The effects of collusion

Collusion between underwriters and institutional investors can have far-reaching effects on the IPO market.

Now that the IPO market has come thundering to a halt and many of the stocks that shot up 100 points on their first day of trading are hovering in the penny stock range, investors and regulators are looking for someone to blame. The prime targets are the investment bankers that underwrite initial public offerings and have a say in the price and distribution of shares before the issue hits the open market.

The Securities and Exchange Commission, the National Association of Securities Dealers and the U.S. attorney for the Southern District of New York are investigating whether some investment bankers awarded shares of IPOs to customers in exchange for unusually high commissions and whether those commissions amounted to kickbacks.

Although the regulatory agencies are releasing few details, at least one investment banking firm, Credit Suisse First Boston, fired two employees after an internal investigation revealed they had violated firm practices in doling out IPO shares to clients. Some of the issuing companies also face shareholder lawsuits in connection with the investigations.

“The SEC has been understaffed in this area,” said George Nichols, IPO analyst at Morningstar.com. “They don't pursue any wrongdoings in the IPO market unless they can turn up a flaming gun quickly.”

At the same time, “It is very unusual that these practices have gone on for years,” he added. “You don't find many examples of regulators throwing the book at anyone.”

Although investment bankers may not have violated explicit securities laws, their practices suggest tighter regulation may be needed.

A situation analogous to an underwriter receiving a kickback for IPO shares would be the purchasing agent who receives a Christmas gift, say a $10 bottle of wine, from a supplier, said Jay Ritter, professor of finance at the University of Florida.

“Most companies don't view that as commercial bribery,” Ritter said. “But what if it's a $200 bottle of wine? Or $200 of cash in an envelope? Or $10,000 stuffed into an envelope?”

By rewarding its good customers with IPO shares, an underwriter also is placing its own interests ahead of the issuer's, Ritter said. That's because the company issuing the stock almost always prefers that IPO shares be allocated to “buy and hold” investors — those shareholders who will purchase the stock and hold onto it for long-term investment.

The result of granting shares to investors who may be in a stock just for a “quick buck” is tangible. It usually means massive trading in a stock on its first day of issue, which usually results in extreme price volatility. The numbers bear this out. During the period 1990 to 1998, the average first-day “turnover” of IPO stocks (trading volume divided by issue size) was 70%, Ritter said. But in 1999 and 2000 that average jumped to 150%, he said. In 1998, about 34% of IPOs had a first-day turnover of more than 100%, Ritter said. In 1999, that figure increased to 78%.

“During the Internet bubble, increasingly underwriters were handing out IPOs as a reward for commission business rather than as a way of getting shares to ‘buy and hold’ investors,” Ritter said.

In addition to investors paying excessive commissions for IPO shares, some securities lawsuits allege that brokerage customers, to receive allocations at the IPO price, agreed to purchase additional shares in the aftermarket at progressively higher prices. This practice, known as “laddering,” can drive share prices to artificially high levels.

Although laddering occurs, Ritter said, more commonly the institutional buyer tells the underwriter it plans to buy additional shares if it receives shares at the IPO price rather than being forced to purchase additional shares at a set price.

Avici Systems, a terabit router vendor, is a defendant in several lawsuits. On its first day of trading, July 28, 2000, Avici's share price shot up 212% to close at $96.75. The stock began plummeting a few months later, however, and recently traded at $8.26 a share.

According to a copy of the lawsuit filed by the firm Lovell & Stewart, the plaintiffs claim that lead underwriters Morgan Stanley Dean Witter and Lehman Brothers solicited and received “excessive and undisclosed” commissions from investors in exchange for substantial blocks of Avici shares. Additionally, according to the lawsuit, the underwriters entered into agreements whereby share recipients agreed to purchase additional Avici shares at predetermined prices that were above the IPO price. Avici Systems denies the charges.

As the lawsuit suggests, collusion between underwriters and institutional investors can have far-reaching effects on the IPO market.

For example, if underwriters get extra commission business from buyers in return for shares in IPOs that are going to see large first-day run-ups, that could give underwriters an incentive to underprice IPOs, Ritter said. In 1999 and 2000, the amount of money “left on the table” in IPOs — the difference between the offer price and the price of the first trade — jumped tenfold, Ritter said.

If regulators turn up hard evidence of wrongdoing, it also could scare individual investors from investing in future IPOs, Nichols said.

“It underlies the fact that the IPO market is brutally inefficient,” Nichols said. “It's not a very transparent market where the buyers willing to pay the most and hold stock the longest get the stock. The IPO market has always been a place where you could make loads of free money in a few minutes, but it's a game rigged for those who are already well-connected.”

Overseas, the Forum of European Securities Commissions is proposing rules to give individual investors fair treatment when they want shares in an IPO. Among other effects, the proposed rules would require companies to disclose the number of shares being set aside for institutional investors, private investors and employees, as well as for “friends and family” programs.

It remains to be seen whether U.S. regulators will turn up any wrongdoing. “I haven't seen a flaming gun yet — where a company's institutional investors say if you give me a huge allocation you can overcharge me on other trades,” Nichols said.

However, the softening of the IPO market has already changed behavior somewhat, Ritter said. Since the bubble burst, the IPO market has reverted to pre-bubble times with regard to the size of first-day price run-ups and turnover.

M&A watch

Acquiring	Acquired	Terms	Closing	Description
Centerpoint Broadband Technologies	Zaffire	Undisclosed	Third quarter	Optical, wireless and broadband vendor acquires metro optical vendor
DSET I	SPSoft	45% of merged company plus $3.3 million in cash, debt and interim funding	September 2001	Telecom software provider acquires broadband provisioning software provider
OpenTV	Static	$59 million	Third quarter	Interactive TV provider acquires London counterpart
First Data	Achex	Undisclosed	July 3, 2001	E-commerce services and payment provider acquires EBPP company
HiddenMind Technology	AnyDevice	Undisclosed	June 25, 2001	Software platform provider merges with mobile software infrastructure company
fusionOne	Levient and Sinia	Undisclosed	Second quarter	Mobile software and services provider acquires two mobile software providers
Compiled by Toby Weber