A Small Voice In Cyberspace

[Georgia Bard]

Wall Street under scrutiny

Follow up to A number of investigations into Wall Street shenanigans are under way May 17th 2001 From The Economist print edition
http://www.economist.com/finance/displayStory.cfm?Story_ID=626583&CFID=2344876&CFTOKEN=71593...

A penny in whose pocket? May 24th 2001 / NEW YORK
From The Economist print edition
http://www.economist.com/finance/displayStory.cfm?Story_ID=635389

Were investment banks crooked when they made billions of dollars from the Internet bubble?

IT ENJOYED the dotcom party as much as anyone. But now that the whole thing has ended messily, Wall Street has become everybody’s favourite scapegoat. Its analysts are accused of abandoning objectivity to tout shares that their investment banks underwrote. Underwriters are said to have set the share price too low in initial public offerings (IPOs), so as to ensure a huge jump in the price when trading began. That jump in turn enabled investment banks to reward favoured clients who were allocated shares in the IPO, which clients could instantly sell at a fat profit. To compound the rascality, the banks shared in those profits by demanding return favours from the clients.

Wall Street is suddenly taking all these accusations seriously. That is in part to reassure investors that IPOs are still worth investing in, and so to help to revive a market that was once lucrative. But it is mainly out of fear of the large fines, or even jail sentences, that might result from investigations under way.

The heads of research at America’s leading investment banks are now working together on a code of best practice for analysts. This is said to include severing the link between an analyst’s pay and the revenues a bank earns on any deal he works on. (This practice is so deeply entrenched that it will be remarkable if such a rule ever sees the light of day.) In the same spirit, the Association of Investment Management and Research said on May 21st that it is producing a paper on “preserving” research integrity and promoting a set of “research objectivity standards”. Prudential Securities has given up underwriting altogether, opting to stand or fall on the independence of its research. Admittedly, it was not a strong underwriting force to begin with.

Wall Street also faces congressional hearings in June about its conflicts of interest. It is conceivable that these could become dotcom show trials, with former gurus being accused of fleecing the public by championing the likes of Amazon and Priceline. Even scarier for investment bankers are three probes into accusations of wrongdoing in the underwriting process, along with a host of class-action lawsuits on behalf of suffering investors. These investigations—by the Securities and Exchange Commission (SEC), the regulatory arm of the National Association of Securities Dealers (NASD) and a criminal one by federal prosecutors in Manhattan—take in most of Wall Street’s leading firms.

Credit Suisse First Boston (CSFB) has borne the brunt of the bad publicity. It is the only target so far of the NASD inquiry, which is further advanced than the others. Unlike the SEC, which is examining industry-wide behaviour, the NASD is (as usual) putting its energies into catching one firm, after which, precedent established, it can go after the others.

Some at CSFB say that the bank is a victim of over-zealous regulators, spurred on by competition between the NASD and the SEC. They detect an attempt to demonise Frank Quattrone, the bank’s high-profile dealmaker in the technology sector. There has not, after all, been a Michael Milken for the best part of a decade. Internal inquiries at CSFB appear to have exonerated Mr Quattrone from any wrongdoing. Still, the bank has suspended two employees, for “unacceptable conduct” that supposedly broke the firm’s own rules, though not the law. Some observers wonder if CSFB is preparing to wriggle off the hook by implying that any abuses were the acts of a few rogue brokers.

Sharing the shares

The main focus of the investigations is the terms under which underwriters allocated shares in IPOs. This is no simple matter. Nobody disputes that the underwriters can choose to whom they distribute shares, nor that they may favour clients that give them plenty of business. Indeed, one preoccupation of regulators is that shares in IPOs have not always been allocated in proportion to the amount of broking business a client does.

The chief concern is about what other clients did to get an outsized allocation. Did they, for instance, hand back to the underwriter some of the profits from selling the shares, by doing a lot of commission-paying business shortly afterwards? Such commissions could be construed, in effect, as part of the underwriting fees earned by the bank. They should therefore have been disclosed. Whether this is so in law may depend on whether such kickbacks can be proved to be a binding contract, rather than a vague indication of intent. Non-binding banter—“I’ll give you shares in this IPO, you take care of me later”—often takes place with good clients, say Wall Streeters.

To get shares in a hot IPO, clients may also have agreed to buy shares in future IPOs that were less exciting. Or they might have promised to buy additional shares in an IPO once trading had begun. This would have amounted to market manipulation. Innocent, plead the banks. To ask clients if they would be willing to buy in the after-market is to help learn how committed they are to the shares—not planning, in other words, to “flip” the shares as soon as trading begins.

The potential revenues from cosy arrangements between Wall Street and its friends were enormous. According to Jay Ritter, an economist at the University of Florida, official underwriting revenues were $7.3 billion in 1999-2000. But the so-called “money left on the table”—instant profits available for clients allocated shares in an IPO that soared on the first day of trading—was $66 billion. Some of that money was certainly split with the underwriters. Strangely, issuers didn’t seem to mind the intentional underpricing of their IPO. A big first-day pop in their share price was viewed as a marketing success.

Seasoned regulators admit that it will be hard to prove that Wall Street firms were systematically up to no good. It will take, at the least, a lot of incriminating tapes and e-mails to prove that brokers overstepped the line between vague requests (“take care of me”) and the demanding of binding promises.

Perhaps, just perhaps, the market is already reforming itself. A few IPOs are now taking place, but not with the huge first-day premiums of yore. Issuers are taking a closer look at the auction-based IPOs pioneered by W.R. Hambrecht, an investment-banking boutique in California. These act to tease out the issue price that pretty much equalises supply and demand and minimises the first-day pop—and, along with it, the opportunity for kickbacks to underwriters.

end of article
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:=) Gary Swancey