| 
Rajesh Aggarwal
Finance
|
|
Remember when dot-com companies fetched outrageous share prices
during their initial public offerings in the late 1990s? Many people
thought the market was riding the promise of the Internet and agreed
with Alan Greenspan, who believed irrational exuberance led to escalated
share prices. New research shows market manipulation also played
a large role.
"It appears that at least some investment banks helped to create
artificial demand for IPO shares," says Rajesh Aggarwal, associate
professor of finance at the Carlson School of Management. "Individual
and institutional investors who bought shares in the aftermarket
and held onto the shares as they started to fall were the ones who
lost the most. In subsequent settlements with the SEC, the investment
banks paid relatively small fines."
Much of this news hit the media in 2002 and 2003, when investors
in well-known IPOs such as Ask Jeeves, e-loan, Global Crossing,
Covad Communications, Juniper Network, Priceline.com, and Web MD
brought class-action lawsuits against Goldman Sachs and Morgan Stanley,
two firms that brought numerous hot IPOs to market. The SEC got
involved, and in January of 2005 the two firms agreed to pay the
SEC $40 million each to settle federal changes that they may have
artificially pumped up stock prices (a third firm, J. P. Morgan
Chase, paid $25 million to settle in October 2003).
In new research, Aggarwal and his colleagues (Amiyatosh Purnanandam
and Guojun Wu, University of Michigan) examine the scope of the
market manipulation by looking at 908 IPOs between 1998 and 2000.
Of those, 173 were named in class-action lawsuits against their
investment bank underwriters. Those lawsuits are still ongoing,
even though 33 had specific evidence of manipulation presented in
the SEC settlements. "I suspect that many other IPOs during
this period were subject to some form of underwriter manipulation,
as well," says Aggarwal.
Market manipulations
Aggarwal's research shows how the investment banks were manipulating
the market in the late 1990s and offers lessons to be learned today,
now that the IPO market is heating up again in the United States
and abroad.
According to Aggarwal's research, investment banks that served as
the underwriters for companies launching IPOs engaged in a process
that allocated shares of stock based on special "tie-in agreements."
These agreements let some customers buy shares at the low IPO price
if they agreed to buy more shares at higher prices once the stock
started trading, says Aggarwal. This helped drive up stock prices
in the after market, which appears to have led to an overvaluation
of the stock.
"These tie-in agreements are illegal," says Aggarwal.
In order for tie-in agreements to work, they need to go undetected.
"Tie-in agreements create an opportunity for underwriters to
ensure larger profits, because they have the informational advantage
regarding the stock relative to other after-market participants
who have no idea how 'hot' the stock really is, and who assume its
price is rising due to high demand caused by its true valuation,"
explains Aggarwal. The customers who participate in the tie-in agreement
trade out of their positions while the stock price is high. Through
a variety of quid pro quo arrangements (higher trading fees or directing
business to the investment bank) with their customers, the investment
banks then share in the profits earned by their favored customers.
Over the next several years after the IPOs, the artificially inflated
prices of those manipulated IPOs then reverted to their true levels,
oftentimes resulting in large losses for those investors who bought
after the IPO and held their shares.
Punishment doesn't fit the crime
And although the crime is clear to Aggarwal and his colleagues,
the punishment is not sufficient to deter such behavior in the future.
"The message sent by the SEC fines was that the underwriters
could pay to make the SEC investigation go away," says Aggarwal.
"The penalties they incurred weren't all that great. The class-action
lawsuits may be more significant, but that litigation could take
many years to resolve."
Therein lies the answers to whether it will happen again, says Aggarwal.
"The investment banks can afford to hire more expensive lawyers
and to drag out these cases, which puts a drain on already over-strapped
SEC resources." Although the SEC budget has doubled since Sarbanes-Oxley
legislation went into effect, the SEC currently gets about 20,000
complaints per year, but only takes action in about 100 cases. Many
of those cases involve small-scale manipulation not involving large
investment banks. Yet the conflicts of interest for some of the
large investment banks, such as the tie-in agreements, potentially
involve many billions of dollars worth of securities. They also
challenge the efficiency of U.S. equity markets. These cases need
more scrutiny by the SEC and the investing public.
"It begs the questions, do we need more regulation, or better
enforcement of current regulations?" asks Aggarwal. "What
is the proper role of investment banks and financial intermediaries?
These are the questions we are looking at in our research."
Written by Dawn Skelly
Reprinted with permission from Insights, a publication
of the Carlson School of Management.
|
