a blast from the past: eToys and the IPO market

In yesterday’s New York Times, business reporter Joe Nocera wrote an opinion column about investment bankers’ behavior in bringing companies public.  It’s based on documents from an ongoing lawsuit between 1999 IPO star, eToys (which went into Chapter 11 in 2001), and its lead underwriter, Goldman Sachs.  Mr. Nocera got the data from the New York County Clerk’s office, where they were supposed to have been under court seal, but weren’t.


No, it’s not the one with the sock puppet.  That was Pets.com.  eToys was an online toy retailer.  Both made it into CNET’s Top Ten internet bubble flops, though.

The pricing range for eToys shares in the initial prospectus was $10-$12.  The final offering price was $20.  The stock closed on its opening day at $77.  It peaked a few months later at $84.  It was trading at $.09 when it went belly up.

The lawsuit:  eToys contends that Goldman failed in its fiduciary duty to get the best price for eToys shares.  Although it was losing money at the time of the IPO, eToys thinks that if it had raised, say, $400 million (an offering price just north of $50) instead of the $155 million it got, it would have been able to stay alive long enough to become profitable.  This was basically the AMZN strategy.  In eToys’ case, who knows what might have happened.

Goldman’s defense is apparently that it had no such duty.

the documents

Grammar and spelling errors aside, the Nocera documents shed some light on less well-known aspects of the IPO process.  No one comes out looking especially good.  For example:

–Goldman allocated 20% of the offering to “flippers,”  that is, to brokerage clients who had no interest in owning the IPO companies.  They just wanted to sell, or “flip,” the stock during first-day trading.

–one investment manager said he did large amounts of trades with Goldman simply to get IPO allocations.  He also appears to me to have paid commissions at almost twice the then going rate.  A cynic would say he got no services for this extra payout;  he just wanted to make the payments fatter–and thereby get a bigger IPO stock allocation.

–an internal presentation argues that Goldman should look at first-day trading gains in an IPO stock as being an asset of the firm, one that Goldman should seek to maximize the return on.

–Goldman regarded first-day gains as a quid pro quo for two things–the size of a client’s commission business and his willingness to participate in “cold” IPOs.  (“Cold” IPOs are ones with little or no upside; participation allows the underwriting syndicate to earn IPO fees at lower risk.)

–Goldman kept track of the first-day gains achieved by each client and informed at least some that it expected to receive 20%-30% of that figure back in increased trading commissions.

the underwriting fee/trading commission tradeoff

In the eToys IPO, the underwriters (I’m including the selling syndicate in here, too) received fees of $11.2 million, or 6.75% of the offering price of $20 a share.  If we assume they received from all brokerage clients what amounts to a kickback of 25% of the first-day gains of $53 on 8.2 million shares, that would have amounted to $108.7 million.

If, on the other hand, the IPO had been priced at $50, the underwriting fees would have been $28 million.  The commission “kickback” would be $47 million.

The total investment banking take at an IPO price of $20 a share would be $119.9 million; at $50 it would be $75 million.

This is Mr. Nocera’s point, and eToys lawsuit contention–that Goldman had every incentive to underprice the offering.

on the other hand…

…let’s suppose that the underwriters could only collect from flippers, who made up 20% of the eToys offering.  SEC-regulated money managers, after all, have a fiduciary obligation to get the lowest possible commissions.  If so, the “kickbacks” would have amounted to $21.7 million and $9.4 million.  The total investment banking take $20 a share would be $32.9 million; at $50 a share it would be $37.9 million.  Not a huge difference.

And I suspect this is closer to the true state of affairs.  Still, the tone of the documents Nocera unearthed suggests to me that Goldman felt it was missing a golden opportunity by not exploiting its underpricing better–not that there was something wrong with the underpricing strategy.  It may also be they knew that firms with more Internet cred, like Merrill (whose famous analyst, Henry Blodget was subsequently barred from the securities industry for fabricating his research reports) or Morgan Stanley (Mary Meeker apparently convinced the SEC she really believed the crazy stuff she wrote) were better able to cash in.




Greg Smith’s resignation letter from GS

the letter

On Wednesday, the New York Times published the resignation letter of Greg Smith, a (former) derivatives salesman at Goldman Sachs.  Smith, a 12-year employee, says he’s leaving because the GS work environment has become “toxic and destructive.”

My first reaction:  plus ça change…

In 1989, Michael Lewis, of later Moneyball fame, wrote Liar’s Poker, an expose of the culture of cutthroat competition and macho banality of Salomon Brothers while he was a bond salesman there.  Salomon, you may recall, had to be rescued by Warren Buffett after top executives colluded to illegally manipulate prices in the US government bond market.  What’s left of the firm now resides inside Citigroup.

Yes, Moneyball shows that Lewis is sometimes reluctant to let facts stand in the way of a good read.  Nevertheless, I think Liar’s Poker is an important book.  In fact, I’ve asked all the securities analysts and portfolio managers I’ve trained since its publication to read it.

Three points from the Lewis account still stand out to me:

–the strong internal pressure for salesmen to get unattractive, illiquid bonds off the company’s books by persuading some gullible customer to buy them

–a sketch of the growing dismay of a certain client as the realization dawns that he has been sold a toxic security that he can’t resell and which will get him fired when his bosses figure out what he’s done (why they don’t already know is beyond me)

–the feverish rush to unload dud bonds on a client the brokerage community figures is so unskilled that he’ll soon be fired.  Like blood in the water to sharks.

Welcome to Wall Street.

an adversarial relationship

What the Michael Lewis book and the Greg Smith letter bring out most strongly, to my mind, is the simple truth that the relationship between broker and client is a commercial one where the interests of the two sides are not aligned.

Two senses:

–Every time you trade, you think you know more than the other party.  You think any security you buy is undervalued and that the other side of the trade will give up future profits by selling it to you at today’s price.  You expect anyone you sell to to lose money by taking your offer.  You also expect the broker to act as the counterparty if he can;t find someone else.  It’s like baseball.  You take the field expecting to beat the other side.  You’ll win; they’ll lose.

–Investment managers earn higher fees by having superior performance, which helps attract new assets; brokers get paid in direct relationship with the amount of trading the client does.  Experience shows, however, that for most managers superior performance and the amount of trading are inversely related.  So, what’s good for the manager isn’t particularly good for the broker, and vice versa.


In addition, each side markets itself to the other.  That is, each tries to replace the cold commercial structure of the relationship with a warmer “like me, trust me” one.  That’s partly because we’re all decent people.  It’s partly so the other side will continue to do business with you after you’ve traded them into the dust.  And it’s also partly because it’s a way of gaining a competitive advantage, of tilting the ratio of compensation to services in your favor.  In my experience, brokers are much more successful in getting clients to deliver excess compensation than clients are in getting excess services without payment.

the business has changed

A generation ago, the principal business of investment banks was providing comprehensive financial services and advice to companies of all sizes–everything from working capital finance to strategy to mergers and acquisitions.  For small- and medium-sized firms, its investment banker may well have held a seat on the board of directors.

Not any more.  In today’s world, however, most firms have an in-house staff of financial professionals who do most of this.

At the same time as businesses based on building long-term relationships of trust have eroded, the trading business, which focuses on rapid-fire, reflex-action, individual transactions, has exploded in size and scope.

As the composition of company profits for brokers has changed, so too has the character of those who rise to positions of control.  The traditional investment bankers, whose temperament is to focus on long-term relationships, are out.  High skilled traders, who focus on short-term profits, are in.

playing hardball vs. cheating

Where to from here?

The huge profits that trading businesses have generated during the past decade are already spurring changes.  Institutions are already shifting to electronic crossing networks, where fees are much smaller and where the activity won’t be seen by a broker’s proprietary trading desk.  Retail investors are doing more business with discount brokers.  They’re increasingly shifting, I think, to passive products like ETFs as well.

Institutions have long memories.  In cases where they believe a broker has crossed the line between aggressively competing and cheating, they simply won’t do business with them anymore.

there’s something about Europe, too

Did it really take Greg Smith 12 years to figure out what brokers do for a living?   …or was it his final year, in Europe, that changed his mind?  Why is it that the losing end in all the toxic credit default swaps was a European bank?



business has changed away from long term repationships—now cos do for selves, change of control toward traders in brokerage firms

Goldman’s trading “huddles” are back in the news again

Reuters reported on Tuesday that the Massachusetts Securities Division is considering administrative proceedings against GS for its conduct in weekly meetings of analysts and traders, called “huddles.”

I wrote about the Goldman huddles when the news first broke a little less than two years ago, so you can read more detail in that post.  It’s not clear whether the meetings still go on, but when the Wall Street Journal revealed their existence, the huddles were weekly get-togethers of GS’s analysts and proprietary traders.  Their purpose was to develop short-term trading ideas involving stocks GS analysts covered.

The issue is how the results, which sometimes ran contrary to the recommendations in GS’s published research, were disseminated.  GS apparently used them in its own trading.  Institutional salesmen privy to the meetings’ output passed the ideas on to a small number of the firms largest clients.  However, GS didn’t inform the rest of its customers, who were left to act on an official “buy” recommendation when favored clients were being told to “sell.”

Massachusetts has long been a leader in sticking up for the rights of ordinary citizens in financial matters, so this is an interesting situation.  I don’t think the case is as open and shut, however, as, say, the Raj Rajaratnam insider trading case was.  Three reasons:

1.  Every GS research report contains several pages of disclosure in small print at the end (I’ve checked).   Sometimes the disclosure section is longer than the report.  But the fact that GS may act against its official recommendations and tell different things to different clients is among them.

2.  According to the WSJ, analysts were “guided” not to utter the words “buy” or “sell” in the meetings.  So while circumlocutions may have made it clear what the conclusions arrived at in the meetings might have been, establishing that in court might be hard.

3.  GS equity research really isn’t that good, in my opinion.  Its strength has always been the collection of large amounts of factual information about companies and industries.  Its weakness is analysts’ judgment.  And the firm has slipped badly in the annual research department rankings by the Institutional Investor magazine, among others, in recent years.  So GIGO might be another defense.

One other note:  the Reuters article refers to the recently-issued GS 10Q.  Footnote 27 to the financial statements mentions in a general way GS discussions with the Massachusetts regulator.  Either the Reuters reporter is incredibly observant, or someone (the regulator?) called her attention to it.  Can it be that what we’re seeing are the first steps in a systematic investigation by regulators of Wall Street behavior before and during the financial crisis?

brokers and standards of care: the SEC study

the report

Last Wednesday the SEC published the results of a study on the differing legal obligations of brokers and investment advisers to their clients.

The SEC’s bottom line:

–while customers are generally satisfied with the investment advice they receive, they don’t really know what standards of conduct their brokers or investment advisers are legally held to.  In addition, they sometimes mistakenly think brokers are required to perform to the same high standard as investment advisers.

–the standard of conduct for brokers should be raised to match that for investment advisers, “when providing investment advice about securities to retail customers.”

why the study?

One might think that it was driven by the realization that millions of Baby Boomers will be retiring in the US over the next decade or so.  The vast majority–government workers are the biggest exception–will not have the security of defined benefit pension plans backed by their former employers. Instead, they have the money they’ve saved in IRAs or 401ks, for which they will have investment responsibility, to support them in retirement.

That’s not the reason, though.  The SEC did the study because it was ordered to in the recently-passed Dodd-Frank Act.

broker or investment adviser:  what’s the difference?

in law…

Investment advisers are regulated by the Investment Advisers Act of 1940.

Broker-dealers are regulated under the anti-fraud provisions of the Securities Act of 1933 and the Securities Act of 1934.

Broker-dealers are specifically excluded from regulation under the Investment Advisers Act.

…and in practice

Investment advisers are fiduciaries.  In practical terms, this means three things:

–the adviser must do what’s best for the client

–the adviser must put the client’s interests ahead of his own, and

–the adviser has to make extensive disclosure of possible conflicts of interest.

Broker-dealers are not fiduciaries.  As a result,

–although brokers aren’t permitted to act in a way that harms their clients,

–they can recommend an investment that is less good than another but which provides a higher profit to the broker.

I’m not sure what the technical requirements for disclosure of conflicts of interest are for a broker.  My experience is that such disclosures are, at best, buried in the middle of large amounts of fine print and couched in language that only a specialist would understand. Goldman’s trading “huddles,” exposed in an article in the Wall Street Journal in 2009, are a recent example of differential treatment of institutional clients, not retail, but it’s still a good illustration of the broker mindset.

The huddles are weekly meetings of analysts and traders that ended up generating ideas, some of which go against Goldman’s official stock recommendations.  These trading ideas are communicated only to a few of the firm’s highest revenue-generating clients.  The official recommendations aren’t changed, so most clients continue to be told the opposite story.  (I just looked at a recent Goldman research report.  This practice is described in paragraph 25 of 30 paragraphs of fine print, covering three pages of the report’s total length of seven.).

if brokers are required to become fiduciaries, what changes?

It may be an exaggeration to say that this would radically change the fundamentals of the retail brokerage industry…but, on second thought, that may not be so far from the truth.  For example,

quality of fund recommendations

1.  Some retail-oriented brokerage houses have their own in-house fund management groups.  In many cases, the records of such proprietary funds is mediocre at best.  Yet brokers are encouraged to sell these funds to clients.  In my view, the main factor–other than the underperformance clients experience–is their greater profitability of in-house funds to the firm. If brokers were fiduciaries, presumably they would have to point out that third-party funds have better track records, or to disclose their financial interest.

2.  Brokers might have to disclose that in general no-load funds sold by Vanguard or Fidelity are a better deal that the load funds brokers sell.

3.  When you go into a brokerage office to have an asset allocation analysis done, it may be that the mutual fund recommendations that the computer spits out come only from fund groups that have paid to have their names displayed to customers–or who have agreed to rebate to the brokerage a portion of the management fee earned on shares sold.  Fund groups that decline to pay get no exposure. In other words, the fund recommendations aren’t the objective assessment they appear to be.

A fiduciary couldn’t do this without clear disclosure.  Actually, I think a fiduciary who tried to do this would be run out of town.

4.  If an individual broker does enough business with a given fund group, he may qualify to bring himself and a guest to  an all expense-paid educational seminar (including nightly entertainment),  in, say, Las Vegas, or San Diego or Disneyworld.  Has any broker ever mentioned that possibility when recommending a fund to you?

quality of stock recommendations

5.  Institutional Investor magazine publishes a yearly ranking of brokerage house research and a list of All-American analysts in each industry.  If brokers were fiduciaries, I think they’d have to tell you if, as many have, they’ve laid off most of their experienced researchers during the recession.  So they have no ranked analysts anymore.  And the report you’ve just been handed recommending XYZ Corp as a “buy” was written by a replacement who only has six months experience, no formal training in securities analysis, and is learning to do research on the fly.

All of this would be a little like watching your meal being prepared in the kitchen of a restaurant that probably won’t pass health inspection.  Certainly, brokers don’t want to be forced to allow you this peek under the covers.

are any changes likely, based on the SEC findings?

I doubt it.  Opposition from “full service” brokerage houses would be too great.  It’s also interesting to note that, while the study was done by the staff of the SEC as Dodd-Frank mandated, its conclusions weren’t endorsed by the SEC.

But this did give me another chance to write about some of the less obvious practices of the retail brokerage industry.  So at least that’s something.

state of New Jersey–the latest strange SEC decision

New Jersey is an odd state.  On the one hand, this small but densely populated region contains a famous research university, Princeton.  It generates much of the pharmaceutical research done in the US.  It contains bedroom communities for New York City and Philadelphia, as well as miles and miles of rolling beaches, and the hills, lakes and horse farms in the western part of the state.

On the other hand, its reputation in the minds of many Americans is determined by the HBO series The Sopranos, about an organized crime family operating in NJ; the reality show Jersey Shore, whose “stars” are, ironically, New Yorkers; and a short–but heavily used–stretch of the New Jersey Turnpike that seemingly threads its way through every oil refinery, chemical plant and natural gas storage area in the Northeast. Local politicians have also done their bit to define the state’s character, as they have sued for the right to remain in office, or to run for reelection, while in their jail cells.

New Jersey has been in the financial news recently for another signal achievement–it’s the first state ever cited by the SEC for securities fraud (San Diego, CA has the dubious distinction of being the first government entity to be the subject of an SEC securities fraud action).  The charges, which New Jersey settled in an administrative proceeding this week, are basically that while Jim McGreevey and Jon Corzine were governors, the state continually deceived potential investors in its municipal bonds.  In bond offering documents and in other official state records, New Jersey either misstated or failed to disclose the increasing underfunding of state workers’ pension plans–caused in part by the fact that the state was “balancing” the budget by no longer making contributions to them.

You might think that this is the strange part.  It isn’t.  The really strange part is that in the cease-and-desist order linked in the paragraph above, no individuals are cited for this misconduct–not the governors who knew what was going on, nor the state treasurers who prepared the fraudulent financials, nor the investment bankers whose due diligence was non-existent.  In this regard, Mr. Corzine’s name in particular jumps out to me, not necessarily because his actions were any worse than the others’ but because his long career at Goldman Sachs, including serving as its CEO, make it very difficult to believe he wasn’t completely aware of the relevant securities laws and of the gravity of what New Jersey was doing.

The rationale for the SEC’s inaction–cooperation from New Jersey, which has promised to mend its ways.

The fact that this is not a court proceeding means there’s no judge to evaluate the SEC’s decision.  But it seems to me that this enforcement action–particularly in an apparently simple and straightforward case–reinforces critics (including judges, in court cases) who say that the SEC is a relatively toothless regulator, more interested in fast settlements than in adequate ones.