The History of the Obscure Law Eliot Spitzer Is Using to Tame Wall Street

Nicholas Thompson, in Legal Affairs (May/Hune 2004):

FOR THREE-QUARTERS OF A CENTURY, an unspoken gentleman's agreement bound the moneymen of Wall Street and the New York attorney general's office. The AG got to use an astonishingly powerful state securities law called the Martin Act, but not against the big boys. Acceptable targets through the years included shady pharmacists, Ponzi schemes, and peddlers of fraudulent Salvador Dali lithographs.

Two years ago, Eliot Spitzer, New York's current attorney general, broke the deal. He took the Martin Act, the securities legislation that is the legal equivalent of King Arthur's Excalibur, and plunged it into the guts of Merrill Lynch. Then he turned his saber on Salomon Smith Barney and the rest of New York's investment banking industry. This past fall he speared several large players in both the hedge fund and mutual fund industries. Others worry that they will face similar fates in the remaining two years of Spitzer's present term. They should.

The purpose of the Martin Act is to arm the New York attorney general to combat financial fraud. It empowers him to subpoena any document he wants from anyone doing business in the state; to keep an investigation totally secret or to make it totally public; and to choose between filing civil or criminal charges whenever he wants. People called in for questioning during Martin Act investigations do not have a right to counsel or a right against self-incrimination. Combined, the act's powers exceed those given any regulator in any other state.

Now for the scary part: To win a case, the AG doesn't have to prove that the defendant intended to defraud anyone, that a transaction took place, or that anyone actually was defrauded. Plus, when the prosecution is over, trial lawyers can gain access to the hoards of documents that the act has churned up and use them as the basis for civil suits."It's the legal equivalent of a weapon of mass destruction," said a lawyer at a major New York firm who represents defendants in Martin Act cases (and who didn't want his name used because he feared retribution by Spitzer)."The damage that can be done under the statute is unlimited."

Spitzer and his allies, of course, see the law the opposite way, lauding its unlimited capacity for good. Given the deep slumber of the SEC and other important financial regulators since 2000, the glaring improprieties of mutual funds and stock analysts—improprieties that disproportionately harm small, trusting investors—might not have been documented and addressed if Spitzer hadn't forcefully applied the Martin Act.

Either way, there's no question that a little-known New York law, intentionally rendered anemic when first passed in 1921, has morphed into something remarkable, helped along the way by ambitious supporters, neglectful opponents, and generous court rulings. The Martin Act has also given Spitzer the stature he needs to run for governor of New York in 2006—and perhaps, one day, something higher.

THE FIRST STATE STATUTE CRACKING DOWN ON FRAUD IN SECURITIES, or speculative investments, was passed in Kansas in 1911. It was nicknamed a"blue-sky" law after hustlers who, the story went, would sell shares of the blue sky if they could. Other states quickly followed, pushed by public concern about fraud as well as by self-interested lobbying from small banks, which worried that money which would otherwise be deposited was being put into securities.

By the end of World War I, the state that served as home to the world's financial capital decided it had to join in. Swindlers stalked Gotham's streets, fleecing the people who were investing with solo speculators and putting money into the stock market for the first time in a burst of postwar patriotic fervor. Much as when shares of Amazon.com hit the NASDAQ, newcomers were everywhere—and they quite frequently lost their bowlers.

New York's legislature was one of the last to pass a blue-sky law, letting through a deliberately enfeebled version. It gave the AG power to counter fraud once it was committed, but left that office with minimal control over who could sell securities in the first place. To the big financial companies that dominated New York politics, a registration law was a bureaucratic burden to be avoided. A simple fraud statute seemed like a good way to swat down small-time sharks and keep the field open for themselves. The weak law went into force in May 1921, bearing the name of Louis M. Martin, its sponsor in the state assembly.

New York barely made use of Martin's act for the first four years of its life, spending almost nothing on enforcement. The attorney general did try to apply it on several occasions in 1923, going after firms like the Multi-Insert Mailing Machine Corporation, which sold stock after spuriously claiming to have developed machines that addressed, folded, and handled envelopes. But he was tripped up by a clause in the Martin Act that granted automatic immunity to anyone who testified under it or even answered questions."It is said that the Martin law has teeth. It has, but they are an ill-fitting set of false teeth," snapped New York City's district attorney Joab Banton to The New York Times.

In 1925, the law found its first aggressive user, Attorney General Albert Ottinger, who was also successful in pushing for legislation that dramatically limited the act's immunity provisions. Spitzer's forebear in many ways, Ottinger sought out high-profile fraud cases and used the Martin Act to shut down the Consolidated Stock Exchange, a lowbrow offshoot of the New York Stock Exchange. His actions riled major financiers and led to several prominent court challenges."In this proceeding, if such it may be called, the Attorney General is . . . the complainant, the prosecuting officer and the magistrate before whom the proceeding is instituted," wrote Louis Marshall, a prominent constitutional lawyer, who led the charge against the act.

But Ottinger beat Marshall in the courts and continued his crackdown. At the end of his term, the AG summed up his political record as follows:"Hammer, hammer, hammer, at every manner and means of fraud and dishonesty, the prevention and assertion of which the Legislature has assigned to the Attorney General." Despite the popularity of Ottinger's hammering, however, he lost a close race for the governor's office in 1928 to a former assistant secretary of the Navy named Franklin Delano Roosevelt.

Ottinger left a two-part legacy for Spitzer. He'd set an example for how an AG could use the Martin Act with vigor. And the court challenges he'd faced ended up bolstering the law. ...