of the view that the Executive, unlike the Judicial branch of government is accountable to the public. It is therefore more appropriate for the political branch of the government to resolve conflicting policies “in light of everyday realities.” “Federal judges, who have no constituency, have a duty to respect legitimate policy choices made by those who do.”

Deference, however, is only part of the story. The travails facing the contemporary SEC were well noted by its official biographer, Joel Seligman in 1999, “The challenge is to strike the right balance between expertise, which is a consequential virtue of a well-run regulatory agency, and political effectiveness, which often can be better achieved by reducing the number of responsible agencies and increasing resources for each.” Here again revisiting the thought of Landis in regulatory design pays dividends.

In 1960 in what was to be his last public intervention in regulatory politics, Landis provided an extraordinary report to president elect John F. Kennedy. The report highlighted both the ambition and the intrinsic flaws associated with the delegation of discretion.

The delegation he still maintained was necessary and persuasive given the complexity of modern society, the incapacity of Congress to devote the time or the resources to deal with them and a conviction that “the issues involved were different from those that theretofore had been traditionally handled by courts and thus were not suited for judicial determination.” The policy problem was that once ceded it had become impossible to limit or retract authority. Indeed “on the contrary, the tendency is to expand them as more and more complex problems arise.

The legislative standards under which the delegations are made are similarly increasingly loosened so that not infrequently the guide in the determination of problems that faces the agencies in not much more than their conception of the public interest".

He warned that in sharp distinction to the optimism that accompanied the New Deal. The “fires that then fed a passion for public service have burned low”. This, he attributed to rising cynicism, unacceptable delays, increased costs and a deterioration in the quality of staffing.

The “prevalence is threatening to thwart hope so bravely held some two decades ago by those who believed that the administrative agency, particularly the "independent” agency, held within it the seeds for the wise and efficient solution of the many new problems posed by a growingly complex society and a growingly benevolent government".

Urgent action was required because “the spark, the desire of public service, has failed of re-ignition”.

Complaining of sinecures and the power of practitioners to gain privileged off-the-record access to senior commission staff, he foreshadowed many of the recurrent problems associated with the regulatory capture literature.

He also complained bitterly about the failure to address foreseeable problems. Absent such planning the need for ad hoc solutions to the particular manifestations of the problem precede and, indeed may preclude any basic policy formulation.

As Landis puts it, “where, however, the greatest gaps exist are in the planning for foreseeable problems. Absent such planning the need for ad hoc solutions to the particular manifestations of the problem precede and, indeed, may preclude any basic policy formulation”.

Resolving them are, ultimately, questions of political design, a fact Landis always recognised. It is in this broader political context that the Global Financial Crisis has such potential programmatic and paradigmatic power.

Quiescence to a flawed design, based on a separation of the corporation and the capital market form societal obligation is no longer assured. This in turn has profound implications for the conceptual frameworks that underpin contemporary regulatory practice; practice that is informed by timidity rather than audacity, inaction, and the maintained faith in false prophets.

It is a response that would — justifiably — have horrified both Roosevelt and his chief regulatory architect, James M. Landis. The unresolved question is why that has occurred, a question to which we now turn.

The author is writing a biography of James M. Landis, which will be published in 2014.

Read Part One of Back to the Future here.