IPO Proposal Is a Dud

According to its website, the mission of the National Association of Securities Dealers (NASD) is to ensure "market integrity and investor confidence." However, just like everything else in the securities industry, the NASD does have a conflict: Virtually every securities firm in the U.S. is a member.

So, it should be no surprise that the NASD's proposed IPO reforms are, for the most part, without much backbone. This is not to imply the process has been a complete waste.

How it works
To understand the proposed reforms, though, it is important to understand the traditional IPO process. The process, in fact, has changed little over the past 70 years. Why ruin something that makes so much money for investment banks?

An investment bank typically underprices an IPO, which creates a pop on the first day of trading. Of course, those who benefit from the pop are not the "mom and pops," but instead institutions and wealthy individuals. If you are a big-time customer of an investment bank, expect to get a call from a broker about the latest hot IPO.

During the late 1990s, the underpricings were quite severe, with first-day surges of 100% or more a routine matter. So, getting on the so-called "friends and family" list for IPO allocations was certainly a good move.

NASD's proposals
Okay, let's take a look at the proposals. First, the NASD is recommending that indications of interest (IOIs) must be disclosed to the issuer (i.e., the company raising money in the IPO) and that there be a pricing committee to evaluate the IPO price.

In an IPO, the issuer will go on a road show, in which management gives presentations to investors (not individual investors, but institutional investors). The issuer's investment bank collects the IOIs to gauge demand for the offering. If there is more demand than supply of shares, the offering is oversubscribed and should do well on its opening.

On the night before the IPO, the management of the issuer and the investment bank will have a pricing meeting. It can be a shout-match. The investment bank usually wants a low price; the issuer wants a high price, so as to raise more capital. But, if the management has access to the IOIs, it can make a better case for a higher price. Plus, a pricing committee might be helpful in resolving the conflict.

Although, for practical purposes, the investment bank has a lot of leverage in the pricing meeting. After all, they control the investors and ultimately write the check. It's too late at this point for the issuer to find another group to take it public.

The next NASD proposal is to restrict individual investors from placing market orders on the first-day of trading. Back in the late 1990s, it was quite common for individual investors to place market orders the night before the IPO. On the next day, these investors got their orders filled at excessive prices. Assuming the NASD rule goes through, individual investors will only be able to place limit orders on the first day of trading.

Now to the "friends and family" provision. Investment banks will still be able to allocate shares to friends and family. But, if so, they must be subject to the same lock-ups of the officers and directors of the issuer. In other words, there is no quick flip for these individuals. Traditionally, a lock-up is for six months, which means the officers and directors are prohibited from selling their shares during this time frame.

Speaking of lock-ups, the NASD has something else: If the issuer decides to shorten the lock-up, it must disclose this to shareholders through a Form 8-K filing and an announcement through a major news service. It is certainly good to know if the officers and directors are dumping stock.

The NASD did set forth some far-reaching proposals. However, it calls them "steps that might be adopted." In other words, don't expect anything to happen.

For example, the NASD indicated that the "Dutch Auction" system might be an efficient alternative for IPO pricing. The firm at the forefront of this is WR Hambrecht + Co. In fact, several weeks ago, I had a chance to take a personal tour of the system. It's pretty cool, actually. An issuer can see all the bids and quantities from each investor, as well as the demand curves. WR Hambrecht sends its bid/quantity list to its issuers every week.

With the auction system, the price of the IPO is based not on WR Hambrecht's guessing, but instead on a sophisticated software algorithm designed by Nobel Prize-winning economist, William Vickrey. There is no friends and family favoritism involved. Rather, it is capitalism at its finest.

Another suggestion from the NASD is to have an investment bank's earnings projections made public. Currently, this information is only disclosed to institutional investors.

Finally, the NASD has broached the idea of having independent broker dealers perform valuations on upcoming IPOs.

What you can do
Alas, expect nothing from these radical proposals. But, hey, since the NASD is interested in helping investors, why not let them know your views on the matter.

More reading:

Tom Taulli is the author of Investing in IPOs(Bloomberg Press), as well as a professor of finance at the USC School of Business (don't worry, but he does come out of his ivory tower). You can reach him at tom@taulli.com.


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