NASD Rule 2110 and the VA Linux IPO

Transcription

1 NASD Rule 2110 and the VA Linux IPO Tim Loughran Mendoza College of Business University of Notre Dame Notre Dame, IN voice fax January 17, 2005 Abstract: On December 9, 1999, VA Linux issued shares to the public and left over $900 million on the table for investors. In the prospectus, the investment banker Credit Suisse First Boston (CSFB) stated it would receive a 7% gross spread as its compensation for underwriting the shares. Yet the SEC alleges some investors paid enormous commissions to CSFB in the form of a kick-back immediately after obtaining the IPO shares. Hence, CSFB had an economic interest in the IPO and there was not a full distribution of shares. This apparent violation of NASD Rule 2110 raises questions as to the credibility of the financial markets. Key words: IPOs, Money on the table, NASD Rule 2110, VA Linux * I would like to thank participants at the 2004 University of Notre Dame Ethical Dimensions in Business Conference, a referee, and Ann Tenbrunsel (editor) for helpful suggestions. One-sentence bio: University of Notre Dame Finance Professor Tim Loughran received a Bachelor of Arts and a Bachelor of Science from the University of Illinois (Urbana), an MBA from Indiana University, and a Ph.D. from the University of Illinois (Urbana).

2 NASD Rule 2110 and the VA Linux IPO A momentous date for any firm is the day of its initial public offering (IPO). In the US, companies almost always use an investment bank to distribute shares to the public in an initial offering. The National Association of Securities Dealers, Inc. (NASD) and the Securities and Exchange Commission (SEC) have numerous rules to protect investors and issuing firms from unethical conduct by investment bankers. One conduct rule, Rule 2110, deals with the standards and principles of trade. This research examines possible violations of Rule 2110 with regard to the initial public offering of VA Linux. The case study also discusses the ramifications of the event for the issuing firm and investors, and highlights areas of future ethics research for other scholars. NASD Conduct Rule 2110 states: A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade. Rule 2110 s subsection on free-riding and withholding is interpreted to mean that members have an obligation to make a bona fide public distribution at the public offering price of securities of a public offering which trade at a premium in the secondary market whenever such secondary market begins (a hot issue ) regardless of whether such securities are acquired by the member as an underwriter, as a selling group member, or from a member participating in the distribution as an underwriter or a selling group member, or otherwise. (Source: NASD website, ( Regulators, especially in underpriced share offerings, want full public distribution of the equity offerings. They do not want underwriters to hold back shares in an offering and then sell them in the aftermarket for a huge and easy profit. 1

3 On December 9, 1999, a young software company, VA Linux, issued shares to the public in an initial public offering. (On December 6, 2001, VA Linux changed its name to VA Software Corp.) VA Linux used the prestigious investment bank, Credit Suisse First Boston (CSFB), to facilitate the distribution of shares. According to the IPO prospectus, CSFB would receive gross spreads of 7% as its compensation for distributing the shares. Chen and Ritter (2000) have documented that US investment bankers disproportionately cluster gross spreads at 7%. Before the offering, the offer price for VA Linux was set by CSFB at $30 per share. A total of 4.4 million shares were issued to the public (excluding any overallotment option). Hence, CSFB would receive $2.10 (0.07 x $30.00) per share, or slightly more than $9 million for its part in taking the firm public. The demand in the financial market for shares of VA Linux greatly exceeded the supply. At the close of the first day of trading, the share price stood at $ Hence, investors lucky enough to get shares in the initial allocation from CSFB made a return of over 690% [($ $30.00)/$30.00] in one day. Money on the table is defined as the difference between the closing market price and the offer price multiplied by the number of shares issued to the public. VA Linux left $920.7 million [4.4 million shares x ($ $30.00)] on the table for investors. This is a staggering amount. To provide some perspective on this amount, Table 1 reports the top ten IPOs in terms of money left on the table over The sample universe includes IPOs with a per share offer price of at least $5. American Depository Receipts, closed-end funds, real estate investment trusts, and unit offerings are excluded. Loughran and Ritter (2004) report that the average amount of money left on the table during was 2

4 $17.5 million. The median amount of money left in their sample of over 6,391 US IPOs was only $1.7 million. Table 1 reports the IPO name and date, the offer price, the closing market price, the number of shares offered (in millions), lead underwriter, and the amount of money left on the table for investors (in millions of dollars). No adjustment for inflation is made, so the amount of money left on the table represents nominal not real values. In this 24-year period, over 6,300 IPOs went public in the US. VA Linux ranked eighth in terms of money left on the table. Some of the IPOs that left more money on the table were older and more established firms such as UPS and Goldman Sachs. Although UPS left more than twice the amount left by VA Linux, it offered almost 25 times the number of shares to the public. Not surprisingly, all the IPOs with the most money on the table went public during the internet bubble period. Several of the IPOs went public in the same calendar week. Arosio, Giudici, and Paleari (2001), Loughran and Ritter (2004), and Schultz and Zaman (2001) provide some detailed discussion on the pricing of internet IPOs. It is interesting to see that all the IPOs with the most money left on the table were taken public by highly prestigious investment banks (CSFB, Morgan Stanley, and Goldman Sachs). After gauging investor interest in the VA Linux IPO, CSFB set the offer price at $30. Yet once the firm starting trading on Nasdaq, the stock price closed above $239 on the first day. Why would a prestigious and experienced investment banker do such a poor job at pricing VA Linux? 3

5 Given that its compensation is tied solely to the gross spread, CSFB should have had an incentive to issue shares at a higher offer price. If the offer price had been $200 instead of $30, CSFB would have received $61.6 million [4.4 million shares x ($200 x 0.07)] in fee compensation instead of the $9.24 million it actually received. At that higher offer price, VA Linux would have received more in terms of proceeds, CSFB substantially higher fee income, and investors a reasonably high one-day return of 19.6% [($ $200.00)/$200.00]. The Securities and Exchange Commission litigation against CSFB appears to explain why the investment banker left so much money on the table in the VA Linux IPO. In its January 22, 2002, litigation release number 17327, the SEC announced it had settled with CSFB on its IPO allocation practices. CSFB paid $100 million in fines in the settlement without admitting or denying the allegations: $70 million in disgorgement of improper gains, and $30 million in civil penalties. The SEC alleges: Employees of CSFB allocated some shares of desired IPOs to over 100 customers who agreed to funnel a portion of their IPO profits to CSFB in the form of excessive trading commission. The portion of IPO profits returned to CSFB ranged from 33% to 65%. Clients who refused to funnel a substantial portion of their IPO one-day gains were, in some instances, completely denied allocations. IPO profits were funneled to CSFB in the form of excessive commissions on offsetting trades of large-capitalization firms. That is, instead of paying the typical trade commission of $0.06 per share, some investors paid commissions as high as $3.15 per share. Why would investors agree to return or funnel part or most of their IPO profits to CSFB? Clearly investors saw the deal as easy money. Assume an investor was allocated 5,000 shares from CSFB in the VA Linux offering. If the investor were able to sell the 4

6 shares at the closing market price of $ (a reasonable assumption), the total one-day profit would be $1,046,250 [5,000 shares x ($ $30.00)]. If even half of the IPO profit had been returned to CSFB in the form of inflated trading commissions on offsetting large-cap trades, the investor would still realize a profit of about $500,000. Not a bad return on a one-day transaction. The SEC alleges that some customers executed one side of a trade with CSFB while at the same time taking the opposite position in another brokerage account. As a hypothetical example, the customer would execute an order with CSFB to buy 85,000 shares of General Electric at a commission rate of $3.00 per share. This would generate $255,000 ($3.00 x 85,000) in commission for CSFB. Shortly after placing the buy order, the customer would sell the same 85,000 shares of General Electric at a more typical commission rate of $0.06 ($5,100 in total commission) with another broker. Hence, the net position of the customer in General Electric would be zero. By grossly overpaying CSFB for stock commissions, the SEC alleges, this customer trading behavior served to funnel the IPO profits from the money left on the table back to CSFB. One might argue that investors who willingly kicked back to CSFB some or most of their one-day profits are guilty of unethical behavior. I disagree. The main actor in this scheme is the investment banker CSFB, not its valued clients. The only way some investors were able to get shares of the offering was to agree to give something back to the banker. If the clients didn t agree to part with some of their gains, the banker would have found someone else who would have agreed to take part. Other investment banks allocate shares of hot IPOs to valuable clients who in the past have generated substantial trading commissions for them. 5

7 If the allegations against CSFB are true, the investment bank would be in violation of NASD Rule 2110 on free riding and withholding. If it received compensation in the form of inflated commissions, CSFB would clearly have an economic interest in the IPO after the issuance because it would receive a fraction of the aftermarket IPO profits. That is, the more money left on the table by VA Linux, the greater the profits transferred to CSFB. If the firm had a direct economic interest in the success of the aftermarket trading of VA Linux, there would not be a full public distribution of shares. This appears to be a clear violation of the full distribution of shares requirement in a hot public offering. Who are the potential losers in violations of Conduct Rule 2110? First, investors, both large and small, may lose interest in providing liquidity to issuing firms if they view the distribution and allocation of shares as unfair. Why would investors want to participate in purchasing shares in an IPO if they are shut out of the hot issues and offered shares in only overvalued offerings? Much of the success of the US capital market is its amazing ability to provide capital for all types of companies. Any perception by market participants that IPO allocations are unfair hurts the credibility and vitality of the world s most successful capital market. The second loser in any violation of Rule 2110 is the issuing firm. With more money left on the table for favored investors, issuing firms like VA Linux receive less in proceeds. Two main objectives in going public are (1) to raise capital for an issuer, and (2) to create a market for shares of the company. More money left on the table is directly linked to fewer dollars raised by the issuing firm, all else equal. 6

8 What are the ramifications for VA Linux of leaving over $900 million on the table? Figure 1 plots the VA Linux stock price in the first year after its December 1999 IPO. In the weeks following the offering, the share price of the firm fluctuated substantially, but then the price started a slow and steady decline. To add some perspective on the relative performance of VA Linux, note that the Nasdaq-100 Trust Series (ticker QQQQ) sold at $78.47 (stock split and dividendadjusted) on December 9, 1999 (the VA Linux IPO date). The Nasdaq-100 Trust is a unit investment trust designed to mimic the market performance of the Nasdaq-100 Index, which includes the largest non-financial firms listed on Nasdaq. The Nasdaq-100 Trust Series reached its peak on March 27, 2000, with a price of $ (stock split and dividend-adjusted). On the one-year anniversary of the VA Linux IPO, QQQQ had a price of $ Hence, the VA Linux poor performance cannot be blamed solely on the decline in the market. The Nasdaq-100 declined approximately 14%, while VA Linux declined over 96%. According to the University of Chicago s Center for Research in Security Prices (CRSP), on its IPO date VA Linux had a market value of approximately $9.5 billion (shares outstanding multiplied by the stock price). Within 50 trading days, the market value had dropped by more than half (to $4.6 billion). About 230 trading days after going public, VA Linux had a market value of $903 million. This value is actually lower than the amount of money left on the table in the IPO. Clearly, the issuer was hurt by the amount of money left on the table. Instead of being transferred to investors by CSFB s allocation policy, the IPO proceeds could have been distributed to VA Linux in the form of a higher offer price. Higher proceeds would 7

9 have enhanced VA Linux s ability to compete in the highly competitive software industry. A critic might argue that VA Linux had a flawed business model and that any additional proceeds most likely would have been wasted by the firm. Yet, five years after going public, VA Linux continues to be listed on Nasdaq. The firm has not been liquidated or gone bankrupt. The company, by surviving in a highly competitive industry for more than five years, is a success. In fact, VA Linux is a success in spite of leaving hundreds of millions of dollars on the table for the favored clients of CSFB. The NASD and the SEC establish codes of conduct for underwriters in order to create a fair trading environment for issuing firms and investors. If they distribute underpriced shares of equity to the public, investment banks must ensure full public distribution of the shares. That is, the banker cannot hold back shares of an offering that is in demand, and then sell them in the secondary market for a quick and easy profit. If underwriters have an economic stake in aftermarket trading of IPOs, there has not been a full distribution of the issued shares. The SEC alleges CSFB had a direct economic stake in the aftermarket success of the VA Linux IPO: extravagant commission costs generated by traders wanting part of the money left on the table. More money left on the table by CSFB made the excessive commissions generated by investors to get those shares even higher. In its December 9, 1999, IPO, VA Linux left an astounding $900 million on the table for CSFB and its favored clients. When investment bankers fail to follow the rules of conduct in underwriting securities, this hurts both investors and issuers. Investors will 8

10 assume that only favored investors are allocated shares in hot IPOs. Issuers receive less from an offering than would have been the case if less money was left on the table. The money left on the table has to come out of someone s pocket. More money left on the table means less money for firms to compete in highly competitive markets. The ongoing success of financial markets depends on all investors, both large and small, to provide capital to issuing firms. Failure to protect investors and issuers from investment banker misconduct threatens the operation of our capital markets. Power seems to be an important element in this VA Linux IPO story. The ability of CSFB to demand compensation from investors suggests that it had the majority of power and used it in ways that are unethical. If customers would not kick back IPO profits, the SEC alleges that CSFB simply denied the client shares in hot IPOs. If VA Linux was unhappy with the offer price that CSFB wanted the firm to go public at, the firm had very few choices on December 9, It might have withdrawn the offering and started the process over again with a different investment banker, meaning a substantial delay at best. Moreover, VA Linux could not be guaranteed a more favorable offer price if it decided to use a different investment banker. It would be interesting to examine whether less prominent investment bankers are more ethical simply because they have less power behind them. Maybe too much power has a corrupting influence on the top-tier bankers. Consistent with this assertion, Loughran and Ritter (2004) find that high-prestige underwriters during reported first-day returns of 72% compared to the 35% for firms brought public by lowprestige underwriters. As power becomes concentrated in fewer and fewer prestigious investment bankers, more unethical behavior is possible. 9

11 Are different amounts of money left on the table related to the IPO market share of the top-tier bankers? Higher investment bank market power might be linked directly to extravagant amounts of money left on the table by issuers. What kind of interventions should be considered to limit violations of Rule 2110 in the future? An obvious solution might be for issuers to use an auction process instead of the investment banker-dominated book building process to go public. The book building process in more than 98% of US IPOs concentrates the share distribution ability with the lead underwriter. In a 2004 IPO, Google used an auction process in an attempt to limit the amount of money to be left on the table in its initial equity offering. Yet few IPOs have chosen the auction procedure to issue shares following Google s successful IPO. One reason the book building system is so well entrenched lies in the issuing firm s desire to get positive analyst coverage from investment banks. As Cliff and Denis (2004) and Loughran and Ritter (2004) note, there is a link between the amount of money that issuing firms will leave on the table and analyst coverage in the aftermarket. Investment bankers like CSFB provide the issuing firm with both distribution of IPO shares and analyst coverage in the aftermarket. The concentration of analyst coverage united with the IPO distribution channels of prestigious investment bankers might be ethically problematical. Less concentration of power in a few top-tier underwriters would most likely discourage future violations of NASD Rule

12 References Arosio, R., G. Giudici, and S. Paleari: 2001, Why Do (or Did?) Internet-stock IPOs Leave So Much Money on the Table?, Unpublished Politecnico di Milano (Italy) Paper. Chen, H.-C., and J. Ritter: 2000, The Seven Percent Solution, Journal of Finance 55, Cliff, M., and D.J. Denis: 2004, Do IPO Firms Purchase Analyst Coverage with Underpricing?, Journal of Finance 59, Loughran, T., and J. Ritter: 2004, Why has IPO Underpricing Changed Over Time?, Financial Management 33, Schultz, P., and M. Zaman: 2001, Do the Individuals Closest to Internet Firms Believe They Are Overvalued?, Journal of Financial Economics 59, Securities and Exchange Commission: 2002, SEC Sues CSFB for IPO Violations; CSFB Will Pay $100 Million, Litigation release available at 11

13 Table 1 Top Ten US IPOs in Terms of Leaving Money on the Table, Shares Offered (in millions) Amount of Money Left on the Table (in millions) # IPO Name IPO Date Offer Price Closing Price Lead Underwriter 1 UPS $50.00 $ Morgan Stanley $1, Corvis Corp $36.00 $ CSFB $1, Palm Inc $38.00 $ Goldman Sachs $1, Goldman Sachs $53.00 $ Goldman Sachs $1, Sycamore Networks $38.00 $ Morgan Stanley $1, Akamai Technologies $26.00 $ Morgan Stanley $1, Agilent Technologies $30.00 $ Morgan Stanley $1, VA Linux $30.00 $ CSFB $ Freemarkets Inc $48.00 $ Goldman Sachs $ Avanex Corp $36.00 $ Morgan Stanley $816.0 The amount of money on the table is defined as: (closing price offer price) multiplied by the number of shares offered to the public. No adjustment for inflation is made.

14 Figure 1 Stock Price of VA Linux in Year Following the IPO 300 Stock Price in Dollars Time