Monday, March 11, 2013

Not Going Far Enough: Joe Nocera Explores the Seamy Side of IPOs

Not Going Far Enough: Joe Nocera Explores the Seamy Side of IPOs

Joe Nocera has waded into one of the areas most rife with conflicts of interest: the initial public offering.  In his Op Ed column yesterday (“Rigging the IPO Game”)[1], Mr. Nocera describes how investment banks try to serve two clients at the same time, even though those clients have diverging interests.  The corporate clients want to achieve the highest possible price for their shares, and institutions and other investors want to be allocated shares at the lowest possible price.  In theory, the investment bank is supposed to balance these interests and come up with a fair price. 

Annual Meeting (2003)

Mr. Nocera documents the case of eToys, which was priced at $20 and soared to $78 in its first day of trading during the Internet bubble more than a dozen years ago.  According to the court documents reviewed by Mr. Nocera, the underwriter (Goldman Sachs) knew that there was huge demand for the stock, and nonetheless set a low price for the offering.  Obviously, those lucky investors favored by Goldman Sachs were allocated stock and enjoyed a one-day windfall as their shares nearly quadrupled in a matter of hours.   Several years later the Internet bubble imploded, and eToys failed.  In a lawsuit against Goldman Sachs, eToys contended that the low-priced offering deprived the company of the capital it needed to survive the downturn.

While I agree with Mr. Nocera that Goldman’s conduct was egregious, I don’t think he went far enough in exploring this issue.  There’s the much bigger issue of whether Goldman or anyone else should have underwritten a two-year old company and fed the speculation then running rampant in the market.  As Mr. Nocera points out, Goldman wasn’t acting as a fiduciary, they probably felt they were just giving the speculators what they wanted and making a nice fee along the way.  Goldman also figured that if they didn’t underwrite the stock, someone else would do the offering.

The same underwriting issue reared its ugly head in the credit bubble, except that the investment banks grossly over-priced securities.   Goldman and the other investment banks totally misvalued all kinds of mortgage-related securities creating a windfall for the mortgage brokers, banks, and other sellers of these toxic assets.  In the end, institutional clients paid dearly.    On balance, the academic literature suggests that IPOs underperform the overall market, despite the periodic euphoria documented by Mr. Nocera.  As a result, investors, rather than companies, are worse off.

In my view, investment bankers should be held to a fiduciary standard.  If they’re going to make the big fees underwriting and selling securities, they owe all their clients a duty to act in the long-term interest of all concerned.   Moreover, they owe the public some level of fiduciary duty as we backstop Wall Street when things go wrong.  Unfortunately, the current system only serves to make Goldman and a few chosen companies and clients extremely rich at everyone else’s expense.

Post script:  Mr. Nocera seems to criticize Goldman Sachs for allowing 20% of eToys offering to be allocated to “flippers.”   Flippers receive stock in an offering and immediately sell.  Obviously in the eToys case, the flippers made a huge profit.  However, if no one were allowed to flip the stock there’d be no market, as all the shareholders would be banned from short-term trading.  Moreover, with so little stock available to trade in the first few days, the ban on flipping exaggerated the upward pressure on the stock.



  1. I'm the one who the federal court appointed as the fiduciary over eToys. Who has tried, for 12 years, to get Bain Capital and Goldman Sachs indicted for their collusion to defraud eToys.

    1. I admire your persistence. You've had formidable opponents