In a recent speech, the SEC's Mr Pitt said that the main issue with the second area of concern, the IPO process, was that "valued brokerage-firm clients are given investment opportunities, but only in return for kickbacks to the brokerage firms that made the opportunity available". This seems to have happened quite often recently. Indeed, one investment bank, CSFB, paid $100m to settle an investigation into its habit of allocating shares in IPOs to favoured clients who repaid a chunk of any profits that they made by subsequently conducting unnecessary trades with the broker.
Friends of Frank
But this is not the public's main concern about IPOs. Their worry is that they never get allocated shares in the initial distribution, and that to participate in an IPO they have to buy the shares at an exorbitant mark-up in the after-market. These are problems that the SEC could do something about (though, distressingly, it shows no signs of doing so), notably by ordering investment banks to use auctions to allocate shares in IPOs to the highest bidders. So far, despite the plucky efforts to promote auctions by W&R Hambrecht, a Silicon Valley investment bank, they are used in less than 1% of all issues.
It is not obvious why auctions should be shunned, especially as W&R Hambrecht charges only 4% of the money raised compared with Wall Street's norm of 7% (a norm so entrenched that it sometimes seems surprising that it has not aroused the interest of antitrust authorities). One possible explanation is that the management of issuing firms may be co-opted into going along with an investment bank's underpricing of their issue by the promise of "friends of Frank" accounts.
Named after Frank Quattrone, an investment banker who led CSFB's technology-industry group in the heyday of the dotcom euphoria, these accounts were given to managers as a reward for hiring CSFB. Through them, they received preferential allocations of shares in future IPOs. In effect, this aligned the interests of the company's managers with those of Wall Street, while putting them in conflict with the interests of their own employer. A solution to this would be to require full disclosure of any other relationships that managers of companies going public have with their underwriter. Jay Ritter, an economist at the University of Florida, says that it would be even better if there were a total ban on dealings between managers and the underwriter until, say, at least two years after their company's flotation. He expects the next round of lawsuits against Wall Street to target the underpricing of IPOs, especially if (as he thinks likely) the suit recently filed by eToys against Goldman Sachs succeeds.
The erstwhile Internet toyshop claims that it was deprived of cash that could have kept it alive because the investment bank deliberately underpriced its IPO in 1999 so as to gain illegal kickbacks from investors who were allocated shares in it. Given that total IPO underpricing during 1999-2000 amounted to $66 billion (based on the difference between the price at issue and the price at the end of the first trading day), the payouts in such cases could eventually be huge.
There may be trouble too if underwriters are shown to have known more than they let on when selling securities in firms that later stumbled. J.P. Morgan Chase is suing insurers who are refusing to pay up on a $1 billion surety bond tied to Enron, claiming the bank misled them about the risk. And on June 4th it emerged that the SEC is investigating claims that Citigroup underwrote shares in Adelphia, having earlier made undisclosed loans of $3.1 billion to the scandal-hit telecoms firm and its founders, loans which were used to support its share price.
Called to Account
The issue troubling investors more than any other, however, is the third of the three main concerns: the quality of financial information that is provided by companies. This is largely due to failures of accounting and corporate governance that are not, at first glance, really Wall Street's fault. However, it was the investment banks that supplied much of the financial alchemy that firms have used to hide the truth — such as at Enron, with its various off-balance-sheet financial structures.
It is in responding to this concern that Mr Pitt's SEC may yet turn out to be revolutionary. Despite criticism over potential conflicts of interest due to his previous employment as a lawyer working for big accounting firms, Mr Pitt is starting to transform the way in which accounting standards are set, and the legal obligations on companies to use accounting data to promote a true picture of their financial condition and risk. He has started to tell the Financial Accounting Standards Board (FASB), America's main accounting-standards setter, what its agenda should be, and he has ordered firms to make clear the most important assumptions they have made in their choice of accounting treatments (and to show how other choices would have made a difference).
He is also requiring firms to announce material changes in their outlook at the earliest opportunity, and is even taking action against firms which abide by accounting principles but do so in misleading ways. For example, Edison Schools, a school-management company, was recently told to stop booking revenues that never really passed through its coffers, even though this did not technically breach accounting rules.
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