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.
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.
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.
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.”
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.
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.
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.”>> |
