Infectious Greed: Restoring Confidence in Americas Companies

The euphoria over the wealth that investment banks were generating from taking technology firms public caused some investment banks to bend ”even break ”the rules. The banks wanted to keep the exuberance over IPOs going and also get more of the wealth being created. Investment banks controlled a scarce commodity ”IPO shares. They used their control of the shares in several dubious ways.

Since the IPO shares were earning such high rates of return on the first day of trading, many institutional investors wanted them. Because those shares were scarce, the investment banks were in a position to allocate them in ways that allowed themselves to get kickbacks. One way to receive a kickback was to charge an institutional investor an unusually large commission rate for trading stock. Normally, the commission that investment banks charge institutional investors is around five cents per share. In order to secure IPO shares, these institutions agreed to pay commissions of more than $2 per share. In other words, the banks wanted to get some of the big returns the investors were getting on the first trading day of a hot IPO. This practice, a form of "tie-in," is not allowed by either the SEC or the National Association of Securities Dealers (NASD), a private regulator of securities firms.

In 1999, Steve Kris ran a small investment firm in Denver called Ascent Capital. His investment fund was known to be a "flipper." That is, it tries to get shares of hot IPOs at issue and then immediately sell (or flip) them during the first day or two that the new company trades. Kris wanted to get a lot of shares of one company going public, VA Linux Systems. The investment banking firm Credit Suisse First Boston (CSFB) underwrote the issue. Kris was not happy with the modest 2,500 shares he was allocated and so pressed for more. After agreeing to be a good CSFB customer on commissions and to buying more Linux shares in the open market, Kris received 17,950 shares of the IPO. ^[8]

On the first day of trading, Linux stock soared an incredible 698 percent. Kris had made $3.8 million on the IPO shares. That same day, he traded many shares in other companies that were so large that no one would have noticed the extra volume. For example, he traded 50,000 shares of Citigroup using CSFB as the broker and paid a commission of $2.70 per share, for a $135,000 bill. He also traded in Compaq, Kmart, Kroger, and AT&T for a total commission bill of more than $500,000. These trades would normally have cost less then $20,000. Another flipper firm, Back Bay Management, also received 17,950 shares of Linux. On that day, Back Bay traded in the likes of American International, Anheuser-Busch, Champion International, IBM, and Merck. Back Bay paid nearly $400,000 in commissions to CSFB. Institutional investors that did not agree to kick back some of the IPO profits found themselves with very few shares of the firms going public.

The other concession that CSFB wanted from investors was to purchase additional shares of the IPO in the stock market on the first day of trading. This buying would create the kind of high demand that would guarantee a very high first day return. Both the high commission and the agreement to buy additional shares in the open market must be construed as a quid pro quo by the investment bank ”an arrangement that is illegal. Indeed, CSFB agreed to pay a $100 million fine to resolve SEC and NASD investigations. ^[9]

Giving shares to investors based on quid pro quo arrangements reduces the number of IPO shares available for average individual investors. This is one reason individual investors commonly failed to get the shares of hot IPO issues they wanted. During the height of the tech bubble in 1999 and 2000, 75 percent of the shares of an IPO went to institutional investors, leaving only 25 percent for individual investors. Since individuals had to buy the shares in the stock market and because many institutions were flipping the shares, the ownership quickly shifted to 25 percent institutions and 75 percent individuals. ^[10] The institutions had bought low and sold high. The individuals had bought high. The quality of these firms was also suspect. The stock prices eventually collapsed and individuals were resigned to selling low. It seems clear that the actions of these banks were not in the best interest of the public investor.

It also appears that some investment banks allocated shares of hot IPOs to corporate executives and venture capitalists. By currying favor with executives, the investment banks hoped to get investment banking services from their companies in the future. The venture capitalists were in a position to steer more IPO business their way. This practice is called "spinning" because its purpose is to give the executives a chance to sell, or spin, the shares for a quick profit. The investment bank hopes that the executives will be grateful for the cash and use the bank to help it obtain capital in the future.

Spinning is not allowed. Not only are investment banks prohibited from allocating IPO shares this way, but executives are prohibited from accepting this type of deal. Nevertheless, in 1998, the Manhattan U.S. attorney's office, the SEC, and the NASD were investigating spinning. In one example, the investment bank Robertson Stephens allocated 100,000 shares of the IPO firm Pixar Animation to Joseph Cayre. Cayre was the executive of another firm that would soon go public. He turned a quick profit of $2 million with those shares and subsequently chose Robertson Stephens to conduct its own IPO. ^[11] While Robertson Stephens claimed that it did nothing wrong, it also changed its internal policy on such matters. Though these kinds of quid pro quo arrangements are not allowed, they are very difficult to prove in court . However, the investigations themselves in 1998 seemed to change the behavior of the banks for a while.

Unfortunately, it appears that spinning might be back. A former ( disgruntled ) broker from Citibank's investment banking business, Salomon Smith Barney, claims that the firm curried favor with executives by allocating them shares of hot IPO issues. Executives who allegedly received shares are Bernard Ebbers (former CEO of WorldCom) and Joseph Nacchio (former chairman of Qwest). The broker, David Chacon, says that Ebbers received 350,000 shares of the firm Rhythms NetConnections at the IPO price of $21 in 1999. When the stock priced jumped more than 600 percent after starting to trade on the stock exchange, Ebbers quickly sold for a $16 million profit. ^[12] The investment banking firm later participated in lucrative offers by WorldCom, including the $11 billion bond offering in May 2002. It appears that banking firm Credit Suisse First Boston also allocated hot IPO shares through a $100 million fund created for wealthy clients . ^[13] Typical clients just happened to be CEOs and CFOs of companies that had hired the investment bank to underwrite large issues.