[A-List] US legitimation crisis: IPOs

["Michael Keaney" <michael.keaney@xxxxxx>]

Put corruption under the hammer
By Lawrence Ausubel
Financial Times: December 20 2002

It is tempting to hope that an apparently imminent global settlement with
Wall Street firms, together with recent developments at the Securities and
Exchange Commission, will halt the news of malfeasance and scandal emanating
from corporate America.

Unfortunately, some superficial changes in the role of stock analysts and
some relatively painless fines will not materially alter the incentives that
created the current mess. Nor will simple changes in regulatory personnel
significantly advance the ability of government to end abuses. Fundamental
structural reform is needed to accomplish any real improvement.

Take one of the roots of today's problems: the mechanism for allocating
shares in initial public offerings. The share price in IPOs often bears
little connection to the equating of supply with demand. IPOs are sometimes
massively oversubscribed and the share price increases by as much as a
factor of five from the offering price to the close of the first day of
trading. Shares in these oversubscribed offerings are rationed not according
to willingness to pay but to favoured clients of the underwriting investment
banks.

In one famous instance, customers were required to kick back a third of
their IPO trading profits to the investment bank. It seems that the payment
took the form of inflated commissions on other stock trades. When an
investor pays a stock-trading commission of $3 per share on a trade of
10,000 shares, one can be relatively sure that it is a kickback.

In other instances, underpriced IPO shares have become the currency for
implicit rebates to executives. Sometimes it looks as though the executives
may have received their personal allotments in exchange for swinging their
companies' business to the investment bank. For example, five
telecommunications executives apparently received IPO shares yielding $28m
in quick profits, at the same time that their employers paid $240m in fees
to the investment bank.

In short, it has become increasingly clear this year that the system for new
security issuance is fundamentally corrupt.

Periodically, regulators contemplate drafting new rules to curb the abuses
associated with IPOs. But no such rule will be effective, as long as new
issues continue to be deliberately underpriced relative to market
conditions. As long as the basic economic facts of under- pricing,
artificial shortage and instant profitability persist, the underwriting
banks will maintain some discretion to dispense the valuable shares to
parties of their choosing. And one can be certain that, regardless of the
rules, the shares will be allocated in return for value received in other
transactions.

Fortunately, there is a way to clean up the entire process. The current
book-building procedure could be replaced by a modern, dynamic auction. The
auctioneer begins by announcing a low stock price and bidders respond with
electronic bids representing the quantities of shares desired. If demand
exceeds supply, the auctioneer announces a higher price and bidders again
respond with quantities desired. The iterative process continues until
demand equals supply, concluding the auction.

An auction process would bring the new issues market into equilibrium.
Access to shares would be determined by price, not by a secret quid pro quo.
Indeed, an IPO auction offers the promise of all but eliminating the current
underpricing. In principle, the clearing price in a well designed auction is
virtually equal to the market price, so the first-day return should be
essentially zero.

IPO shares would no longer be the currency for kickbacks and favours, since
the instant profits and the associated scarcity would vanish. There would be
no need for the government to set rules for share allotments, since the
underlying incentives for abuse would be gone.

Of course, there are obstacles to IPO auctions. One is that, while an
auction in advance of an IPO is allowed, current SEC rules appear to require
that the bids be indicative and non-binding. Any policy requiring bids to be
non-binding is clearly detrimental; for an auction to work effectively, bids
need to have real consequences. At the same time, there is no good rationale
for such a requirement, so it should be feasible to get the SEC or courts to
overturn the rule.

Perhaps the greatest barriers to auctions are the vested interests earning
rents in the current process. The IPO auction is not a panacea. Indeed, the
danger of overpromoting shares of worthless companies would remain; an
auction does not eliminate the risks of hype or asset bubbles.

Yet modern, dynamic auctions have been successfully applied in many other
sectors of the economy and they can eliminate the incentives behind several
aspects of today's Wall Street scandals.

The writer is professor of economics at the University of Maryland