Commentary: IPOs: How Wall Street Can Give Everybody a Chance

Underwriters should disclose how they parcel out the shares of the companies they take public

The securities industry likes to brag that U.S. stock markets are the best and fairest in the world. But to many investors, that boast had a hollow ring during the initial public offering bonanza that began in the mid-1990s and ultimately saw more than 2,800 companies raise more than $270 billion. Insiders reaped much of the profits, and individual investors were too often locked out.

Today, investigators are probing whether Wall Street bankers essentially demanded kickbacks in exchange for allocations of hot IPO stocks. An early focus of the investigations, by the Securities & Exchange Commission, the U.S. Attorney's Office in New York, and the National Association of Securities Dealers, has been Credit Suisse First Boston, though at least half a dozen more firms are being investigated. CSFB has acknowledged it has been questioned but says that what it did was in line with standard industry practice.

ON THE HUNT. Regulators and the Justice Dept. may have trouble bringing charges because existing rules covering any alleged abuses they turn up don't apply specifically to superheated IPOs. So while the authorities hunt for ironclad evidence of misconduct, they should also move to clean up the IPO business. That way, they can make sure that in the future IPOS are fair to all investors, not just a select few.

COMMISSIONS: TOO HIGH? Wall Street firms are at center stage because of how the IPO market works. They buy stock from a company and then sell it to investors, such as mutual funds, hedge funds, or wealthy individuals. When IPO stocks are rocketing after hitting the market, the firms become financial kingmakers, because they decide who gets to ride along. This was especially true at the peak of the IPO boom. Many companies saw their stock prices double on the first day of trading, with the biggest one-day gain--on shares of VA Linux Systems Inc. (LNUX )--topping 695%.

The probes under way focus on whether Wall Street firms, eyeing those fat gains, threw their weight around to get a cut for themselves. One major question investigators are trying to nail down is whether Wall Street forced investors to agree to pay abnormally high commissions on later transactions in return for getting hot IPO shares. Another is whether firms required that investors getting IPO shares agree to buy more shares--or not sell them--once trading began in order to shore up stock prices.

On paper, the investigators seem to have plenty of legal ammunition on hand to attack abuses they uncover. An NASD rule dating back to 1943, for example, outlaws excess commissions; another bars unreasonable compensation. Companies must also disclose in reports to the SEC how much they pay in fees to Wall Street firms for IPOs. In principle, each IPO must be widely available to the public, not just a handful of favored customers. And long-standing safeguards intended to prevent market manipulation apply to trading in IPO shares after they're in the hands of the public.

The trouble is most of these rules are vaguely worded. That on excessive commissions, for example, speaks of "fair" prices depending on market conditions. So regulators may have to rely heavily on catch-all rules, which allow regulators to cast a wide net. The NASD, for instance, frequently disciplines members who fail to "observe high standards of commercial honor and just and equitable principles of trade." The SEC requires securities firms to document virtually everything they do. If they haven't a complete paper trail in the IPO cases, they're vulnerable.

TOUGH LINK. Clearly, there's enough ambiguity in the rules to make enforcement cases shaky. For starters, investigators would have to prove that payments or arrangements were made specifically to obtain IPO shares. Making such a link is never easy. Then there's interpretation. Consider the question of high commissions on later trades with investment banks in order to obtain IPO shares. To an ordinary person, that smells like a kickback. But legally, it's not that obvious. "In the most benign sense, it would be compensation for the opportunity to participate in an offering not otherwise available," says Leo F. Orenstein, a Washington securities lawyer and former SEC enforcement official. "It's not altogether clear [that it is illegal]."

Lawyers also worry that rules not designed to cover IPOs would be stretched too far. And they may have a point. "It's not fair to bring an enforcement case if you don't have clear standards," says Richard Roberts, an SEC commissioner from 1990 to 1995 who is now with a Washington law firm.

Of all the practices under scrutiny, the post-offering buy and sell arrangements have received the most recent attention from regulators. SEC legal staffers specifically reiterated last year that making customers buy extra shares was prohibited. But that admonition came long after the boom began, and then only as an advisory.

Securities insiders caution against a rush to new regulation. "The American capital markets are the wonder of the world," says Charles Snow, a New York securities lawyer and another former SEC official. "Why would we want to restrain our own markets and lessen our flexibility?" But if--as Wall Street pros often say--the bedrock of the markets is investor confidence, then more needs to be done.

RIGHT TO KNOW. A minimum first step must be to ban both kickbacks in the form of higher commissions and requirements to buy more shares to pump up prices once trading begins. The NASD and the New York Stock Exchange can do that quickly by changing their own rules. Once that's done, a full-blown SEC rule should follow.

Investors are also entitled to know more about how investment banks parcel out the shares in IPOs. Ideally, the banks should name names and amounts. No doubt, the banks would complain about overregulation and being forced to divulge sensitive information. They may be right. But public securities markets are ultimately just that and public interest should be the driver.

Now, Wall Street has a chance to prove that its markets are the fairest and the best in the world. It should seize it with both hands.

By Christopher H. Schmitt

With Mike McNamee in Washington

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