Toys R Us bake-off.

Photographer: Andrew Burton/Getty Images.

Analyst Would Do Anything for Toys 'R' Us IPO, Including That

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Today the Financial Industry Regulatory Authority fined 10 banks $2.5 million to $5 million apiece for letting their research analysts get too involved in pitching for an initial public offering in 2010. The company was Toys "R" Us, which was then owned by a group of private equity sponsors including Bain Capital and KKR, and still is, since the IPO never happened. But back when they thought it was going to happen, the bankers and analysts really wanted the deal. How much did they want it? Let's ask the research analyst at Needham & Company, the littlest bank that settled with Finra today:

The Needham analyst understood that his May 5 presentations to TRU and the Sponsors could help determine whether the Firm would win a role in the TRU IPO. In an email about his role in the TRU IPO, he wrote: "This is me batting in the big leagues."

The Needham analyst conveyed his enthusiasm about the TRU IPO to his colleagues, as well. When a rival firm announced in early May 2010 that it was initiating research coverage of toy manufacturers and the toy industry, the Needham analyst sent an email to a colleague stating the firm's initiation of coverage was "[s]hameless positioning to get a certain upcoming toy IPO," and that he "would do it too. I would crawl on broken glass dragging my exposed junk to get this deal."

Wellllllp, now his junk is exposed. (No deal though!) Needham, the smallest bank, was also the thirstiest, but everyone else wanted in too. Finra gives a little summary of the Goldman Sachs analyst's meeting with Toys and its sponsors; it ends with this:

He concluded his presentation by telling TRU and the Sponsors, once again, that he was "EXTREMELY EXCITED" and "APPRECIATE[D THEIR] TIME."

I guess that was ... all caps in the PowerPoint? Do you think he was excited? I mean, people are weird, maybe he loved the idea of going to a pitch and saying things like "global category dominant firm." I rarely found it that exciting. The all-caps feigned enthusiasm just seems sort of degrading, though not naked-on-broken-glass degrading. But it's what you do to get a big trade.

What else did these banks do to get a big trade? Hahaha well all of them apparently violated the rules against involving analysts in IPO pitches? This settlement involves 10 banks, including nine of the top 10 banks for U.S. equity offerings in 2010.  And the way Finra tells the story, it's a short story:

  • KKR and friends were like, "Hey if you want to do an IPO for us you'll have to break some research rules."
  • All the banks were like, "Cool yeah let's do that."

And that's it. One bank is "inadequate supervisory procedures" or whatever, but 10 banks is, this was just normal procedure.

How bad was it? I don't know. The research analyst rules are prophylactic, designed to basically keep analysts away from evil evil bankers so that they're never even tempted to be dishonest about their opinions. So Finra doesn't even argue that the analysts' views of Toys "R" Us were dishonest. That would be a hard argument to make, since the analysts never published those views, and Toys never went public.

Instead, Finra points to two more technical violations. The first is that the banks all trotted their analysts out to Toys and its sponsors as part of the process of pitching for the IPO. Analysts are allowed to meet with IPO targets, but only for limited purposes. Here is Finra:

Under NASD Rule 2711(c)(4), an analyst may communicate with an issuer during the solicitation period as part of the analyst's due diligence efforts to gather information about the company, but may not communicate with the issuer in furtherance of soliciting a role for his investment bank in the underwriting. In the context of a meeting requested by an issuer during the solicitation period for the purpose of obtaining an analyst's views as part of the underwriter selection process, as occurred in the TRU IPO, an analyst from a soliciting investment bank may not communicate to the issuer his views about the issuer or the issuer's industry, such as his views about valuation or comparable companies.

Huh.  So. You can go to a meeting to conduct due diligence. But while you're there, you can't do things like:

  • tell "TRU and the Sponsors that he was 'Institutional Investor ranked' and that the JPMS 'retail and consumer franchise is the best on the street. ...'" (JPMorgan.)
  • say "that TRU was a 'global category dominant firm,' and that, with respect to 'global potential,' 'barriers to entry are high' but TRU had 'answered those questions' and could 'get paid for it.'" (Goldman.)
  • say that you "strongly believe[d] that TRU will demonstrate it deserves a strong valuation because, by virtue of its store setup, sourcing and better systems, it is creating wealth out of nothing." (Needham, haha.)

From the settlements, Finra's understanding of its rules seems to have been ... different from the banks' understanding. I mean, the banks all agreed to meet with Toys, and none of them seem to have been there for diligence. There seems to have been a pretty wide gray area. There you are. Doing your diligence. Presumably you've, like, dressed nicely. You've brought some materials. Maybe you don't stick strictly to the script. Ribs are nudged, eyes are winked. Perhaps, when pressed, you admit that you might want to win the business. Perhaps you even insinuate that your research might be part of how that business is won. Here's a crazy passage from the Deutsche Bank settlement (emphasis added):

During his presentation, the DBSI analyst noted that he was restricted in his ability to remark on certain questions and indicated at the outset through a disclaimer that he could not comment on, among other things, valuation, research coverage, or imply what the coverage would look like. TRU Sponsors questioned him nonetheless on valuation, comparables, and positioning, inviting the analyst to speak on the subjects since the bank's attorneys were not present. Consistent with the directive from Legal and Compliance, the analyst did not address these matters despite urging from TRU Sponsors.

When the DBSI analyst finished presenting, he briefed the Firm's investment bankers, who expressed concern among themselves that the analyst's performance may have hurt the Firm's chances to win the TRU IPO business. One investment banker sent an email stating that the "Firm totally screwed up -- all is lost."

Wait, what? Analysts came into the Toys "R" Us pitch, said, "We're not allowed to pitch you," and the sponsors were like "No it's fine there are no lawyers here hahahaha let's misbehave"?

Or rather, "go ahead and misbehave." After all, Toys and its sponsors aren't in trouble here. Their behavior was perfectly reasonable. They wanted to do an IPO with positive research coverage. So they called every bank and said, in essence, that they wanted more or less explicit promises of positive research coverage in exchange for IPO consideration. All of that is totally legal, and a completely rational thing to do, and a good idea. Every company should do that. It's just illegal for the banks to say yes. But banks can resist everything except temptation.

The other bad thing that the banks did (all except Needham ) is this. Toys and its sponsors sent each bank a form that asked for "Equity Commitment Committee approval of a definitive equity valuation range" signed off on by banking and research. All of the banks sent back the form with the range filled in. I sympathize with the sponsors here. A while back I wrote about the Royal Mail IPO post-mortem, which featured this chart tracking the pricing range from initial pitch to actual IPO:

Basically the way an IPO works is, the bankers pitch a really optimistic valuation range, to flatter the client into giving them the mandate. Then they spend the next few months walking back that range so they can market something a bit easier to achieve. Then their research analysts come out with their own valuations that are (in theory) totally independent of the bankers' valuations, and therefore a surprise to the client. Toys "R" Us's sponsors just wanted to get some predictability in this silly process, and to hold the banks to their promises. Again: a sensible desire, and a good request, even if it's illegal for the banks to agree to it.

My main question on this case is: How did Finra find out? It is hard to come away from these settlements with the impression that this was an isolated case. It was 10 banks! And two big private equity sponsors! If it happened here, it happened elsewhere. Presumably the banks were tripped up by the nakedness (sorry!) of the cynicism here: that awful Needham e-mail, which really reads like something out of 1999, or the sponsors' explicit nobody-here-but-us-non-lawyers instructions to the Deutsche analyst. But this doesn't read like an anomaly; it reads like an extreme case of what happens all the time.

  1. Usual disclosure here (I worked there, have a little restricted stock). I worked in capital markets, though not really on IPOs, and I don't think I'm revealing any state secrets when I say that my interactions with analysts were limited and extreeeemely lawyered. I should add that I never to my knowledge attended an equity offering pitch with a research analyst, so I don't have any state secrets to reveal.

  2. Barclays, Citigroup, Credit Suisse, Goldman Sachs, JPMorgan, Deutsche Bank, Merrill Lynch (a Bank of America production), Morgan Stanley, Wells Fargo and Needham & Company (which alone among the banks refused to give Toys a joint banking/research valuation, good for them). Bloomberg's U.S. Equity Offerings league table (LEAG <GO>) for 2010 has nine of those banks in the top 10; the lone big bank missing from the settlements is UBS, eighth in the league table that year. Needham was 44th.

  3. I say "KKR and friends" -- it's mainly KKR, Bain Capital and Vornado -- because I assume that this is about currying favor with the sponsors, not a toy company. I suppose, like, Facebook or Alibaba could command similar commitment, but most non-private-equity companies that are looking to go public probably get less banker attention.

  4. That rule now has an exception for "emerging growth companies," not relevant to this deal (which happened before the JOBS Act).

  5. Deutsche Bank was named a bookrunner on the proposed IPO, by the way, so all was not lost.

  6. Well, I mean, some could resist. Deutsche Bank did! But they still got fined by Finra! The Morgan Stanley settlement is similarly weird on this point. Basically the analyst never did anything wrong, as far as I can tell? He prepared a presentation that included discussion of his coverage of another retailer -- apparently off-limits -- but the legal department made him take it out. And the bankers sent a bunch of e-mails to Toys praising his retail experience, but that's the bankers, not the analyst, and I think that's allowed? It looks like guilt by association for Deutsche Bank and Morgan Stanley, and some of the other banks. To be fair, the fact that the DB and MS analysts showed some spine seems to have saved them a million bucks in fines ($4 million for them, Merrill, and Wells Fargo, versus $5 million for Barclays, Citi, Credit Suisse, Goldman and JPMorgan). I'd have given them more credit though.

  7. Which therefore paid the lowest fine, $2.5 million, despite having the worst quotes.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net