The SEC's Mission Improbable - Industry Trend or Event

Regulators looking into the way IPOs are handled will have a tough time nailing any culprits.

SITTING IN A PLUSH SILICON VALLEY office last year, two venture capitalists swapped fish tales, one-upping each other with stories about the hot IPOs they'd gotten in on thanks to friendly investment bankers. Like a prize marlin, the size of the VCs' profits grew from the hundreds of thousands to millions of dollars, recounts a former investment banker who had been sitting nearby.

There clearly was a cozy relationship between the bankers handling an IPO and the VCs eager to get in on the debut. But the real catch was snagging VCs who bring their own deals to the bank sometime down the line.

Sure enough, when one of the VCs decided weeks later which of a half-dozen banks would take his company public, the deal went to the very investment bank that had given him access to a previous IPO.

Of course, it might have been a coincidence. But that's not how it looked to the former investment banker. "Investment bankers were buying the loyalty of venture capitalists so they'd pick them for their next deal," he says. "How are you going to say no to that?"

Ensuring a customer's loyalty by giving him special access isn't necessarily illegal. Businesses have always rewarded their best customers. But paying kickbacks or bribing underwriters to get shares of a valuable public offering is illegal.

That's why the Securities and Exchange Commission and the U.S. Attorney's Office for the Southern District of New York are investigating the practices of investment banks in allocating IPOs. The agencies are specifically looking at whether some funds or investors paid exorbitant commissions on some trades in exchange for access to highly desirable IPOs. Many of the major investment banks, including Goldman Sachs Group, Lehman Brothers Holdings and Credit Suisse First Boston, and some minor ones have received requests for information from regulators. Goldman and Lehman declined to comment on the investigation. CS First Boston said it believes its allocation methods are consistent with industry practices and added that it's cooperating with the investigation. Neither regulators nor prosecutors would comment on the probe.

Behind the investigation is a basic principle supporting the U.S. financial markets: An IPO is supposed to offer shares of a company to the public, not be private or exclusive or for sale to individuals or institutions that will pay the highest commission. That principle is especially important today, with more than half of American families owning some form of common stock, either directly or through mutual funds. Yet when IPOs became a passport to riches early last year, no one really believed that all investors had equal opportunity to get in on the ride. "Investment banks are the gatekeepers of the IPO," says Andrew Geist, a securities attorney at O'Melveny & Myers in New York and a former SEC attorney. "As a general matter, the allocations are fair, but not always democratic."

Wall Street professionals and watchdogs alike point out that any quid pro quo will be hard to prove. The elite culture of investment banks protects its own, and insiders will often only comment on how IPOs are allocated if they're guaranteed anonymity. But even if the probe is toothless in its outcome, outgoing SEC Chairman Arthur Levitt is wedded to the idea that even the appearance of an unfair advantage in the market should be squashed. The SEC has looked into similar matters over the years. In 1997, the agency opened an investigation into the so-called spinning of stocks, wherein company executives were able to get scarce IPO shares in exchange for hiring the investment firm as an underwriter for future issues.

No charges were brought.

In 1999, the Justice Department's antitrust division examined whether it was mere coincidence or price-fixing that resulted in nearly all investment banks charging the same 7 percent commission for underwriting new issues of stock.

No charges were brought.

While those investigations certainly had an impact -- lawyers advised their clients to change their procedures, industry panels discussed it at conferences and news reports about the investigation put the fear of God into some companies -- many in the industry say that the practices haven't stopped. And the parties who brought them to the attention of securities regulators may be some of the big players themselves, who are tired of being shaken down.

"I've heard hedge funds and institutions complain that banks are wanting kickbacks," says Richard Peterson, a market strategist for Thomson Financial and the author of Inside IPOs. "These practices have been going on for years. When the IPO market was going strong, no one complained."

But those sizzling IPOs have tumbled back to earth, bringing with them the number of IPOs overall. And as those new-economy pillars have toppled, the rules of the old economy stand strong -- nowhere more prominently than on Wall Street, where the golden rule has long been "Do unto others depending upon what they can do for you." Whether it's wining and dining clients, threatening to take away business or promising more business, the Street's backroom deal machine is always in motion.

"You're not seeing people walking around with suitcases full of money," says Steven Stone, a securities lawyer at Morgan, Lewis & Bockius in Washington. "It's simply business as usual." The question is whether "business as usual" means paying sky-high commissions, kickbacks or other incentives that are a swap for shares. And whether that's provable.

Doug Henwood, author of Wall Street, calls such practices "an ancient part" of investment banking culture. "It's free money. It does not cost the brokerage house anything," he says. "Why should the bankers feel guilty? They have no scruples. The only thing they worry about is getting caught."

Investment banks already receive a princely reward for taking a company public. Last year, 35 percent of all investment fees, or $4.2 billion, went to those firms for underwriting new stock issues, according to Thomson. Even though the IPO market cooled in the second half of the year, that was 11 percent higher than 1999's $3.8 billion in fees. That's because more than 13 of the deals last year, such as AT&T Wireless' spinoff from AT&T, raised more than $1 billion. So there's more than enough reason for bankers to do a favor in exchange for the chance to get that IPO business.

But the stakes in taking companies public have changed. In 1980, shares in the typical IPO went up 10 percent to 15 percent in the first day. Most offerings were bought by about 100 institutions that managed more than $1 billion each. Institutions would go around soliciting customers to buy IPOs, which were much riskier than other investments. Then, during the high-tech boom, getting access to some IPOs was like winning the lottery, as IPOs doubled or tripled on their first day of trading. Institutions that had once been solicited to buy the shares suddenly scrambled to be sure they got enough for themselves. In a heartbeat, they could "flip" the stock and make millions.

At the same time, the Net was allowing individuals access to the same information that was once available to only big institutions. Suddenly, everyone from daytraders to Aunt Gilda wanted shares in IPOs, too. Individual investors now own more than half the shares of technology companies that have gone public in recent years -- and when IPOs become hot again, they will want more.

Retail brokers are trying to get enough shares in IPOs to provide individuals with an entree. "The problem we're wrestling with is that e-brokers don't get good allocations. But at some point, we feel we have to offer them," says Michael Dunn, a spokesman for Datek, an online brokerage. "Our customers want to have access to IPOs. But you have to have a decent allocation to make them worthwhile."

For the time being, the lull in stock deals may make the investigation seem out of touch. But the issue is likely to heat up if IPOs bounce back.

"When the IPO window opens, people will start playing games again," says Samuel Hayes, a Harvard Business School professor of finance. "That's the way it works."

                             Pop Goes the IPO
                 The five IPOs with the biggest first-day
                   gains debuted just before the Nasdaq
                            peaked last March.
                         OFFERING FIRST-DAY          CURRENT CHANGE SINCE
COMPANY      IPO DATE     PRICE     CLOSE   INCREASE  PRICE   FIRST DAY
Avanex     Feb. 4, 2000   $36.00   $172.00    378%   $44.69     -74.0%
Crayfish   Mar. 8, 2000   $24.50   $126.00    414%    $7.25     -94.2%
FirePond   Feb. 4, 2000   $22.00   $100.25    356%    $3.19     -96.8%
Selectica  Mar. 10, 2000  $30.00   $141.83    371%   $18.38     -87.0%
WebMethods Feb. 11, 2000  $35.00   $212.63    507%   $69.88     -67.1%
COMPANY    LEAD UNDERWRITER
Avanex     Morgan Stanley Dean Witter
Crayfish   Morgan Stanley Dean Witter
FirePond   Robertson Stephens
Selectica  CS First Boston
WebMethods Morgan Stanley Dean Witter
SOURCE: THOMSON FINANCIAL AND THE STANDARD
USING DATA FROM BLOOMBERG AND IPO.COM

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