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Were underwriters really undertakers?

The practice of underwriting--taking a company through the maze of Wall Street to sell its shares on public markets--has fallen under increased scrutiny since so many investors lost their money in the free fall of Internet stock prices.

 

Were underwriters really undertakers?

By Sandeep Junnarkar
Staff Writer, CNET News.com
June 5, 2001, 4:00 a.m. PT

As an Internet analyst at investment bank PaineWebber, James Preissler witnessed the birth of traffic as the currency that would fuel the Internet's early commercial history.

He was part of the land rush of entrepreneurs, venture capitalists and investment bankers who latched onto traffic--the number of people visiting Web sites--as the measurement to gauge success in the absence of any established business precedents. Their thinking was simple, if not simplistic: Why bother with difficult matters such as revenue and earnings when big traffic was all that was needed for a successful initial public offering?

"There was no experience--we were all shooting in the dark," Preissler, now an executive at HelloAsia, an Internet direct-marketing firm, said in an unusually frank interview. "Everyone was making a very tenuous connection between basic metrics they didn't fully understand and some nebulous projections that it would become revenue."

Such was the dubious foundation for the house of cards that was to become the digital economy.

Start-ups manufactured from business plans drawn on the backs of envelopes were rushed through the IPO process by banks and other institutions in the complicated procedure known as "underwriting." In shepherding a company's stock to the open market, underwriters buy the new securities in preparation for selling them to institutional and retail investors.

In the past, underwriting a company meant taking on some risk. But as the Internet bubble grew, the process became akin to minting money at a time when companies routinely expected their stock prices to at least double or triple on their first day out. For the underwriters, the payoff comes from selling the stock at a higher price to the public than what they paid to the company--a practice that led Wall Street firms to reap record revenues from the IPO boom of the late '90s.

"Undoubtedly there was hype, and lots of money was made," said one investment banker who requested anonymity. "It is really hard to tell people to make less money: 'Come into work every day and make less money.'"

A lesson in objectivity
That hype is what others find troubling. Most, if not all, of these underwriters were part of larger financial institutions charged with providing impartial advice on stocks to individual investors. The ability of these institutions to remain objective while benefiting from underwriting certain stocks has long raised questions involving potential conflict of interest.

Some investment bankers say they served as the voice of reason, telling prospective companies to cut their projections in half and to create realistic goals. But others say such warnings were the rare exception at the height of the merger frenzy that gripped the industry.


These Internet content companies were some of the biggest first-day IPO gainers before May 2001.
Date of issue Company % change to 5/14/01 price from offer price Lead underwriter
7/16/98 Broadcast.com Acquired Morgan Stanley
11/10/98 EarthWeb -69% J.P. Morgan
11/12/98 TheGlobe.com -96% CSFB
1/15/99 CBS MarketWatch -84% DLJ
2/10/99 Healtheon Merged Morgan Stanley
3/18/99 iVillage -96% Goldman Sachs
5/10/99 TheStreet.com -90% Goldman Sachs
6/30/99 Ask Jeeves -86% Morgan Stanley
7/12/99 Chinadotcom -38% Lehman Brothers
10/28/99 Akamai Technologies -64% Morgan Stanley
11/18/99 CacheFlow -62% Morgan Stanley
12/8/99 Andover.Net Acquired WR Hambrecht
Source: Thomson Financial Securities Data
"I don't understand what (underwriters) mean by 'being the voice of reason,'" said Fred Taylor Isquith, an attorney at Wolf Haldenstein Adler Freeman & Herz, a law firm that specializes in securities class-action suits. "Underwriters are salesmen; they are committed to selling the stock."

Although the issue is not new, the practice of underwriting has fallen under unprecedented scrutiny in no small part because so many investors lost such large amounts of money in the free fall of Internet stock prices.

Take the case of TheGlobe.com, an online community site, which soared about 606 percent the first day it traded back in November 1998, pumped up by its exuberant traffic numbers--the steroid of choice. The stock has plunged more than 96 percent from its offer price as traffic figures have failed to produce promised revenue.

Wall Street's role in this kind of debacle has drawn the attention of Congress. Rep. Richard Baker, R-La., a member of the House Committee on Financial Services, on May 16 announced a hearing tentatively scheduled for mid-June to examine the possible conflict of interest between the investment banks' underwriting branches and their analysts, who purportedly provide unbiased opinions on stocks often held by their own banks.

"While the agenda for the hearing has not been set, when you examine possible conflict-of-interest issues in the investment banking business, the IPO question is likely to come up," said Michael DiResto, Baker's press secretary.

The voice of reason
Not everyone, of course, is willing to indict the entire underwriting industry. Some Web executives defended the banks that helped bring their companies to the public market.

"When we first met, (Morgan Stanley) told us we weren't ready to go public and set realistic goals for us," said Mark Cuban, the founder of Broadcast.com. "When we hit (the goals), we pushed forward on the IPO. They did a great job."

Cuban's experience, however, may be colored by his eventual financial success: He was one of a handful of executives to cash out before the bubble burst, making him an instant billionaire. Most executives and venture capitalists expressed frustration at any delays, believing the time was ripe to collect a windfall from their investments.

"The underwriters tried to keep some semblance of a financial model, but they underwent tremendous criticism for not pricing stocks higher," said David Menlow, president of the IPO Financial Network.

Pricing remains a controversial issue that is moving from Wall Street to the courts. A growing number of companies are facing class-action lawsuits filed on behalf of shareholders alleging that preferential deals with underwriters led to artificial demand and pricing.

"They decided that the best way to create a hot market is to make it look like a hot market--by creating great expectations of demand and excitement," Isquith said of the underwriters. "Whether they exercise their responsibilities in this market to people they were selling stocks for is a question of some import."

Many underwriters said their actions were dictated by the companies they represented. For example, setting the share price of an IPO based on projected traffic growth was always a point of contention. If an investment


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bank pushed too hard to scale back a company's projections, the start-up could just as easily approach a rival bank during the IPO mania.

"From a research point of view, you are trying to make sure the company can meet its projections. So you are trying to cut back on their projections, and that cuts down on their valuation," Preissler said. "That is where the biggest battle would lie--between the companies, the banks, the venture capitalists. That is where all the tension rose."

Others explain the phenomenon in more basic terms, as a function of human nature. Few professions are as competitive as the financial world, they note, so the blind rush toward going public was just a matter of survival.

"You are judged against your peers," Andrea Williams Rice of Deutsche Banc Alex Brown said with a heavy sigh. "If your peers have coverage of a promising sector or company that is generating enormous profits for them and you don't, you are putting yourself at a disadvantage." 


 



Although traffic as a measurement has fallen from favor, its role in propelling Internet IPOs skyward is not being scrutinized as unlawful.

Rather, Internet companies are being dragged to court for allegedly failing to disclose the behind-the-scenes deals they cut with underwriters that resulted in artificial demand and pricing of their shares on the eve of their IPOs.

The charge that appears repeatedly is that companies allowed underwriters to cut deals with preferred institutional investors, giving them shares at the IPO price under the condition that they commit to purchasing additional shares on the open market at a particular price.

"They created artificial demand by requiring people who received allocations of the IPO to buy additional shares on the open market--and created artificial pricing by having them committed to buy at a certain price level," said Fred Taylor Isquith, of law firm Wolf Haldenstein Adler Freeman & Herz. "That is the heart of the matter."