IPO system needs overhaul to be fair process not controlled entirely by bankers

Posted: Friday, September 13, 2002

NEW YORK (AP) -- Landing shares in hot initial public offerings during the stock market boom was like getting courtside seats at a big sports event.

You weren't given a front-row pass by just standing in line with the masses.

No, the doling out of IPOs was all about who you knew and what you knew. It was a serious game of corporate back-scratching where investment bankers used IPO shares to reward high-worth clients or entice those who could give something back.

But with the IPO market slumbering with the rest of Wall Street, the time is right for regulators to overhaul the system -- not just to give better access to the little guy, but to create a fair process where bankers can't rule the game.

The public was consumed with IPOs during the late 1990s. Investors big and small wanted a piece of the action, believing that getting into an IPO guaranteed big profits.

And the lucky ones who got in often did see their fortunes rise.

The average first-day return for IPOs climbed to 65 percent in 1999 and 2000, up from 15 percent from 1990 to 1998, according to research by University of Florida professor Jay Ritter and University of Notre Dame professor Tim Loughran.

While the average investor clamored for IPO shares, few got to join the party.

Instead, IPOs became an important marketing tool for investment bankers, who underwrote the stock offerings for companies and had most of the control over how they were dispersed. Many used the shares to woo clients and win more lucrative bank business.

In recent weeks, a congressional investigation has revealed just how potentially corrupt the IPO allocation process was during the boom times.

Salomon Smith Barney admitted it provided its best customers with access to IPOs. That's not the worst thing, given that businesses often reward their top clients.

The real problem might lie in whether the IPO shares were exclusively given to certain individuals because they could throw more business back to the bank.

That's what the House Financial Services Committee is investigating. Former WorldCom chief executive Bernard Ebbers amassed more than $11 million from shares of IPOs given to him by Salomon Smith Barney, and now the question is whether Ebbers got to buy those shares as an inducement for banking business.

Other banks have come under investigation for similar dealings.

In August, two Credit Suisse First Boston executives were fined $200,000 each for their role in the firm's alleged abuses in distributing IPO shares.

The disciplinary action followed CSFB's agreement earlier this year to pay $100 million to resolve regulators' allegations that it gave favored investors a larger number of the IPO shares and got a share of the profits in the form of inflated commissions on other stock trades.

Securities and Exchange Commission Chairman Harvey Pitt has taken note. He's already asked officials at the New York Stock Exchange and National Association of Securities Dealers to review the IPO process.

But how tough the changes will be remains to be seen.

Will slapping firms with big fines really be enough to stop them from doing it again? Or will it take more oversight and forced disclosure to put a cleaner spin on the process?

A place to start might be to make underwriters reveal how they distribute shares and how long the recipients hold on to them. It would discourage some of the corporate cronyism and might deter banks from giving shares to certain investors.

Regulators also must crack down on how IPOs are priced. Under current rules, the banks don't have to publicly say how they come up with the offer price, and there has been great concern that many underprice the shares.

While underpricing means lower initial fees for the banks, they tend to make up the money -- maybe more so -- in other ways, often by only distributing IPO shares to customers who agree to kick back part of the profits or pay higher commissions on other trades.

If investment banks had to publicize the demand for an IPO, namely how many shares investors want and at what price, they would have a tougher time underpricing shares.

Making the process more fair is not an easy fix. It doesn't mean average investors will get the bulk of IPO shares, but at least they'll have a chance.


Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org

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