Cheap Shots, Bona Fides,
and Last-Minute Regulation

As with a winter's snow storm, Wall Street has once again been hit bya year-end regulatory flurry; and as with most bad weather, everyone complains about it but no one does anything.   

In early December, a number of major Wall Street firms and issuers reportedly received subpoenas from the Securities and Exchange Commission (SEC) and the United States Attorney’s Office in the Southern District of New York (USAO) demanding document production involving Initial Public Offerings (IPOs).  The SEC and USAO appear to be probing the manner in which major firms allocate hot-issue IPOs, with a focus on illegal tie-ins. On another front, as disclosed by the Wall Street Journal in mid-December, the SEC is once again examining NASDAQ spreads and price improvement and is planning to produce yet another report replete with alleged disclosures that there may be more frequent price improvement on the NYSE than at NASDAQ. 

So, what harm is there in conducting yet another round of high-profile investigations or in firing up the presses to spit out yet another weighty report?  Nothing . . . in theory, but let’s step back for a moment and look at the bigger picture.  

IPO Allocations: More the Merrier or Fewer the Better? 

Most regulatory professionals in the securities industry are aware of the practice among underwriters to allocate IPO units to favored customers. Typically, the factors weighing in such preferential allocations are 

• a history of secondary market purchases following an IPO;
• a pattern of “investment” versus “trading” in IPO units;
• a willingness to purchase less-attractive IPOs; and
• sufficient cash balances in the account to cover the proposed allocation.

From an underwriter’s perspective, the considerations referenced above represent the touchstone of a loyal and dependable customer, one who is entitled to some appreciation --- be it in the form of box tickets to a sporting event, an invitation to the company’s annual golf outing, or the allocation of a hot-issue IPO. However, when considerations become preconditions (replete with quotas and obligations), regulators understandably become concerned. Unfortunately, such concerns historically manifest themselves in the form of prosecutions of smaller broker-dealers charged with pumping or priming the aftermarket through over-selling an IPO and requiring advance secondary-market orders.  

Regulatory attorneys routinely counsel their clients about NASD Interpretive Material 2110-1: Free-riding and Withholding (IM-2110-1), which has served as the basis for many an enforcement action involving the bona fidepublic distribution of IPOs that trade at a premium in the secondary market. We scrutinize the percentage of issuer-directed shares. We warn about the dangers of an oversold offering that appears coupled with improper aftermarket commitments. But what does the public in a public offering really mean - - - and how much of the lore and law surrounding the issue makes sense? 

Certainly some customers want --- and expect --- first crack at hot IPOs in consideration for their year-long support of the underwriter’s various offerings (some less profitable than others). Such buyers expect a quid pro quo. Shocking? I don’t know.  Last time I looked, major league sports teams offer season ticket-holders first crack at playoff tickets. And if you wait in line for two days at the mercy of the elements and manage to get to the ticket window, where do you think you’re going to sit . . . the fifty-yard line? . . . right behind the dugout? Fat chance! Unfair? Discriminatory against blue-collar fans? Seems to me that fair is fair and business is business and the two worlds need not always coincide. But unfair is not the same as illegal. 

Underwriters and issuers prefer to distribute an offering among a smaller number of proven, reliable investors. After all, the name of the game is to place the IPO as quickly as possible with the highest level of confidence that the indications of interest will convert to firm orders. Among the more notable Internet flops have been attempts to democratize the IPO process with online auctions - - - all too often accompanied by a lack of interest, cancellations, reneges, and “flipping.” Certainly, the IPO process is at the heart of our securities markets --- it’s the incubator, the nursery --- and we must be wary of reckless attempts to tamper with such a primordial force. This is not the time for amateur hour.   

Low-Fat Spreads

Let us for a moment turn our attention to the other ongoing regulatory initiative: the spreads on NASDAQ. Having read the sordid details of the 1996 Department of Justice/Antitrust Division’s NASDAQ investigation and the SEC’s equally damning 21(a) Report --- and having publicly greeted the government’s tepid responses with disdain --- I could hardly be considered as an apologist for NASDAQ or the NASD. But even as hardened a critic and gadfly as I must ask whether we need yet another report, and must wonder aloud as to why the SEC has apparently chosen at this point in time to leak the report --- in piecemeal fashion --- to the press. Is this an effort by departing SEC Chairman Levitt to get in one last shot at his former nemesis --- a last hurrah of the AMEX old guard? Or is this yet another exercise of the art of the cheap shot?

We read that NASDAQ does not offer as much price improvement as the NYSE. This requires a federally-funded report? Could we not merely have dusted off the 1996 Antitrust Division/SEC findings? However, one should not extrapolate that because one market offers price improvement more frequently than another does, that the latter is somehow inferior.  A simple explanation may be that spreads on the NYSE are less reflective of the real market and, as such, are more amenable to price improvement.  

Let me relate a story by way of explanation. My father owned a deep-discount liquor store.  One day a customer asked him how much a quart of Dewar’s scotch was. My father said $8.49. The customer said, “I thought you were a discount store. I can buy Dewar’s around the corner for $7.99.” My father looked up the wholesale cost of the bottle, which was $8.48, and said to the customer that the competitor was selling the scotch below cost. The customer then asked my father to reduce his price. My father replied that he couldn’t meet the $7.99 price.  The client again asked what his best offer was. My father reiterated that he couldn’t meet the $7.99 price and suggested that the client walk around the corner and buy the bottle at the better price.  At that point, the customer informed us that our competitor was out of stock. My father, without missing a beat, turned to the customer and said, “Well, when I’m out of Dewar’s quarts we sell them for $7.75.” 

So what’s price improvement? A quoted price is not necessarily indicative of a true market; and the ability to get a better price for oranges (NASDAQ stocks) isn’t necessarily related to that for apples (NYSE stocks). Price improvement within a specialist system is not necessarily comparable to price improvement within a market-making system. Does an allegedly modest difference in price improvement at the NYSE counterbalance the alleged fraudulent Floor practices cited in the Oakford cases? Does any legitimate SEC concern on this issue justify blind-siding NASDAQ through lurid headlines derived from planted stories in the press? I offer this modicum of sympathy to my traditional foe and adversary because we in the small- and mid-sized BD community are all too familiar with the impact of these damnable practices --- having suffered from their implementation by the SEC and the NASD against us. 

Additionally, market forces and competition, if left to their own devices, may better align any perceived inconsistencies.  Admittedly, a totally free-hand was inappropriate in years past, as evidenced by the anti-consumer acts and price-fixing conduct disclosed in the 1996 government reports. But, of course, ultimately one must ask what the Antitrust Division and the SEC really expected would happen in light of their failure to impose significant sanctions upon the targets of their separate investigations.  

An Alternative 

In many inner-city neighborhoods residents greet with mock enthusiasm the highly publicized undercover crime sweeps that trumpet the eradication of drug dealers. Why such sarcasm? Because the community’s residents all know, and knew for years, where the pushers were conducting business; hell, even an eight-year old knew. But the squad cars that passed by, the cops on the beat, City Hall . . . they never knew until some politician got a photo opportunity before the press. This seems a remarkably similar scenario for Wall Street’s regulators: they just don’t seem to be in touch with the industry. And when our regulators finally snare the bad guys, it’s months after everyone else knew about them, and, to make matters worse, once the cameras are turned off the priority seems to dwindle and the victimized public customers are left penniless.

A solution, a better approach? How about regulating by promulgating new rules, rather than the costly and unfair procedure of regulating by prosecution?  You don’t like the idea of underwriters allocating IPO units to favored clients, fine --- pass a clear and precise rule. You are unhappy with “price improvement,” then pass a clear and precise rule. Instead we continue to be confronted by an intellectually bankrupt approach to regulation that favors confrontation above consensus and continues to believe that leaked reports and bully-boy tactics are a substitute for thoughtful rule-making. 

Conclusion

Wall Street is no longer a local address, it is a global metaphor. And as we pack up our parochial biases and move into new international quarters, we must demand that our regulators similarly adjust. First and foremost, we must ensure that defrauded investors are made whole and that the miscreants are fully and meaningfully prosecuted. But we ain’t going to get there if we continue to fund costly studies of well-known problems and leak controversial reports in an effort to interfere with free-market forces. For all the SEC and USAO staff now investigating IPO allocations, there remains a lack of resources dedicated to overhauling the anti-consumer SIPC system and promulgating effective redress for the unpaid arbitration and court-ordered awards owing to thousands of defrauded public investors. And let’s not fool ourselves; a dollar spent in one place is a dollar unavailable for another. Regulatory agendas are as much about power and politics as everything else in this country appears to be. Where are the bona fides when we really need them?