IPO Controversies - Issues

Bill’s Point of View

Comments on the FINRA/NYSE IPO Advisory Committee Report

Bill Hambrecht
CEO, WR Hambrecht + Co

May 29, 2003 [ Archive ]



I was pleased to have the opportunity to serve on the recent FINRA/NYSE IPO Advisory Committee, which had been formed at the request of then SEC Chairman Harvey Pitt. The Committee made significant progress in assessing and documenting the material damage caused by underwriters using the traditional IPO process and suggested a number of incremental reforms that should have a positive impact. However, the majority of members on the Committee were unable or unwilling to push for more significant reforms that would fundamentally eliminate the incentive for corruption that continues to exist in the traditional process. There are three particular areas in which I feel the Committee fell short:

1. While the Committee attempts to address the issue of arbitrary pricing and the report recognizes a fiduciary duty for issuing companies to go to the “best market,” it fails to hold underwriters to the same standard.

While the report suggests some important steps to increase transparency between the underwriter and the issuer, the Committee fails to recommend an explicit fiduciary duty that would make underwriters accountable for their IPO pricing decisions. The SROs have been quite successful at promoting better broker dealer pricing in the equity secondary market. For secondary market trades, broker dealers are required at all times to seek the “best market” – regardless of their individual economic interests. The use of new technologies has made it easier to access these alternatives, with significantly increased liquidity and substantial reductions in transaction costs.

In contrast, the traditional IPO book-building process remains closed and non-transparent. The IPO market pricing mechanism currently resides outside of the framework of rules and regulations that govern conduct to insure best execution to both buyer and seller. The notion that an underwriter is a principal given the “bought deal” nature of the underwriting transaction is not compelling, since the vast majority of deals are fully sold immediately to new buyers. We should do everything we can to bring this market under similar rules so that the underwriter has a fiduciary duty to find the best execution for an IPO.

2. The Committee further fails to address the systemic problem that creates an incentive for underwriters to underprice, namely preferential allocation.

The report details a wide range of abuses by underwriters and acknowledges a general trend of underwriters delivering guaranteed profits to preferred clients – yet its recommendations only cover the end results of these abuses. The Committee refuses to target the fundamental cause of the abuses: the unchecked ability of underwriters to allocate shares to their best clients.

If an underwriter is permitted to limit the recorded demand for an offering to select clients and to allocate shares at its whim, it will inevitably be tempted to underprice. This underpricing creates a guaranteed profit, which ensures that potential investors will emerge to bid on the value created. Even if, as expected, the SROs limit excessive underwriter compensation in the form of inflated commissions, potential investors or other related parties will find other ways to compensate an underwriter for that value.

The Committee, in fact, chose to emphasize that the report “in no way is intended to restrict the underwriter’s lawful exercise of its allocation discretion.” That is a mistake in our view. The only way to fundamentally address the abuses in the system is to utilize every available distribution channel to gather demand from all suitable investors and to allocate based on the issuer’s best interests.

3. The Committee’s recommendations do not sufficiently level the playing field on information related to an IPO.

The general regulatory trend has been to eliminate the selective disclosure of information to various investor classes. Regulation FD has been successful in putting individual investors on the same level as institutions in terms of access to information on public companies. The legacy IPO process is conspicuously exempted from that requirement. The Committee discussed, but failed to endorse, an innovative way to improve the situation: the inclusion of forward projections in the prospectus. Currently, estimates are generally available to only the institutional market and solely through the book-running underwriter research analyst, creating a de facto information monopoly for that firm.

The current Global Settlement that generally separates research analysts from the distribution process, will exacerbate this selective disclosure, as only those investors that have direct access to the book-running analyst will get this information. The intention of the regulators to exclude the book-running analyst from the public IPO marketing process was reinforced by the recent response to Bear Stearn’s use of an analyst in a road show for a recent IPO. Given that the market will continue to demand forward estimates, the requirement that they be included in the prospectus is the best alternative to the current reality of selective and non-accountable disclosure.

Conclusion
Most of the leading underwriters are now parts of large, integrated financial organizations. This has led to the integration of distribution channels that create inter-relationships with other parts of their own businesses, and has dramatically changed relationships with outside distribution channels, buyers, issuers and regulators. Historically, underwriting, distribution, research and lending were provided by separate firms, helping to create systemic checks and balances. This is no longer the case. While equity research and investment banking conflicts have received the most attention, conflicts also exist among other investment banking areas, in institutional trading, hedge fund prime account business, commercial lending and merger and acquisitions activities.

As firms have grown in market power, and as new technology has allowed almost instant real time communication, the SROs have developed sound rules of practice that have allowed tremendous growth in liquidity, dramatic reductions in transaction cost, and a re-affirmation that a fiduciary has a duty to deal in the most appropriate and effective market to gain the best price for his customer, irrespective of his own self-interest. The IPO segment of our capital markets is too important to be left out of the regulatory and ethical framework that governs our secondary market. Given the Committee’s final report, it is my hope that the market will ultimately reject arbitrary pricing, preferential allocation and uneven information disclosure in favor of an open, transparent and fair solution.

http://www.wrhambrecht.com/ind/strategy/bill_pov/200305/index.html
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