Regulation bursting from the South Sea Bubble

03 August 2015 Professor Robert W Vivian, Agata MacGregor & Justine van Vuuren, University of the Witwatersrand

The beginning of insurance regulation in the UK was touched upon in the previous edition and the story continues to the South Sea Bubble incident of 1720 in this article.

Generally, this incident is usually quoted as demonstrating the need for government regulatory intervention. An example of this is the opening statement by Justice Wallis in the recent case of Executive Officer: Financial Services Board (FSB) versus Dynamic Wealth Ltd and others ZASCA 2011 193; “Ever since the bursting of the South Sea Bubble in 1720, governments have recognised the need, in the interests of the investing public, for regulation of the financial services industry.”

The above quotation contains two common mistakes; the first is about the South Sea Bubble and the second about regulation.

Clearing up misconceptions

The first mistake is the belief that legislation was passed as a result of the collapse of the South Sea Company, in modern terminology an investment bubble. It was not passed as a consequence of the collapse; it caused the collapse. Secondly, it was not passed in the interests of the public; it was passed to protect the vested interests of the establishment back then.

It is almost always claimed that regulation is passed in public interest. There is little evidence to support that view. The evidence is that it is passed to protect or promote the interests of those who propose the legislation.

Our previous article concluded with the legislation which was passed conferring jurisdiction on a specific court. That legislation was not passed in the interest of the public, but in the interests of the various legal factions as to which courts would have jurisdiction over insurance matters.

A controversial timeline

The South Sea Company was formed by an Act of Parliament in 1711 and was granted the monopoly of trade to the South Seas. General legislation to form companies did not at the time, so a specific Act of Parliament to form the company was to be expected.

The creation of a monopoly in 1711 was controversial. The UK parliament had made it unlawful in terms of the Statute of Monopolies in 1623 for the crown to grant monopolies, which was usually done in exchange for money.

Monopolies required a special Act of Parliament. But, in fact, in the end the South Sea Company did little or no trading in the South Sea.

The driving force behind the company was a banker and the South Sea Company became involved in funding government debt. It transformed itself from a trading company into a financial institution.
On 22 January1720, parliament considered a proposal that the South Sea Company take over the nation’s debt and in return, parliament would pay 6% on the advances made by the company. The Bank of England did not like this idea since it wanted part of the national debt itself and so opposed the scheme. Members of parliament voted in favour of the South Sea Company.

On 2 February 1720, the investment frenzy began as parliament accepted the proposal of the company, resulting in the value of the company’s stock soaring. Those who held stock in the company found their wealth had increased by 300% overnight. It seemed as if, by magic, wealth could be created instantaneously.

The directors, chairmen and holders of stock found a new unbelievable source of instant wealth; shares. They did everything in their power to talk up the price of shares. Extravagant rumours began to circulate about new mines with gold, silver and iron.

When the Act was passed in April, the investment frenzy had gripped London as everyone scrambled to buy oversubscribed shares in the company, allowing the company to issue even more shares. The who’s who of the establishment all owned shares in the company.

Many a fool, many a rogue

However, on 3 June 1720, shareholders began to sell instead of buy. Inspired by this instantaneous wealth, of course, others had jumped on the bandwagon. Over a hundred new projects were floated, ‘promoted by crafty knaves pursued by multitudes of covetous fools to the ‘impoverishment of many a fool, and the enriching of many a rogue’.

Some of these projects lasted only long enough for the promotor to collect the deposits on the shares and then disappear – never to be heard of again. Few cared about the projects – all they cared about was the rapid appreciation of the price of the shares they had purchased.

The problem with these other fraudulent schemes was that funds were being diverted away from the South Sea Company, threatening the appreciation of the price of these shares which had started to decline on the 3rd June.

On 11 June, the King issued a proclamation outlawing all of these schemes, and a month later the Lords Justices assembled in the Privy Council and issued an order dissolving all these bubble companies.

Steps taken by the government did not originate from the collapse of the South Sea Company but were taken in an attempt to shore-up the the Company. These steps were taken before the collapse of the South Sea Company. They were not taken in the public interest to protect the investing public. The steps taken then caused the demise of this company.

Demise of fraudulent schemes
What happened is succinctly summed up by Morgan and Thomas in their history of the LSE, “No doubt there was genuine concern about what was going on, but the timing and sponsorship of the Act leave little doubt that the main purpose was not to protect the public but to protect the company from competition in the new issue market.”

The truth began to dawn. There was no difference between the South Sea Company, brought into existence by an Act and Parliament, and the other bubble companies the government had shut down to prevent funds from being diverted from the South Sea Company. Soon, few buyers could be found and panic selling set in, ending the South Sea Company.

Subsequent investigations revealed enormous corruption within the government at the highest levels. The South Sea Company had offered free phantom shares to the First Lord of the Treasury, the Chancellor of the Exchequer, the Prime Minister, the Post-Master General and so on. These shares could be sold back at any stage to the company and the recipient paid the difference. The Secretary for the Treasury cashed £250 000 in just before the crash.

One consequence of the South Sea Bubble is that private companies were not allowed to be formed until 1844.

The public developed a strong distrust of companies and their managers, and this took well-over a century to shake off. The corrective legislation was not passed as a consequence of the South Sea Bubble; it caused it, and it was not passed in the public interest but in the interest of the promoters of the legislation.

The basic cause of this problem was the inability to distinguish between the price of shares and the value of shares. The distinction can still not be made.

Very little has changed in the 300 years which have passed.

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