Investor participation in initial public offerings.

Author:Schwartz, Kyle J.

INTRODUCTION I. THE MECHANICS OF AN IPO A. Overview of the IPO Process B. Underpricing Theories 1. The "Winner's Curse" 2. Information Revelation 3. Litigation Risk 4. Summary II. EXISTING REGULATIONS A. History B. The Securities Act of 1933 and the Securities Exchange Act of 1934 C. Recent Amendments III. INCREASING ALLOCATIONS TO RETAIL INVESTORS AS A CLASS A. Overview B. The Dutch Auction Is Not a Desirable Solution C. Comparison to Creditors in Bankruptcy D. Trend Toward Regulation E. Providing Small Investors with Access to IPO Shares CONCLUSION INTRODUCTION

Eight years after Facebook's founding, when shares at its initial public offering (IPO) were priced at $38 each, Facebook's valuation of $104 billion made it "the most valuable U.S. company at the time of its stock market debut." (1) But in the days and weeks that followed its May 2012 IPO, the company's stock price was dropping fast, and a Wall Street Journal contributor commented that "[t]he newly public shares are losing an average of about $1 per trading day since their offering. If that lasts, the social-networking company would be worth nothing before the end of June, and Chief Executive Mark Zuckerberg's trips to McDonald's will seem less chic and more necessary." (2) So what, if anything, went wrong?

To start, IPOs are generally "underpriced," that is, the initial offering price is usually set below fair market value such that the shares yield positive returns during secondary trading in the moments after the shares hit the market. (3) But did Facebook even fail on this metric? At least for certain investors, the answer is no. Facebook shares reached a high of $45 on the first day of trading, (4) meaning that some investors who were able to buy Facebook stock at the IPO price of $38--and time the market well--were able to flip their shares for a quick profit. Both with Facebook and more generally, these lucky investors are usually large institutional traders (5) or select individual investors (6) who have longstanding relationships with the investment banks that underwrite IPOs. Thus, although some individual--or retail--investors are able to acquire stock at the IPO price, most individual investors who want to acquire stock in newly public companies often need to purchase shares during secondary trading, (7) leading some commentators to adopt critical views of the underwriting process. (8) While this method of allocating IPO shares has existed for decades in the United States, heightened media coverage of Facebook's IPO coupled with significant losses for some retail investors--many of whom were uninformed and trading on nothing more than sentiment--brought the IPO machine under increased scrutiny.

For example, Khadeeja Safdar, writing for the Atlantic, revisited Facebook's IPO one year after its "disastrous debut" and reported that despite the losses incurred by many retail investors, "the preferred clients of big banks walked away with huge profits." (9) These institutional and well-connected individual investors, who often possess superior knowledge--by virtue of their relationships with investment banks--than do most small investors, were able to do so by either taking a short position in Facebook stock (i.e., betting against the company), or selling the stock for a quick profit moments after acquiring it at the IPO price. Scott Sweet, a managing partner at an IPO research firm, recalled that one of his hedge fund clients sold the stock at $42 and shorted it to make the hedge fund's "largest profit of the year." (10) Sweet went on to say that it would be impossible for an ordinary investor to have access to the hedge fund's superior information without having "a friend at a multi-billion dollar institution." (11)

While IPO underpricing is not a new phenomenon (12) and there are numerous theories that try to explain it, (13) many commentators choose sides and suggest either (1) that the current system of allocating underpriced shares to favored institutional investors is not a problem, or (2) the opposite, that such allocation practices are unfair and an unbiased lottery system should be used instead. In this Comment, I posit that neither of these approaches is perfect because on the one hand, institutions play an essential role in the IPO process and must be enticed to continue their participation, while on the other hand, retail investors as a class are also an integral component of a stable market, and excluding the majority of individual investors from taking part in IPOs (or only allocating shares to them in overpriced IPOs) risks driving these investors away from the stock market altogether. Congressional and administrative agency action over the last century has attempted to shape the market into a domain that is fair for and accessible to all investors, (14) and following this trend, additional measures should be considered to give retail investors access to hot IPO shares and ensure that the retail allotment offers at least a partially equitable distribution within the class, a reform that I suggest can be accomplished without upsetting the existing IPO framework.

This Comment begins with a brief overview of the IPO process and an exploration of theories in the academic literature that offer varying explanations for IPO underpricing. In Part I, I also suggest that although there is a legitimate need for underpricing and book building, there is room for a small--but guaranteed--unbiased allocation of IPO shares to retail investors. In Part II, I review legislation, dating back to the Securities Act of 1933, that has attempted to increase disclosure of corporate financial information to investors. Despite the continued introduction of laws and regulations in this area, however, the controversy that followed Facebook's IPO demonstrates that there continues to be a lack of transparency for the average individual investor who seeks to participate in the IPO process or understand the true value of a firm. In Part III, I propose that a small tranche of the shares of every IPO be distributed to retail investors through an unbiased lottery system. By adopting a statutory allocation of IPO shares for consumers, underwriters will be able to continue their relationships and information networks with institutional investors without excluding small individual investors from the process. I conclude by suggesting that a small but guaranteed allocation of IPO shares to retail investors, to be distributed through an impartial system, while certainly not solving all of the complex issues related to Facebook's IPO, would nonetheless improve the public's and the media's perceptions of fairness in the market.


    1. Overview of the IPO Process

      When a company sells shares to the public for the first time, it generally hires an investment bank to underwrite its initial public offering. (15) Other investment banks also participate in the IPO and form an "underwriting syndicate." (16) The IPO can be organized in a number of different ways. Two common structures are the "firm commitment" deal (where the underwriter guarantees that a minimum amount of money will be raised) and the "best efforts" arrangement (a deal with no financial guarantee). (17)

      The lead underwriter prepares a registration statement, required by the U.S. Securities and Exchange Commission (SEC) as a prerequisite to offering shares to the public. (18) The registration statement protects investors by mandating the disclosure of a significant amount of information about the issuing firm. (19) Schedule A of the Securities Act lists broad disclosure requirements, ranging from basic biographical information about the company (e.g., names and addresses of directors and partners, as well as "the general character of the business") to detailed financial statements, including a balance sheet and income statement. (20) As part of this process, the underwriter prepares a preliminary prospectus (or "red herring (21), which includes most of the information that will appear in the final registration statement, but not the offer price or the number of shares available. (22) This material, along with other information related to the issuer, is available to the public online through the SEC's EDGAR database. (23)

      With the preliminary prospectus in hand, the issuer and underwriter market the IPO at "road shows," where presentations about the issuing firm are made to potential investors. (24) While road shows were exclusively conducted in person in the past, modern technology and new regulations have allowed road shows to be conducted electronically as well. (25) This, however, has raised new concerns about what constitutes a road show and whether average retail investors, who were often excluded from attending traditional in-person road shows, (26) should be able to access them. (27) If important information about the financial health of an issuing firm is revealed at a road show, it is important for all classes of investors to have some way of accessing it. While the SEC promulgated a rule called "Regulation FD" to ensure that all investors receive material information about a publicly traded company at the same time, (28) it has been suggested that "IPO issuers, like Facebook, are exempt from Regulation FD because the issuer is not yet a reporting issuer." (29) In any event, the underwriter gauges demand for the IPO in response to the information received at the road shows, and adjusts the offer price accordingly.

      If the issuing firm and the underwriter choose to use the traditional "book-building" process, then "[t]he underwriter prices the offering, herds investors and provides a sales force to issue the securities." (30) Additionally, the underwriter "will learn, among other things, which investors might buy shares, in what quantities, at what prices, and for how long each is likely to hold purchased shares before selling them to others." (31) In the United...

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