IPO quid pro quo squeezes investors Hedge funds allegedly granted pre-IPO allocations by underwriters in exchange for buying stock in the after market OPINION By Christopher Byron MSNBC CONTRIBUTOR
June 16 — The early-summer slide in Internet
stocks highlights an important question: Exactly
how did these stocks get so overvalued in the
first place? One disturbing answer: apparent
price-manipulation by underwriters at the time
the companies went public.
Is the IPO market being manipulated? Weigh in on the Byron BBS
AN MSNBC.COM INVESTIGATION into the
matter reveals that, in many cases, underwriters of Internet
IPOs appear to have engaged in a widely practiced
marketing scheme known as a “tie-in.” Its explicit purpose:
to push up the after-market price of IPO shares.
In these ploys, underwriters offer their hedge fund
clients the opportunity to get in on IPO offerings at cheap,
pre-market prices. But the offer is conditioned on an
unwritten, oral agreement in which the funds, in turn,
promise to give back to the underwriters what amounts to a
blank check to buy many more shares for their account the
minute the deal goes public.
Such tie-ins have the effect of letting buyers acquire
stock at low, pre-market prices, while secretly providing the
financing to help to manipulate the value of their holdings
upward in the aftermarket.
‘This certainly goes
on. Preferential
allocation of shares
to favored clients
gives the
underwriters
controlling leverage
over the whole
process, both
pre-market and
aftermarket.'
— WILLIAM
HAMBRECHT
Says William Hambrecht, the former name partner in
San Francisco's Hambrecht & Quist underwriting firm,
“This certainly goes on. Preferential allocation of shares to
favored clients gives the underwriters controlling leverage
over the whole process, both pre-market and aftermarket.”
Hambrecht has recently opened a Web site —
www.wrhambrecht.com — offering IPOs directly to the
public via a Dutch auction marketing method that makes
tie-ins impossible.
The entire tie-in practice is, in fact, illegal.
“Securities law can be very complex,” says Martin H.
Kaplan, a securities lawyer with the New York firm of
Gusrac, Kaplan and Bruno. “But this type situation is very
simple and clear-cut. Any undisclosed tie-in that requires
the aftermarket purchase of securities in order to obtain a
pre-market allocation of stock in an IPO is per-se fraud and
illegal. It violates the Sec. 17 fraud provisions of the
Securities & Exchange Act of 1933, and Sec. 10 of the
1934 Act.”
As recently as May 27 the SEC filed an injunctive civil
fraud action in New York federal court against a Long
Island penny stock underwriting firm, HGI Inc., and 13 of
its registered representatives. The action charges them,
among other things, with asking their customers, prior to the
public offering of various pending HGI-underwritten deals,
to agree to purchase shares in the aftermarket once the deal
went public. The complaint says HGI and its registered reps
even went so far as to require the customers to agree to buy
a specified numbers of aftermarket shares in order to get the
securities at the IPO price.
‘GOES ON ALL THE TIME'
Interviews for this story were conducted with officials
at six different hedge funds. Only one of them — Jeffrey
Gradinger, who runs a small, San Francisco-based fund,
Diamond Capital Corp. — agreed to speak for attribution,
and then only in generalities.
‘It goes on all the
time — especially
when big allocations
of 10,000 shares or
more are involved.
From the sleaziest
bucket shops to the
biggest and best
firms on Wall
Street, everyone
does it.'
— JEFFREY
GRADINGER
Diamond Capital Corp.
But whether on the record or not, all confirmed
Hambrecht's assertion that for hot IPOs, tying pre-market
access to an agreement to buy more shares in the
aftermarket has become a widespread and common
element in the marketing of Internet IPOs on Wall Street.
The sources agreed moreover that the practice is followed
even at the industry's leading, most prestigious firms — at
least at the broker level, if not as unofficial but clear policy
by syndicate managers themselves.
The hedge fund sources interviewed for this story
managed assets ranging from under $5 million to more than
$500 million, and all have invested in numerous Internet
IPOs in the last two years. But not one could cite a single
example of a deal in which he had been offered a
pre-market allocation without simultaneously having been
required to buy yet more shares in the aftermarket.
Said Gradinger of Diamond Capital Corp., “It goes on
all the time — especially when big allocations of 10,000
shares or more are involved. From the sleaziest bucket
shops to the biggest and best firms on Wall Street, everyone
does it. It definitely happens.”
Said one source,
who runs money for a
New York-based $500
million hedge fund:
“Agreeing to buy shares
in the aftermarket is part
of the game. To play you have to pay. Otherwise you go
straight to the penalty box and never get on the ice at all.
It's that simple.”
eToys Inc. (ETYS)
price
change
$40.88
+3.375
TheStreet.com, Inc. (TSCM)
price
change
$27.63
+1.813
Host America Corporation
(CAFE)
price
change
$1.75
unch
Data: Microsoft Investor and S&P
Comstock 20 min.delay
Said another source, “It's as common on Wall Street
as the air you breathe. If you breathe in and out every 15
seconds you eventually stop thinking about it.”
Said a third hedge fund source, who professed to find
nothing illegal or improper in the practice: “The main thing
an underwriter wants to know before giving you an
allocation is whether you've been generating substantial
commission business for the firm. In other words, are you a
good customer? But I would have to say that aftermarket
purchases are part of the equation. No question about it.”
SENDING PRICES SKY HIGH
By artificially creating additional aftermarket demand
for shares, such “blank check” arrangements help
underwriters bring to market weak IPOs that they might
otherwise not be able to sell. And because these
arrangements are kept secret, retail buyers in the
aftermarket are never told that the sky-high prices being
quoted to the public have been manipulated upward by a
collusive price-propping artifice.
So widespread has the practice become that hedge
fund investors say a de facto scale has developed: for a
pending, run-of-the-mill IPO with not much “buzz” about it
in the market, a hedge fund investor may be asked to buy
two shares in the aftermarket for every one share he is
allocated in the pre-market. For a “hot” IPO, the ratio can
rise to five shares in the aftermarket for every one share in
the pre-market.
Two recent hot
IPOs that saw
incredible
at-the-open demand
— TheStreet.com
and eToys.
With the market for Internet IPOs now weakening,
hedge fund buyers have lately begun hedging their risks.
Says one, “What you do is this: You tell the
underwriter that you agree to support the stock in the
aftermarket — but only with a specified market order at the
opening of trading. Then, unknown to the underwriter, you
call up another broker and simultaneously agree to short the
equivalent number of shares, also at the open. This way,
your exposure on the blank check purchase is hedged out
to nothing, and you're still ‘long' your shares at the
pre-market IPO price.”
The effect on the stock's performance is, of course,
hardly surprising. Faced with massive “buy at the market”
demand for the shares, the IPOs begin trading at two and
even three times their pre-market price. But the opening
price is as high as the stock ever goes, since no sooner does
it begin trading in the aftermarket than it is hit by wave after
wave of selling.
Data provided by MSN Investor
One recent example is Internet retailer eToys.com, an
IPO that went public on May 20 at $20 per share, and
instantly vaulted on its very first trade to an astonishing $83.
That was the price at which retail investors, having foolishly
committed themselves to “buy-at-the-market” orders via
online brokerage firms became obligated to purchase
eToys.com shares.
But the buying of retail investors was instantly met with
offsetting sales and the stock quickly began to weaken, with
the result that instead of “opening high” and rising higher, the
stock opened high and fell, closing the day at just a touch
over $76.50. Since then the shares have headed steadily
lower and on Wednesday closed at $37.50.
It was the same story with another recent, and
much-hyped, IPO — for TheStreet.com, the well-known
financial and investment Web site. The stock went public on
May 11th at $19 and soared to $61 per share on its
opening trade. Though the shares moved up a bit thereafter,
selling pressure soon engulfed them and by day's end the
stock was once again back at $60. Since then the shares
have headed straight downward, and are now trading for
barely $25.50.
Data provided by MSN Investor
Officials at TheStreet.com said they were unaware of
any such tie-in arrangements in the marketing of their IPO,
and directed all inquires to the underwriter, Goldman Sachs
& Co. An official at Goldman, which also underwrote the
eToys IPO, would say only that the firm “does not make the
allocation of IPO securities conditional on an undertaking to
buy securities in the aftermarket.”
The practice isn't confined just to Internet stock
offerings either. Consider a Connecticut-based corporate
and institutional catering company — Host America Corp.
— that was taken public in July of 1998 by Barron Chase
Securities Inc., at $5 per share. One hedge fund manager
says of the deal, “I was told by my broker at the firm that if
I wanted to get any stock at the pre-market price, I had to
agree to buy 50 percent in the aftermarket. I did and I made
money, what can I say.”
All hedge fund sources interviewed for this story
stressed the same basic point: Nothing is ever written down
in these quid-pro-quo deals, and often as not, the
negotiations involve no one other than the client and his
broker — at least so far as the client knows.
“Sometimes the broker may only have an allocation of
100,000 shares to sell,” says Gradinger of Diamond
Capital. “So, if demand is strong he's going to wind up
trying to parcel it out to the customers who will create the
most business for him as a result.”
But others say that with big and much-hyped deals, the
brokers are required to clear their arrangements with the
firm's syndicate manager. Says one fund source on the
matter, “It's just one of those corrupt things that goes on all
the time on Wall Street. There's nothing more to it than
that.”
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