Ipo Fees: Coincidence Or Collusion?
Collusion on Wall Street is not easily spotted. When academics William G. Christie and Paul H. Schultz first figured out that NASDAQ market makers rarely quoted stocks in increments of less than 25 cents, their 1994 treatise in the Journal of Finance didn't definitively conclude that anything was amiss. But the paper triggered lawsuits and a two-year federal investigation that uncovered widespread collusion among brokers to fix prices on hundreds of NASDAQ stocks. The result: dramatic reforms that lowered spreads and saved investors more than $25 billion.
Will another academic study lead to similar upheaval in one of Wall Street's most cherished businesses--the lucrative market in initial public offerings? In an upcoming Journal of Finance article, two University of Florida academics raise disturbing questions about the fees that investment banks charge to take companies public. Their research shows that investment banks almost invariably charged a flat rate of 7% of the per-share offering price in the vast majority of IPOs over the last three years (chart). The fee is twice as high as that charged by investment banks abroad.
ODD CLUSTERING. Coincidence, or another case of price-fixing? Professors Jay R. Ritter and Hsuan-Chi Chen don't say. But they wonder why, in the supposedly highly competitive investment-banking market, no one competes on price. "I'm not sure this is a smoking gun, but regulators need to keep their eyes and ears open for evidence of collusion" among big Wall Street firms, Ritter says.
A Securities & Exchange Commission panel last reviewed IPO pricing in 1994 and spotted a similar pattern. "Ritter's study raises a series of troubling issues," says former SEC Commissioner Steven M.H. Wallman. "The clustering around the 7% spread seems very abnormal. There are possible innocent explanations, but there are also possible nefarious ones." John E. Fitzgibbon, editor of the IPO Reporter newsletter, says it's an "oligopoly." In recent years, IPO volume has averaged $40 billion per year. If fees were on average 1% too high, that would mean excess banking fees of $400 million a year, Ritter calculates.
Antitrust officials, though, have had little interest in the issue. The reason: No one has come forward to complain that the cost of going public is too high, Wallman says. For companies that want to go public, banker's fees are low on their list of concerns. Much more important is how much money their bankers can raise in an IPO and how strongly they can push it with investors.
But since the 1994 study, pricing has become even more uniform, Ritter says. Between 1992 and 1994, for example, only about half of all IPOs had 7% fees, according to Wallman. But in the last three years investment bankers charged precisely 7% about 75% of the time. The fee clustering recently prompted the National Association of Securities Dealers to warn underwriters not to collude on pricing.
On Wall Street, the 7% fee, or "spread" in Street parlance, "is viewed as the last bastion of the old, clubby, cigar-smoking world of investment banking," says Andrew D. Klein, founder of Wit Capital Corp. in New York, an investment banking boutique that sells IPOs over the Net. With margins on brokerage and other fees shrinking, IPO fees are crucial sources of profits. "Out of mutual self-interest, most bankers have lived by a not-needed-to-discuss code that they wouldn't cut spreads," Klein says.
HAGGLE-PROOF. Investment bankers and IPO lawyers say there are numerous reasons why banks maintain the 7% spread. Most important, says John J. Egan III, an IPO attorney at Goodwin Procter & Hoar in Boston, a standard fee makes it easier for investment banks to work together in syndicates, since it eliminates haggling over the division of fees. Few companies going public question the fee because "it's much more important to have a harmonious offering, and for syndicates to work harmoniously you have to have a standard set of fees," Egan says.
It may not be obvious there's a problem that needs to be fixed. Still, investors bought NASDAQ stocks at unfair prices for decades until a couple of academics pushed regulators into giving the matter a look. The Ritter-Chen study may provide the ammunition for a similar review.
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