The Stock Spinners
The problem with venality
in business is that getting outraged about it makes it easy to miss the
systemic problems that venality often disguises. And that's exactly what's
happened in the uproar over the Wall Street practice called "spinning."
"Spinning" has, apparently, been common on the Street for as long as anyone can
remember, and yet it had never really been written about until a November 1997
article in the Wall Street Journal broke the story. The mechanics of it
are simple: An investment bank that's underwriting an initial public offering
gives shares in that IPO to corporate executives at companies with which the
investment bank is either doing business or would like to do business. The
executives can then "spin" the shares, which is to say, sell them for a quick
profit as the stock's price bounces higher, something most IPOs have tended to
do on their opening days of trading. Robertson Stephens, for instance, gave one
client 100,000 shares in the IPO for Pixar, the company responsible for Toy
Story ; the client spun those shares into a $2-million profit. The
assumption, of course, is that an executive who receives a gift like this will
be more likely to direct his company's business toward the investment bank that
proffered the shares. Quid pro quo.
If that's not unsavory enough for you, in some
cases the investment banks don't give the shares to the executives until the
stock has started trading well above the offering price. In other words, if an
IPO's opening price is $20, and within a couple of hours of the opening bell
it's trading at $35, a bank will choose that moment to allocate the shares to
the executive's account. The executive gets the shares at $20 and sells them at
$35, all in one fell swoop. Banks are able to do this only by abusing a
regulation that permits them to cancel a mistaken allocation of IPO shares
before the first trading day ends. The conversation, one imagines, goes a
little bit like this: "Now that the stock's price has risen, I realize I didn't
mean to give them to this person's account. I meant to give them to you! Now,
about that deal we were discussing ..."
Well,
it's probably not quite that crude, but spinning does seem unquestionably to
violate state laws that prohibit corporate executives from taking personal
advantage of financial opportunities that they get because of their position at
a company. One columnist recently wrote that "America's unique strength has
always been that the path to success isn't totally rigged, that it's not simply
about being a member of some inner circle that cuts you in on the action for
life," and that spinning threatens this strength. But though he deserves a nice
pat on the back for the graduation-speech rhetoric, thinking in terms of
fairness doesn't really get us very far. Spinning is unfair, but then so is
life, as our parents told us. To see why spinning really should be eliminated,
you have to look at the question from a hard-nosed efficiency angle.
Why, after all, do we have laws against
bribery? If someone really wants my company's business, why shouldn't he be
able to do everything he can--including paying me off--to get that business?
Because bribery encourages people to make decisions based on the wrong
criteria, which means in the business world that it distorts the efficient
allocation of resources. Absent the bribe, I would decide to give my company's
business to Investment Bank A. But because Investment Bank B allowed me to spin
shares in a new Internet IPO, I give my company's business to them instead.
This is
bad in two different ways. First, I'm violating my fiduciary responsibility to
my company, because I'm making a decision based not on what's best for it, but
rather on what's best for me. Second, investment banks that already do a lot of
IPO business will tend to get more business, simply because they have more
shares to spread around. The rich get richer, not because they're more
efficient but because their ability to bribe is greater.
Ordinarily, of course, bribery tends to be
somewhat self-limiting, in the sense that you don't want to spend more on
bribes than the revenue that you generate through them. But spinning costs
investment banks nothing at all. Once an investment bank has underwritten an
IPO--which means that it has committed to selling all the company's available
shares at a set price--all it has to worry about is making sure those shares
get bought. Needless to say, people are anxious to buy shares when they know
they can sell them seconds later for an easy profit. So while a company that
bribes customers is typically hurt by the fact that money that could have gone
toward profitable investments instead goes toward bribes, in the case of
spinning, both briber and bribee win.
The fact
that some investment banks are getting more business than they otherwise might
is a good enough reason for regulators to step in. But spinning has still worse
consequences. The practice works only if the price of an IPO bounces
significantly higher on the first day. That gives investment banks an incentive
to set opening prices lower than they should be. Instead of taking a company
public at $30 a share, and watching it trade at $30 all day long, an investment
bank can take a company public at $20 a share, watch it jump to $30 right after
the opening bell, and allocate those now-profitable shares to its clients.
It's possible, of course, that investment banks
just keep getting surprised over and over again by the strong demand for IPOs,
and that they really make their best effort to match opening prices with market
demand while giving themselves reasonable insurance against getting stuck with
unsold shares. But somehow it seems unlikely that spinning would have become
such an institutionalized practice if investment banks didn't have a pretty
good sense that a stock's price was going to jump on its opening day. And that
means the real losers are the companies whose IPOs end up underpriced.
Underpricing an IPO, of
course, deprives the newly public company of capital. When Pixar went public,
the money raised from that very first sale of its shares was what it used to
run its business in the future. But Pixar went public at a price 77 percent
lower than the highest price people paid for its shares on the opening day of
trading. And while it would be a mistake to say that the stock could have
opened at that highest price, it's safe to say that if Robertson Stephens had
done a better job of gauging demand, millions of dollars that went into
traders' pockets would have gone into Pixar's vaults instead.
What's frustrating about
all this is that the moment when a company goes public is when the stock market
should function most efficiently. That's the only time when the money you pay
for a stock goes right to the company, rather than to another trader. The price
of an IPO, then, should reflect as nearly as possible what investors really
think about a company's prospects. And yet everything about the IPO
process--from spinning to the fact that shares are distributed mainly to large
institutional clients to the fact that some investors are fed information
before the IPO that other investors never see--works against the market's
efficient operation. Wall Street has come a long way from the insider-dominated
world that was blown apart by the Great Depression. But spinning is an
excellent reminder of how far toward real transparency the Street still has to
go.
