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A three-pronged investigation by the Securities and Exchange Commission, the National Association of Securities Dealers and the U.S. Attorney’s Office for the Southern District of New York has been probing for the past year the practices of underwriters in allocating stock in “hot” or oversubscribed initial public offerings, and regulatory action appears imminent. The transactional pattern that has drawn their attention is not the classic “pump and dump” scheme of the boiler shop, but rather the extraordinary first-day run-ups in the stock prices of firms on offer, which during 1999 averaged over 100 percent on the first trading day and sometimes exceeded 500 percent. Why should this pattern concern the government when investors seem to have been making money? In the wake of last year’s crash in the high-tech market, three different classes of putative victims have surfaced, with distinctly different legal grievances. First, retail investors who did not receive IPO allocations are claiming that their failure to obtain shares was the result of practices that involved, in substance, commercial bribery and the payment of kickbacks by institutional investors to obtain IPO allocations. Second, some IPO issuers have already sued, asserting that their stock was deliberately underpriced by the underwriters in order to enable them to award cheap stock to their preferred institutional customers, who in turn compensated the underwriters with hefty — and sometimes well above-market — brokerage commissions. Third, investors who purchased IPO stock in the after-market have claimed that they bought at inflated prices because the secondary market was artificially manipulated by practices deliberately designed to create an illusory, but short-lived, price spike. More than a dozen class actions are pending, alleging one or more of these theories. All signs point to the SEC and the NASD pursuing one or more of these theories in the near future, and criminal prosecutions also seem probable, given the scale and duration of the U.S. Attorney’s investigation. But which of these theories regulators should or will adopt remains an open question. Whatever the theory chosen, prosecutors will predictably receive enthusiastic support from the press and public because a broad cross-section of American retail investors lost money in significant amounts when the high-tech bubble burst in early 2000, and some of the evidence already leaked to the press sounds patently suspicious. Yet, precisely because there is a danger in this context that scapegoats will be unfairly blamed for a market crash that actually had deeper causes, it is important to evaluate the claims of these three classes of putative victims objectively and not accept an automatic equation between side payments and criminality. THE VARYING STRENGTHS OF THREE CLASSES OF CLAIMS Ultimately, this column will conclude, on both legal and policy grounds, that these three classes have claims of very different legal and factual strength, ranging from weak to strong. The grievance of the retail investor who did not receive an IPO allocation is an imagined one, based on an asserted, but nonexistent, legal duty to apportion IPO stock equitably. In contrast, the IPO issuer’s claim that its stock was underpriced in breach of a duty owed to it by the underwriters is more ambiguous and fact-sensitive, but it, too, should be sustained only when the secondary-market price rise can be shown not to have been, itself, illusory. Finally, the secondary-market buyer’s claim that it was injured by market manipulation is the strongest of these three legal theories, but probably a difficult one to prove factually. Ironically, however, most of the recent press leaks about the government’s investigation have stressed the first theory: namely, that kickbacks were paid to underwriters by institutional clients eager to obtain hot IPO allocations. Press reports have indicated that some hedge funds may have paid brokerage commissions as high as $1 per share, or 20 times the normal institutional rate of 5 cents per share, to generate credits that entitled them to a desired IPO allocation. Assuming that the link between the above-market brokerage commission and the IPO allocation can be proven, does this become an illegal kickback? Abundant precedent has held that prosecutors can indict under the mail- and wire-fraud statutes when an agent or employee receives undisclosed compensation in breach of a fiduciary or similar duty to an employer or client. See, e.g., United States v. Bronston, 658 F.2d 920 (2d Cir. 1981). However, more recent cases have sometimes added the element that tangible harm to the victim must be shown before the kickback becomes criminal. See United States v. Jain, 93 F.3d 436, 438 (8th Cir. 1996). Even if some ambiguity exists in the case law when a professional receives a side payment that can be deemed a kickback, the better line of defense for broker-dealers probably involves the nature of the fiduciary duty they owe to their retail clients. Traditionally, hot IPO stock has been allocated either to preferred customers who have done more business with the broker-dealer or to prospective future underwriting clients — a practice known in the industry as “spinning.” No duty to prorate IPO stock among all customers, or to otherwise apportion it “fairly,” has ever been recognized within the industry. RULE AGAINST ABOVE-MARKET COMMISSIONS WOULDN’T HELP Nor would a special rule prohibiting above-market commissions as kickbacks make much policy sense. It would still leave large mutual funds able to use their leverage to obtain IPO allocations, but it would uniquely disable smaller, newer competitors, such as hedge funds, which generate less aggregate commissions and so need to pay a higher per-share commission in order to obtain equivalent allocations. For example, if there were a strict rule forbidding the payment of above-market commissions to obtain IPO allocations, institutional investors could simply forgo their ability to obtain brokerage discounts in return for IPO allocations. In short, low visibility trade-offs and norms of reciprocity would continue, and only those institutions that lacked a long and continuing relationship with the underwriter would be prejudiced. To be sure, excessive brokerage commissions may also violate NASD rules and are contrary to a long-standing SEC ceiling limiting equity brokerage commissions to 5 percent. But this SEC policy was designed to protect unsuspecting small investors from paying excessive markups. Applying it to the case of consensual transactions between sophisticated parties involves a considerable stretch and may conflict with the SEC’s obligation to prove scienter, at least in the case of a Rule 10b-5 proceeding. Although the SEC can avoid the need to show scienter by instead suing based on � 17 of the Securities Act of 1933, it still faces a problem with proving materiality. For example, the failure to disclose above-market commissions received in return for stock allocations arguably means that the underwriter has misstated in the registration statement the total underwriting compensation that it received. Yet this omission may be immaterial to reasonable investors, who are more interested in appraising the issuer’s prospects than the underwriter’s ethics. Nonetheless, federal prosecutors could probably still indict such an omission in a registration statement as a violation of 18 U.S.C. 1001 (“False Statements”) on the theory that the misstatement of underwriting fees amounted to a false statement to the regulatory agency. Yet it remains debatable whether technical violations of this sort should be criminally prosecuted, absent some stronger showing of real injury to investors. CORPORATE ISSUER MAY HAVE THE STRONGER CASE In contrast to the retail brokerage client, the corporate issuer has a potentially stronger case that it was harmed by the underwriters’ receipt of “excess” brokerage commissions because it can claim that in return for such undisclosed benefits the offering was underpriced. Already, one recent IPO issuer, Mortgage.com, has filed a class action raising exactly these allegations. But, again, there are practical obstacles. First, underpricing is a well-known phenomenon in initial public offerings, and thus even first-time issuers, when assisted by experienced venture capital investors, should have anticipated and arguably acquiesced in such underpricing. Second, issuers may rationally accept underpricing because the first-day run-up is believed to attract favorable market attention and thereby strengthen the secondary market into which the issuer’s own insiders will later sell their shares. Third, the typical first-day price spike in an IPO is typically a short-term phenomenon that may last only a few days before the stock price recedes to, or drops below, the initial offering price. This brief price peak is the result of a combination of practices, discussed below, that create a temporary imbalance between supply and demand. The empirical evidence shows that IPO stock prices usually fall to, or below, their initial offering price sometime during the course of the following year. SeeJay Ritter, “The Long-Run Performance of Initial Public Offerings,” 42 J. Fin. 365 (1991). Thus, if the first-day spike in an IPO’s stock price is the temporary product of structural factors that produce a supply deficit in the IPO after-market, the issuer has less clearly been cheated by the underwriter because any underpricing is arguably short-lived and artificial. Finally, in the wake of the dot-com crash, it seems clear that many IPOs in the 1998-2000 era were overpriced, not underpriced, thus further confounding efforts to present the issuer as victim and the underwriter as villain. Interestingly, Mortgage.com, the plaintiff in the above-described class action, is itself in bankruptcy. THE PRACTICE OF ‘LADDERING’ MAY VIOLATE REGULATION M Nonetheless, one final scenario does identify valid victims and true villains. Some press reports have noted that the SEC is investigating a practice, known as “laddering,” under which the underwriter requires institutions to make large purchases in the secondary market as a condition of receiving their desired allocation; by agreement, these additional purchases are to be made at progressively higher prices, thus, it is hoped, creating a crescendo effect. On its face, such activity would seem to violate Rule 101(a) of Regulation M, which forbids an underwriter or affiliate to “attempt to induce any person to bid for or to purchase a covered security during the applicable restricted period.” If proven, such practices would tend to indicate that the first-day spike in IPO prices may have been artificially manipulated by an orchestrated buying program, thereby injuring those investors who bought in an inflated aftermarket. IPOs are particularly vulnerable to such manipulation because the IPO after-market has an inherent imbalance between supply and demand. This imbalance results because the underwriters typically constrain supply both by requiring corporate insiders to enter into lock-up agreements, under which these insiders cannot sell their shares in the issuer for six months after the offering date, and by imposing anti-flipping restrictions on noninstitutional purchasers in the offering. Although these constraints have been recently upheld against antitrust attack ( see Friedman v. Salomon/Smith Barney Inc., 2001 U.S. Dist. Lexis 884 (S.D.N.Y. Jan. 23, 2001)) on the ground that the SEC has implicitly approved them, the SEC has never approved underwriters arranging for secondary-market buying programs during the “restricted period” and has clearly warned that such practices violate Regulation M. See In the Matter of Victor M. Wang, SEC Release No. 34-4333 (Oct. 11, 2000). Ultimately, regulators face a rapidly approaching choice in their IPO investigation: They can address the real causes or only the symptoms of IPO market volatility. Viewed realistically, kickbacks and excess commissions are a byproduct of supply-and-demand imbalances. Once experienced institutional investors realize that the IPO market will normally experience a short-term price spike and then subside, they will rationally pursue a policy of flipping IPOs and will offer side payments, many of which will inevitably remain invisible, for allocations. If regulators focus on this aspect of the approaching IPO “scandal,” it will show them content to address only symptoms, possibly on the false premise that retail investors denied an IPO allocation were true victims. In contrast, a focus on “laddering” and market manipulation, while perhaps more difficult to prove, would protect an always vulnerable, but critical, market from real abuse. John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School.

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