Should We Regulate IPO Allocations?

Recently there has been discussion in the media regarding whether “WE” should regulate the allocation of IPO’s (initial public offerings of stock) and if “WE” should regulate it, what form would those regulations take and who would regulate it.

The possibility of rules that would basically institutionalize the practices of the last several years in the IPO market, angers me to such an extent it is very difficult to control. To me this discussion is like a really horrible “good news - bad news” joke. The good news is that we finally are talking about one of the real issues of our little stock market party that we are all still hung over from. But the bad news is “WE” still just don’t get it.

Basically, the issue is this: During the bull market the surest way to make easy money was to “get in” on IPO’s. What this meant was, you would hear of a very “hot” IPO that was to be offered to the public, and you would decide that you would like to buy some of the stock offered in the IPO. An over subscribed IPO was considered “hot” and this meant that it was anticipated that there was more demand for the stock than there were shares for sale.

The next step would be to ask, beg or otherwise convince a broker (of one of the firms in the offering group of brokers that was bringing the stock public) to allocate some of those shares to your account. If you were lucky enough to receive an allocation of a hot IPO, and it was in fact “hot”, the excess demand for the stock (those who wanted to buy the stock but were not allocated any in the IPO) would attempt to buy the stock on the normal market after the IPO and often at a significantly higher price. The people that already owned the stock, those that were “in” on the IPO, were then free to sell their shares that were purchased at the significantly lower IPO price (a practice known as flipping IPO’s).

Take the example of PALM, which came public priced at $38 per share. That same day the stock traded up to $140 per share, more than a slight miscalculation if you were in the business and handsomely compensated to price these issues. Another example, which has been in the news lately because of Worldcom’s Bernie Ebbers, was Rythms NetConnections which went public in April of 1999 at $21 per share. The good news was that Mr. Ebbers was not notified of his “allocation” until the stock was trading $90 - so he sold it for a $16,000,000.00 profit – not bad for a days work. What do you think Mr. Ebbers did to make Solomon Smith Barney want to allocate a $16,000,000.00 gain to his account?.

Given the size of the dollars involved, the discussion of who is entitled to receive these gross short term profits sickens me. Why should anybody be entitled? And what is the motivating factor in allowing these profits to occur? What this in effect does, is it allows the brokers in these IPO groups to have an amazing amount of currency (I was advised not to use the word bribes) that can be used to return favors, develop new business or potentially compensate others for reasons having nothing to do with the price of that particular stock.

Please allow me to digress for a moment and describe the other side of the transaction - what the company going public is attempting to do. Let’s assume for a moment that you own a hot dog stand (I am going to stay away from the internet here so I do not excite too many people) and it is doing really well. So you open another hotdog stand and it does just as well. Every time you can earn or borrow enough, you open another stand and each is better than the last. Then you decide that more capital is needed to expand in a big way and you decide to sell shares in your company to get the required capital. To do this, you would go to the large brokerage houses / investment bankers to bring your stock public. In preparation for going public there is a lot involved, from analyzing what your company is worth, dealing with the regulatory agencies, listing the stock on an exchange, making sure investors are aware of the stock and of course physically selling the stock. Simply put, what the hot dog company is paying for is someone to determine what the stock is worth, sell it at that price and make a market in the stock after it is public. The typical fee for this service is 6% of the value of the stock sold in the IPO.

In the old days a successful IPO would go something like this – the IPO value was set and the trading range in the first month was from the IPO price to 10 – 15% higher. This way the company got the true market value of the stock, the IPO purchasers were compensated (as they should have been since buying an unknown stock that does not have a known market is risky) and the underwriters received their fee. But this changed big time in the bull market. Now, if you were the hog dog stand owner and you spent your whole life developing this company, why would you not be upset that your “experts” (that were handsomely compensated), sold your company at 25% of what the stock was trading at an hour later? Someone made huge profit on your company – and it was not you. Let’s be clear on another point - the experts would have received a much larger compensation (typically 6% of the value of the stock sold in the IPO) if the stock had sold in the IPO at the price it traded in the open market! So why were they so obviously under pricing the IPO? And why weren’t there huge lawsuits being filed by the owners of the companies? Whenever I see people apparently not acting in their financial best interest, I get the same sensation that I get around extremely old fish….

There is a huge conflict of interest here, in that the brokers who are representing the company and bringing the stock public are also acting as agents of the buyers, because they are also your brokers. I have a genuine problem with situations where there is an inherent conflict of interest. So in the interest of full disclosure, I will tell you that a good part of my anger on this topic is due to the fact that my brokerage firm was adversely affected by other brokers ability to allocate IPO’s to their clients. Many investors would not consider our firm because we were not in the business of bringing firms public. Even more frequently, many of our clients would maintain accounts with “IPO” firms, telling me that they were paying significantly higher commissions for service that was not as good, due solely to the fact that they needed to generate a certain amount of commission dollars there to receive IPO allocations. To me these brokers were allowed to compete by charging their clients very high fees and commissions and repaying them by selling them something of someone else’s that was intentionally under priced (even though they had a responsibility to the company going public to get them the best price). A profitable business model, but one I am glad that we did not imitate.

But enough about me and my firm. The question still remains – Why would a company that is going public allow itself to be so dramatically under priced?

At the time, these same “hot” IPO’s were bringing a smaller percentage of the company public, with some of the hottest IPO’s bringing only 10 – 15% of the company public. When pondering what the benefits of this could be, I naturally thought that maybe it was worth it to the officers, directors and CEO’s since they were the owners of the other 85 - 90% and restricting the supply of the stock might be worth it to them. I considered this, but I do not believe that this was reason enough to allow this intentional under pricing to happen, since these same people usually had lock up provisions that prohibited them from ‘flipping the IPO’ and realizing the profit.

What is the real reason this happened on such a large scale? You may remember the buzz on the street when the companies noted above were going public – everyone knew that the first trade after the IPO was going to be some huge multiple of the IPO price, everyone. Why did the companies not stop this, which they can do, and say “I think the price is a little low”? It appears that the companies that have made it into the official scandal category seem to have had a significant amount of investment banking activity and many of the key players also had a large amount of IPO’s stock allocated to these individuals personally. I would hate to think that the investment banking activity, and potentially the prices these companies received could have been impacted by the amount of IPO stock allocated to individuals personally. I can only hope that someone looks into the “hot” IPO’s and the personal investment activity of the decision makers of those companies, to assure the investing public that these individuals were not “allocated” into acting in ways contrary to the best interest of their company. As much as I would hate for this to be the answer, there needs to be some resolution, some confirmation as to why this would happen.

Now back to the original question as to whether IPO allocation should be regulated. The simple fact of the matter is, if the IPO is priced correctly there should be no excess demand. No excess demand means no huge jump in price after the IPO, no “flipping of IPOs”, no hundreds of thousands of dollars of gains in minutes (sometimes sold before the allocation for a risk free transaction) and therefore no reason to even allocate, let alone regulate, the allocation process. The other side to this answer is, if IPO’s are under priced, and under priced consistently, the underwriters should have liability to the companies and the reasons for this should be thoroughly investigated. If transactions of this size cease to make economic sense the stench can become overpowering.

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