Commentary: How to Clean Up Wall Street's IPO Machine
Will initial public offerings ever be the same again? Not if regulators do their job right. For months, they have been beating up on Wall Street in a bid to restore integrity to the way bankers raise capital for Corporate America. On May 29, a Securities & Exchange Commission advisory committee delivered the latest blow: It recommended 20 ways to fix the ailing system, ranging from making it easier to auction IPOs to banning banks from doling out hot shares to clients.
The committee's proposals are a step in the right direction. But it's up to SEC Chairman William H. Donaldson to beef them up so that bankers can't slide back into their old bad habits once the stock market recovers. Ultimately, regulators will have to stop Wall Street from using IPOs as party favors. Period. Bankers must also be held more accountable for getting the best IPO prices for their corporate clients issuing the stock. Until that happens, the conflicts of interest that arise because the banks are serving both sellers and buyers will remain a problem.
The committee's proposal to abolish cumbersome rules that hinder open auctions could do the most to clean up Wall Street's IPO machine. At present, bankers must reconfirm every investor's order for it to be final -- a big hindrance to innovators such as WR Hambrecht & Co., which has struggled to set up real-time auctions in which shares go to the highest bidder. Similar auctions are standard in markets such as Paris, where they have raised capital for hundreds of companies.
Most of the committee's other major suggestions need to be ratcheted up a notch:
IPO ALLOCATIONS The proposal to bar investment banks from doling out shares to execs to win lucrative investment banking work needs to apply to money managers as well. Why? Because bankers are tempted to underprice offerings so that these professional investors are virtually guaranteed a first-day pop in an IPO price. They do this because the more hot IPOs investment banks offer money managers, the more likely they are to harvest future trading orders -- and commissions -- from them. The billions of dollars in first-day trading gains really belong to the companies that pay hefty fees to the banks to take them public -- and no one else.
ROAD SHOWS The advisory committee's call to open IPO road shows, or marketing events, to all investors is a great idea. Right now, only professional money managers are invited. But to ensure that the playing field stays level, the SEC has to see to it that the pros don't quietly get privileged information from investment banks through other channels. Under the current rules, IPOs are exempt from the SEC's Regulation Fair Disclosure, which mandates that individual and professional investors should have the same access to information from public companies. IPOs need to be included. Otherwise, companies going public could leak crucial information, such as earnings forecasts, in closed meetings with money managers while keeping individuals and research analysts at rival investment banks in the dark. "There's a risk that the road shows will get dumbed down," says committee member Jay R. Ritter, a finance professor at the University of Florida.
PRICING Holding bankers more accountable for their IPO pricing is another crucial reform. The committee suggests trying to achieve this by requiring company boards to appoint pricing committees that will keep pressure on bankers. But regulators should explicitly make the banks legally responsible for getting the best price for issuers -- as they must do for clients when they execute an order to buy or sell shares on the stock market. Since IPOs are, in effect, a trade, "Why shouldn't [investment banks] have to live under the same rules as they have to in the secondary market?" says committee member Bill Hambrecht, CEO of WR Hambrecht.
SEC insiders say Donaldson has been thoroughly briefed on the report. Still, the SEC may need a year to iron out the new rules. Given the dearth of IPOs now, this may not seem urgent. But getting new rules in place well before the market takes off again is crucial. "My concern is that if we enter another bull market, we will see a return to the practices condemned in the [committee] report," says Harvard Business School Professor Emeritus Samuel L. Hayes. If regulators fix the system properly, IPOs will almost certainly not have the same stellar first-day gains they had in the 1990s. But chances are they won't suffer the same crash landings, either.
By Emily Thornton
With Mike McNamee in Washington