OpenIPO: In The Media

POLITICAL CAPITAL By Alan Murray, Washington Bureau Chief, CNBC

Tuesday, September 10, 2002

The Rationing of IPOs Encourages Corruption

It has been 13 years since the fall of the Berlin Wall, and 11 since the collapse of Gosplan, the Soviet economic planning agency. So isn’t it finally time to get rid of rationing on Wall Street?

The U.S. capital markets are the most sophisticated, deep and efficient the world has ever seen. But when it comes time to distribute shares in new public companies, the financial whizzes revert to a system that would make Stalin proud. To each according to his clout. It is a system that let WorldCom Chief Executive Bernard Ebbers pocket $11 million because he had access to 21 “hot” initial public offerings from Salomon Smith Barney that were out of the reach of ordinary investors.

The narrow question being asked by investigators for the House Financial Services Committee is this: Did Mr. Ebbers throw his company’s investment-banking business to Salomon Smith Barney because of these sweet IPO allocations? If so, they are kickbacks.

But the bigger question Wall Street should be asking is: Why in the world are the world’s pre-eminent capitalists rationing IPO shares in the first place?

When the price of a stock jumps to $20 from $10 in the first day of trading, reaping instant profits for the lucky few who have been allocated shares, the investment bankers celebrate a “hot” offering. They ought to have their bonuses rescinded, for doing a poor job of pricing. Apologists say pricing a new issue is more “art” than “science.” That might have been true 20 years ago; today, it is hogwash. As William Hambrecht , CEO of WR Hambrecht & Co. has demonstrated, today’s technology makes it perfectly possible to use auctions to find the market price of a new issue.

Wall Street veterans whose views I respect (and who have asked that their names not be used in my rant) argue there are subtle benefits from the current IPO system. Much of their argument centers around marketing. Greasing the palms of “distinguished” investors such as Mr. Ebbers, and creating a “buzz” around a “hot” stock, may help companies going public for the first time get attention they desperately need.

Moreover, these veterans note, there seems to be no pressure from the companies issuing IPOs to do it differently. These companies, after all, are the ones being short-changed by the process. If their shares double in a day, that is money they have left on the table. But taking a company public is a big, one-time decision, fraught with uncertainty. As a result, issuers haven’t been inclined to shake up the system. Mr. Hambrecht’s efforts to persuade companies to issue IPO shares by Dutch auction have had only modest results. “It hasn’t been easy,” he confesses. Says investor advocate Nell Minow: “If you are 25 years old and operating out of your garage and somebody offers you tens of millions of dollars, are you going to quibble?”

So if the people being shafted by the current system don't care, why should I?

Because it encourages corruption. For the last decade, U.S. government officials have been preaching the virtues of free markets to countries emerging from behind the Iron Curtain. The sermon has gone something like this: When you have controlled prices, you can't prevent corruption. When you allocate credit, people bribe loan officers. When you have import quotas, people bribe customs officials. The best antidote for corruption is free markets, with the market clearing prices.

Wall Street needs the same lecture. The Ebbers revelation has prompted a review of IPO allocation rules at investment banks. But that doesn't go far enough. The question isn't just how financial firms allocate hot shares; it is why they allocate them. That is what markets are for -- to find the right price and assure that supply equals demand so you don't have to ration. Why can't the capitalists embrace capitalism?

The resistance from those on Wall Street who benefit from the current system is sure to be intense. Favored investors who receive “hot” IPOs have a lot to lose from change. So do the bankers and brokers who dole them out. But then, the folks at Gosplan had a lot to lose, too.

House Financial Services Committee Chairman Michael Oxley has directed his committee's investigators to keep digging into IPO practices, but says he has no plans to legislate. Instead, he wants to keep a spotlight on the problems, and let Wall Street come up with solutions. SEC Chairman Harvey Pitt has asked the National Association of Securities Dealers and the New York Stock Exchange to take on these issues, asking them to look not just at how IPOs are allocated, but also how they are priced. New York State Attorney General Eliot Spitzer is on the case, ready to embarrass Messrs. Pitt and Oxley if their enthusiasm lags.

As a result, Mr. Hambrecht now believes, change is coming. “Bringing these practices to the surface” he says “is going to assure that there is going to be a new system.” If so, it's about time.

ABOUT ALAN MURRAY: Alan Murray is Washington Bureau Chief for CNBC and co-host of Capital Report, which airs Tues.-Thurs. at 9 p.m.