Burnt Offerings

In its trading debut in late 1999, VA Linux Systems' shares soared as the public plowed money into a would-be Microsoft killer. Not. Turns out that VA Linux's record one-day pop might really have been driven by manipulation.

At least that's what the SEC thinks. And, since billions have been wagered and lost on new tech offerings, heads are rolling. Credit Suisse First Boston, underwriter of the VA Linux (recently renamed VA Software) deal and many other high-fliers that eventually crashed, agreed to pay a fine of $100 million to settle charges that it improperly allocated shares of IPOs allegedly to insure post-IPO support and other forms of payback. By January, the SEC probe into IPO abuses had spread to other major Wall Street firms.

Lawyers in the private sector, naturally, are not waiting for government investigations, which will take many months: They are already suing. In fact, the number of suits filed against broker/dealers last year more than doubled to 478 from about 200 annually in recent years, according to a study conducted by PricewaterhouseCoopers for Registered Rep. The bulk of the cases, more than 300, involve accusations of laddering, which occurs when an underwriter agrees to sell stock to some favored, large investors at the offering price — a deal unavailable to the average investor — in exchange for the buyer's commitment to buy more stock on the open market. The flurry of buying activity after the offering sometimes drove up stock prices and attracted retail investors, since they mimicked what they perceive to be enlightened Wall Street trading.

Laws covering IPO abuses are decades old. The Investment Acts of 1933, 1934 and 1940 prohibit financial firms from charging side fees to complete a deal, and stipulate that all fees must be published in the prospectus. Moreover, firms can't attempt to manipulate a stock price once an issue is publicly traded (unless, of course, it is to keep an orderly market). In 1999 and 2000, the peak of the Internet run-up, those laws were widely flouted.

Suits also have been filed against Wall Street analysts, alleging that equity researchers were merely instruments to win the more lucrative investment banking business. Although brokers are not directly named in these suits, the implications are clear: Many brokers sold shares in IPOs that were underwritten by their firms, and the appearance of impropriety can damage client relationships.

Brokers Probed?

The SEC is studying the role that broker/dealers played in the IPO allocation scandal, according to Ned Dodds, an attorney with Dechert, Price & Rhoads, who is representing several underwriters in the SEC investigation. “There's going to be a significant amount of attention paid to how broker/dealers communicated with their clients,” he says.

Wall Street firms are developing new policies to guard against future abuses in the IPO market. But in some ways, it's a Catch 22. Attempts by brokers to keep clients from selling new IPOs (in a bid to keep the price up) is a form of price “managing.” For instance, UBS PaineWebber recently backed off from a plan to fine brokers when clients sold IPO shares soon after the offering. Brokers argued that they can't control clients' actions.

In a likely sign of what's to come, UBS PaineWebber instead decided to implement tracking software that monitors post-IPO trading. Branches or brokers with unusual activity won't get allocations of shares in the future. (In a possibly ominous development for an industry that's already undergoing a great deal of scrutiny, companies are now homing in on the allocation issue. Last June, software firm HPL Technologies asked underwriter UBS Warburg to peruse trading data and regulatory filings on investors' holdings to help select buyers of its IPO). In recent months, investment banks have sought to avoid further controversy by steering shares to institutional investors. They reason that retail investors are too prone to “flipping” their IPO shares quickly.

Nevertheless, some speculate that the industry will have to reverse that policy. SEC Chairman Harvey Pitt, like his predecessors, is committed to keeping public markets open to all types of investors. And newly-public companies don't want to be strictly in the hands of institutional investors. “Companies are always clamoring for a broader mix of institutional and retail investors,” says Bob Lamm, who chairs the Securities Practice Group of Gunster Yoakley and is director of the Association of Public Companies. “Individuals will stay with you over a longer course.”

Of course, if retail investors are to return to the IPO market in a meaningful way, brokers must do a better job of explaining the merits of a prospective investment. And Lamm thinks that the closed road show process will need to open up. “I think you'll see online road shows become more popular once brokers (and their clients) become more comfortable with the Web,” he says. That would be in step with the expressed goals of Pitt, who has demanded that investors receive more information in real-time. “The changes could ultimately benefit the retail investor,” says Lamm, “but I'm not sure the (underwriting) institutions are thrilled about that.”

In the near term, many brokers may choose to avoid the IPO market, as the sector comes under continuing scrutiny. Bill Nortman, who was a regional chief in New York and Miami for the SEC in the 1970s and 1980s, expects Congress to hold a number of hearings on the IPO market later this year. If congressional hearings dominate the nightly news, retail investors will be wary of taking a flyer on new IPOs.

Nortman also expects the SEC to issue sweeping new guidelines in the coming months. “Pitt has said that statutes were written before the electronic age and need to be rewritten,” says Nortman. With industry regulations in flux, compliance officers may advise brokers to steer clear of IPOs for now.

If brokers do continue to place IPO shares in client accounts, industry watchers have a sound piece of advice: “Make sure that everything is documented, including a review of the suitability of a particular stock for a particular client,” says Nortman. He urges compliance officers to stay involved in the IPO allocation process and carefully review all conversations and transactions. John Capone, who is the regulatory advisory partner at Andersen Consulting, thinks that most compliance officers have already gotten the message. “They're certainly being a lot more careful now that the SEC is watching.”

The lessons learned from these past few years have brought a more sober and mature tone to the market. Investors are unlikely to get burned in the same manner as in years past.

IPO Trends: The Story So Far

Away from the Spotlight, the IPO Market Quietly Heats Up

This IPO market is markedly different. The average new IPO rose just 12.88 percent on its first day of trading in 2001, compared to 53 percent in 2000 and 68 percent in 1999.

As the IPO debacle unfolded in 2001, many investors questioned whether they even wanted to be involved in this highly speculative sector. Turns out, there wasn't much to think about, because IPO activity virtually dried up.

But since late September, IPO activity has bounced back. (Still, as the table on this page shows, overall IPO activity was at historically low levels.)

To the surprise of many, IPOs are now trading well and garnering interest from more intrepid brokers. In fact, since Oct. 4, 28 new stock issues have come out, posting an average gain of 26 percent. By contrast, the S&P 500 rose 5 percent and the Nasdaq rose 24 percent from that point through the end of 2001.

So is it time to steer your clients back to IPOs? Yes, with a few caveats. For starters, it's important to remember that this IPO market is markedly different from recent years. The average new IPO rose just 12.88 percent on its first day of trading in 2001, compared to a 53 percent average pop in 2000 and a 68 percent first-day gain in 1999, according to the Web site ipomonitor.com.

That means that momentum investors should look elsewhere if they're looking for a quick hit. And that's a welcome change for IPO analysts. “This looks a lot more like an old-fashioned IPO market,” says Renaissance Capital's Linda Killian, who co-manages her firm's IPO fund. “It's a much more constructive marketplace.”

Today's IPOs are a different breed. Instead of aggressive upstarts with scant revenue and nonexistent profits, they are more seasoned. The average IPO in 2001 had been in business for 12 years, according to a University of Florida study. In addition, nearly half the companies that went public were profitable, compared to just 21 percent in 2000.

Brokers may want to avoid taking a flier on smaller, less-established companies. Of the ten worst IPO performers, five raised $16 million or less.

It's too soon to predict where the action will be in the IPO market in 2002. Investment bankers are scrambling to catch up and place companies in the IPO pipeline. So it will be several months before we see a steady diet of IPOs make their debut. And when they do, the action will likely be centered around sectors that are currently in vogue. A large group of energy stocks went public in early 2001 in the wake of the spike in energy prices. Later in the year, security and defense stocks proved popular, as the events of September 11 led investors to conclude that these areas would see an increase in spending.

One trend is sure to continue: carveouts. “You'll see more spin-outs by big players in 2002,” predicts Matt Zito, co-founder of ipoguys.com. Philip Morris and Lucent Technologies both took subsidiaries public in 2001, and other companies are eyeing similar moves in 2002.

Citigroup is set to spin off its Travelers insurance business in early 2002. Also look for Verizon and Vodafone plan to complete a long-awaited IPO for Verizon Wireless, and Cingular, the joint venture between SBC Communications and BellSouth, is also expected to go public this spring. Each of these deals could fetch up to $4 billion, according to preliminary filings.
— DS