Small Investors Unlikely to Benefit From IPO Probe

The government is hot on the case of how major brokerages allocated stocks in initial public offerings in the late 1990s.

But small investors hoping for a fix that makes the IPO process fairer for them probably will be disappointed, many experts say.

The IPO probe harks back to the government’s high-profile campaigns against insider trading in the mid-1980s and against Nasdaq’s dealer-run system for setting stock prices in the mid-1990s.

The first of those investigations brought down Ivan Boesky, Michael Milken and brokerage Drexel Burnham Lambert, among others. The second halted widespread dealer collusion that had rigged the Nasdaq market with artificially large gaps between bid and offer prices for shares, at investors’ expense.

As with those investigations, regulators in the IPO probe are confronting a systemic problem that has no solution short of drastic, industrywide change, critics say.

In this case, however, many experts say the prospects for sweeping change are bleak. The IPO underwriting process, as it stands, benefits the investment banks, their big clients and company executives--everyone but small investors.

“The parties who have the most at stake all have their interests aligned in maintaining the current system,” said Dartmouth business professor and IPO expert Rakesh Aggarwal. “We’re pretty unlikely to see major change happen in the next couple of years.”

In any case, experts note that the IPO probe so far isn’t about whether the process of deciding who gets coveted new stocks is fair: It’s just about whether money improperly changed hands.

Among other things, investigators from the Securities and Exchange Commission, the National Assn. of Securities Dealers and the U.S. attorney’s office in Manhattan are weighing evidence that brokers at Credit Suisse First Boston and at least eight other major brokerages agreed to sell shares in the most sought-after IPOs to favored clients in exchange for illegal kickbacks often disguised as higher-than-usual fees on unrelated trades.

The probes could result in civil actions or criminal charges. Scores of investor lawsuits also have been filed, piggybacking on the regulators’ cases. And CS First Boston recently fired three San Francisco-area brokers after an internal inquiry into the matter. Attorneys for the men say they were only following orders--a defense that could pave the way for the brokers to strike deals with regulators and testify against their former employer, lawyers say.

But securities law experts, bankers and academics who have studied the wild IPO market of the last few years say even prosecutions are unlikely to change the way the system is rigged against small investors and in favor of top investment banking firms and their most prized clients.

Huge Demand for Hot Tech IPOs

Simply fining investment banks and their executives without reforming the system itself will leave the door open for new abuses in the next IPO boom, critics say. The IPO market is in a depression this year because of Wall Street’s bear market, so IPO players don’t have a lot at stake at the moment. But the IPO market inevitably will come back.

In the boom year of 1999, Wall Street brokerages collectively earned $3.2 billion in IPO underwriting fees by bringing more than 400 companies public, according to Securities Data Co.

Along with the official fees are the unofficial benefits, including kickbacks from big investors--a principal subject of regulators’ investigations.

According to people closely involved with the record number of large-scale IPOs in 1999 and 2000, the groundwork for such kickbacks was laid by the ravenous demand for IPO shares once they began trading. Many of those IPO shares, especially in the once red-hot technology sector, have since crashed and burned. But at the time they were issued almost all soared, guaranteeing early investors instant capital gains.

Last year, the average first-day gain on an IPO was 57% as investors who couldn’t get the stocks at the IPO prices dramatically bid up the shares as soon as they began trading. Those buyers included many individual investors.

The investment banks, increasingly confident that the stocks would rocket, consistently priced them lower than they needed to.

Interviews with CS First Boston veterans and dozens of other professionals in the IPO machine show that weak federal securities rules and deliberate underpricing of shares set the stage for kickbacks.

Though underpricing deprived IPO-issuing companies of additional capital, it benefited executives of the new companies by boosting the odds that share prices would continue to rise from the first opening bell to the day, six months later, when the executives typically could begin to sell their own stakes, under so-called lockup agreements.

More surprising, the tactic helped the investment banks, even though the low IPO prices meant smaller official fees. In part the banks benefited because grateful company executives tended to reward them with additional business down the line.

On top of that, bankers used the low IPO prices to generate artificially high demand for the stocks, which they parlayed into more business, or even bribes, from the buyers they selected for the shares, sources say.

“If you have a system of preferential allocations and a guaranteed discount [to first-day trading prices], you’re in effect giving away guaranteed profit,” said Bill Hambrecht, founder of San Francisco investment bank WR Hambrecht and a veteran Silicon Valley financier.

That means the underwriting bank or its employees inevitably got back some of that money, Hambrecht contends. “If you’re giving away guaranteed profit, I guarantee that some way, someone is going to get a cut.”

Much of the process was perfectly legal. And where it wasn’t legal it wasn’t hard to disguise, a former CS First Boston banker said. “It’s not like greed is a foreign concept inside an investment bank,” said the banker, who spoke on condition he not be named.

CS First Boston declined to comment on those allegations.

SEC rules require full disclosure of IPO sales commissions. And they prohibit “fraud or deceit” in general, which legal experts said includes kickbacks but not the more pervasive mutual back-scratching among IPO players.

As it is, the system makes perfect sense for those calling the shots.

Brokerages typically get 5% or more of an IPO’s price in legitimate underwriting fees. With a 50% kickback of any first-day trading profits, perhaps hidden as commissions on other business in a quid pro quo, it would be in the underwriter’s interest to underprice deals.

Say that the market would be willing to pay $40 a share for 1 million shares of XYZ Corp. If the IPO goes out at that price, the brokerage could collect about $2 for each share, or $2 million total.

But if the IPO was underpriced at $20, and the shares were distributed only to customers who would kick back $10 a share out of an instant $20-a-share profit, the brokerage could make a $2 commission and a $10 bribe on each share, or $12 million total. That’s six times the take the firm would have received by pricing the stock at $40 a share.

Thus, while underpricing an IPO leaves money on the table, it sets up “an indirect form of underwriter compensation,” Tim Loughran of Notre Dame and Jay Ritter of the University of Florida wrote in an October study. “Even though underwriters may be able to capture only a fraction of the money they left on the table in the form of quid pro quos, they are able to get higher total compensation than if all of their compensation was in direct fees.”

Other IPO studies have revealed the same pattern.

Business-school professors Aggarwal, Laurie Krigman and Kent Womack found this spring that underpricing led to a first-day run-up in a stock price, which tended to increase attention by Wall Street analysts. That attention tended to lead to higher share prices six months down the road, when executives generally could begin to sell their stakes.

Though the boom market exacerbated the situation, deliberate underpricing already was apparent more than two years ago, according to a third study by professors Krigman, Womack and Wayne Shaw.

Even so, IPO stocks’ total first-day gains, as a percentage of the dollars raised in the offerings, reached wild heights in 1999 and 2000.

The 333 IPOs in 2000 effectively left a combined $26.7 billion on the table, according to Ritter. That’s the amount the stocks gained, in aggregate, on their first trading days. Theoretically, that means the issuing companies could have taken in 40% more capital than the $66.1 billion they actually raised, had the stocks been priced as high as the public was willing to pay.

Double Standard on Stock ‘Flipping’

A big first-day jump in a company’s stock price wouldn’t distort the system so much if everyone held on to their shares until things settled down.

Many investment banks do explicitly bar small investors from “flipping,” or selling off their IPO shares, during the first day’s jump. If they do flip they could be barred from getting future IPOs.

But the Krigman study looked at flipping and found a severe double standard. Hedge funds and other large investors, which are the brokerages’ best customers, are expected to flip at least some shares on the first day, when the profits are easy. And they tend to flip more when a company’s stock is the most overvalued, the study found after examining 1,232 large IPOs.

Stocks that are flipped the most “significantly underperform IPOs with less flipping” in the ensuing six months, the study concluded. Big investors “appear to possess and use superior information” about the true value of shares, it said.

That too is nothing new.

“This market is really designed for big players,” said Thomas Lemke, former chief counsel at the SEC’s division of investment management in Washington. “They fully expect when they send a lot of business to a broker-dealer that they will get some of the good securities.”

Then-SEC Chairman Arthur Levitt said as much in a speech to investment professionals last year.

“It’s no secret that the driving force behind allocation of today’s IPOs is the weight of the brokerage relationship,” Levitt said. “Those clients that direct the most business to investment banks are more likely to be rewarded when it comes time to divvy up an IPO.”

CS First Boston cited those comments in a filing to regulators declaring that it acted within industry norms. And it said even unusually generous commissions weren’t against the rules.

“There is absolutely nothing written in any guideline, rule, regulation, case or speech by a regulatory official that forbids the voluntary payment by clients of large commissions to CSFB to demonstrate that such clients are good enough customers to deserve being given IPO allocations,” the filing said.

Another unchallenged piece of the IPO system is the mechanism for testing investor appetites for a new stock issue. That’s done through the “road show,” a carefully managed presentation for investors by bankers and company executives.

As part of the road show and follow-up sales calls, it’s standard practice for investment bankers to ask not only whether investors would be willing to buy the stock at the IPO, but whether they would be willing to buy additional shares on the first day of trading.

Those questions can appear geared to reduce the amount of flipping and make sure that the stock doesn’t instantly tank. But critics say such questions also are half a step away from sewing up after-market purchases and making sure that IPO allocations go only to those willing to pay more once trading begins--perhaps with higher commissions.

Direct tying of IPO purchases and after-market purchases is considered to be fraud under long-standing federal securities laws.

“If it’s simply saying, ‘I would buy that in the after-market,’ that happens routinely, and it helps ensure the success of the offering,” said Lemke. But “if someone said, ‘I’m going to buy in the after-market’ simply to support a deal [for IPO shares], that could be over the line.”

Sometimes Shares Sold Above IPO Price

Sometimes it’s even more blatant, with customers agreeing to pay a specific price above the IPO price.

Jeffrey Plotkin, an SEC attorney turned securities-industry defense lawyer in New York, said he recently represented one broker who, before an IPO his company was helping to sell, received an advance check from a customer for shares at a price $2 above the IPO level.

“That’s out-and-out manipulation,” Plotkin said. It’s “designed to keep the appearance of a successful after-market going.”

Much more common, Plotkin and others said, is a wink-and-nod system almost impossible for regulators to find--and not obviously illegal when they do find it.

Several years ago at CS First Boston, clients would authorize unnecessary bond trades to reward the broker who got them in on an IPO, a former veteran banker there said.

Since then, the firm may have gotten sloppier, simply charging higher commissions as the number of hot IPOs soared, the banker said.

In the IPO boom period, “It was a lot of people trying to do things on the fly, and they may have done some stupid things,” another ex-CS First Boston banker said.

CS First Boston declined to comment.

Some critics say the government at least could make a point by bringing legal cases that emphatically declare such practices to be forbidden.

Though a prosecution won’t stamp out the problem, it certainly couldn’t hurt, said Columbia University securities law professor Harvey Goldschmid, a former SEC general counsel.

He compared the burgeoning scandal with the insider-trading epidemic of the 1980s, which ended with some offenders in jail. “Undoubtedly, there is still insider trading,” Goldschmid said. “But it has been meaningfully reduced by criminal and civil penalties.”

A comprehensive solution, perhaps years off, would make the IPO system more transparent to outsiders and reduce the incentives for doling out favors.

Dutch Auction Allows Market to Set Price

One possibility is a government embrace of a system like the one devised by Hambrecht, Goldschmid said. WR Hambrecht brings IPOs to market via a so-called Dutch auction process that allows the market, rather than the underwriter, to set the IPO price. Once the price is set by the market, each bidder pays the same for each share. And the system gives small investors the same shot getting in on the deals.

“If you’re an underwriter, you have to think about how to protect yourself from regulatory exposure,” Hambrecht said. “The only way you’ll ever get rid of it is to move to a new system.”

Yet WR Hambrecht, which launched its system in April 1999, has conducted only seven IPOs based on such auctions.

And many analysts question whether the government could, or should, get into the business of mandating a specific IPO system.

Many company executives prefer the current IPO marketing system for a number of reasons, including their belief that buyers lined up by brokerages are more likely to hold the shares longer.

Other ideas to improve the IPO process include opening road shows to all investors, strengthening the firewall between brokerage analyst reports and investment banking income, and even forcing company executives to offer some of their own shares in their IPO sale, thereby boosting their interest in getting a high initial price.

But few experts expect wholesale change in the foreseeable future.

“If change is going to come, it’s going to come because small investors who are frozen out of the process somehow generate a large enough voice to force that change,” Aggarwal said. “I’m just dubious that’s going to happen.”

Times staff writer Joseph Menn can be reached by e-mail at joseph.menn@latimes.com.

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The IPO Game, 1990s-Style

As the sums raised in initial public stock offerings soared in the 1990s, so did the stocks’ gains on their first trading days. That was money “left on the table,” or forfeited--meaning it was the amount IPO-issuing companies conceivably could have received if the stocks has been priced according to true demand. Industry insiders say some of that money was funneled back to the investment banks, as kickbacks by the investors who profited handsomely by buying at the IPO prices.

Excluded are smallest IPOs, foreign companies selling U.S. shares, and IPOs of closed-end mutual funds and real estate investment trusts. First-day gains are derived from the difference between IPO price and the closing price on the first day of public trading.

Sources: Jay Ritter, professor at the University of Florida; Securities Data Co.