THE NEXT POST-ENRON ISSUE
Washington Post: In all the post-Enron corporate scandals, the policy question has been the same: Which abuses lie beyond the market's ability to self-correct, and therefore require government action? Bad accounting clearly falls under the heading of action needed: If the basic numbers that companies publish are wrong, investors are helpless. On the other hand, conflicts of interest among Wall Street analysts present a more ambiguous case: Investors are free to ignore analysts at the big conflict-ridden banks and to rely instead on research-only companies. The latest post-Enron issue to emerge falls somewhere in the middle.
That issue is the pricing and allocation of shares issued by companies when they first sell stock to the public. In the 1990s these "initial public offerings" often jumped in value in the first days of trading, so the investment banks that had the job of allocating the shares used them to reward their favorite clients. This is galling to ordinary investors, who had no chance of getting their hands on hot IPOs that were reserved for high-rollers. But in a way it isn't surprising. The banks had this hot stuff, so, naturally, they doled it out strategically.
The clearest victims of this practice were the entrepreneurs who built the companies issuing the shares and who were allowing the fruits of their efforts to be sold off at a discount. Smart entrepreneurs are not the kind of people who need government protection. In ordinary times, they are perfectly capable of insisting that their IPOs be priced at around the value at which they will likely trade, allowing a slight discount to compensate investors for the risk of buying stock in an unknown firm. It was only in the irrational exuberance of the tech boom that entrepreneurs allowed IPO discounts to get out of hand. They were getting so rich so quick that they ceased to worry about underpricing their own stocks. And since their firms had no revenues, profits or assets, who could judge what level their shares would trade at?
There are, however, other potential victims of the IPO racket. Even if in normal times IPOs will on average be rationally priced, the banks that manage them will always know which ones are likely to jump in value; they are therefore in a position to reward friends by giving them the good ones. If the banks demand a quid pro quo for such favors, there may be a problem. The House Financial Services Committee has extracted documents from Salomon Smith Barney showing that the bank allocated large slabs of IPO stock to Bernard J. Ebbers, then chief executive of WorldCom Inc., at a time when his firm was channeling millions of dollars to Salomon in investment-banking fees. If Salomon was getting this business partly because of personal favors to the CEO, WorldCom's shareholders may have been the losers. Similar suspicions surround all the major banks in the IPO business.
Shareholders, unlike entrepreneurs, are ill equipped to defend themselves against this sort of abuse. So are workers whose 401(k) investments may be managed by an investment bank selected not on merit but because of IPO stock given to the workers' bosses. These potential abuses merit more regulatory attention than they have received.