Spinning in a hot IPO: breach of fiduciary duty or business as usual?

• Author: Maynard, Therese H.
• Position: Initial public offerings

INTRODUCTION

I have a story to tell. A story with several lessons--some familiar, some novel. This story reflects the rapid pace of change in today's securities markets. It reflects the competitive pressures of today's securities markets and the influential power that these forces of competition wield in shaping the business practices of the participants in our modern financial world. It reflects the prevailing sense of business ethics among the participants in today's business environment. Finally, and most importantly, this story reflects the essential role that the rule of law continues to play in defining the scope of fiduciary duty imposed on individual managers operating in our modern business world. But, I get ahead of myself.

My story begins with the incredibly hot market for new issues that prevailed for a brief period in the late 1990s. (1) As old-timers recall, it was in this hot new-issue market that we saw the initial public offering (IPO) of VA Linux Systems, Inc. Linux's IPO went effective at $30 a share and by the close of its first day of trading, it had surged 698% to close at a whopping $239.25, for the biggest-ever first-day gain. (2) In this market, the competition to get an allocation of shares in a hot IPO was fierce owing in no small part to the widely held perception that IPOs--especially of Internet-related issuers--would yield tremendous profits to any buyer lucky enough to get the opportunity to purchase hot IPO shares from the underwriters.

In the midst of this frenzy of IPO activity, at least one individual investor made a substantial profit flipping shares allocated to him as part of a hot IPO. According to a November, 1997 article in the Wall Street Journal, (3) Joseph Cayre, who was the CEO of a privately held computer software firm, GT Interactive Software, was lucky enough to receive a sizeable allocation of shares of Pixar's hot IPO. (4) Pixar's IPO shares soared by 77% by the close of its first day of trading, and Mr. Cayre was heard to brag about the $2 million profit he made when he "flipped" (sold) his Pixar shares in the aftermarket. (5)

In a market dominated by institutional players, (6) one might wonder how it was that an individual investor such as Mr. Cayre was able to receive the sizeable number of Pixar shares that he was allocated by Pixar's lead underwriter, Robertson Stephens. (7) According to the Wall Street Journal, the allocation of Pixar shares to Mr. Cayre's personal trading account at Robertson Stephens was apparently made in anticipation that Mr. Cayre would direct his company's future investment banking business to Robertson Stephens. (8) In fact, when GT Interactive Software went public a month later, Robertson Stephens served as the lead underwriter of the company's IPO.

"Spinning" is the term of art that Wall Street generally uses to refer to the decision of Robertson Stephens, as lead underwriter, to allocate shares of Pixar's hot IPO to Mr. Cayre's personal trading account. In turn, Mr. Cayre "flips"--that is, sells--these shares at a substantial profit and pockets the profit (here, $2 million) in his own personal trading account. (9) The underwriter's practice of spinning shares in hot IPOs to individual investors as the quid pro quo for future underwriting business is the focus of this Article.

Spinning is a story with a number of different dimensions. My analysis of spinning will be separated into two distinct lines of inquiry. In Part I, I analyze whether the allocation decisions of the lead underwriter in the context of an IPO violate any provisions of either the federal securities law or the rules of the NASD. Here, the story focuses on the conduct of the managing underwriter, such as Robertson Stephens, who served as lead underwriter for Pixar's hot IPO. In Part II, I shift the focus of the analysis to the conduct of the investor who receives the hot IPO allocation, regardless whether he or she flips the shares. (10) Now the focus of the story is on individuals such as Mr. Cayre, the CEO who flipped his allocation of Pixar shares for a substantial profit, and whether this sort of conduct creates any disclosure issues under either federal or state law. In Part III, I examine the separate issue of whether this CEO may be usurping a corporate opportunity when someone such as Mr. Cayre receives Pixar's hot IPO shares for his own account, an inquiry which may give rise to a possible breach of fiduciary duty claim against the corporate officer.

The moral of this story is set out in Part IV, where I explore the implications of my analysis of the story of spinning, focusing primarily on corporate managers, as well as the transactional lawyers who advise these business clients. By way of conclusion, this story of "spinning in a hot IPO" provides compelling evidence that the courts should continue to strongly enforce a rigorous standard of fiduciary duty as the default rule in our modern system of corporate law. Thus, the lessons learned from the story of "spinning" stand in sharp contrast to the modern law and economics view that parties should be afforded complete freedom to contract for the entire scope of fiduciary duty between owners and managers of the corporate enterprise. In this way, the story of spinning serves to emphasize the important and influential role that the law of fiduciary duty continues to play in shaping and monitoring standards of fair and ethical conduct for modern corporate managers, and, in the process, serves to reinforce the professional responsibility of modern corporate lawyers.

1. SPINNING BY THE LEAD UNDERWRITER

   By way of general background, the lead underwriter is a broker-dealer firm that is subject to regulation by both the SEC and the NASD. The issuer hires the lead underwriter to manage a company's IPO. (11) As a matter of generally accepted practice today, underwriters offer investors--both individuals and institutions--the opportunity to invest in hot IPOs. In recent years, institutional investors have dominated the market for IPOs. (12) In the hot equity market of the late 1990s, however, individual investors increasingly demanded the opportunity to invest in hot IPOs and their voice did not go unnoticed. With some important assistance from recent developments in Internet-based technologies, the securities markets responded by increasing the direct participation of individuals as retail consumers of shares of hot IPOs. (13) The focus of this section, therefore, is on the allocation of shares made by the lead underwriters in a hot IPO, (14) with the primary emphasis on the decision to allocate hot IPO shares directly to the trading accounts of certain types of individual investors.

   Under the 1934 Act, (15) the NASD has been delegated considerable authority to regulate the lead underwriter and its practice of allocating IPO investment opportunities, subject to SEC oversight. The SEC reviews both the promulgation of the NASD's substantive rules, as well as the enforcement of these NASD rules. (16) In addition, the registration statement that the issuer files with the SEC must include detailed disclosures regarding the underwriter's plan of distribution for the corporate issuer's IPO. (17) This section first examines various aspects of the SEC's disclosure requirements as they apply to the underwriter's decisions regarding allocating shares in an IPO. More importantly, however, the remainder of this section analyzes the various NASD rules that regulate the lead underwriter's decision as to how to allocate shares in an IPO transaction.

   1. Disclosure of the Underwriter's Allocation Decisions Under Federal Securities Laws

      In general, the lead underwriter's decision as to how to allocate the shares of an IPO is not subject to substantive regulation under the terms of either the 1933 or the 1934 Acts. (18) This means that the lead underwriter, acting pursuant to the authority delegated to it by the other members of the underwriting syndicate, has broad discretion in deciding how to allocate the shares in an IPO. (19) However, the failure to disclose the practices used by the lead underwriter, acting on behalf of the syndicate, to make its decision as to the allocation of IPO shares may give rise to several different types of potential disclosure violations under federal securities law. (20) Let me illustrate these potential disclosure issues in the context of the lead underwriter's decision to spin out shares of Pixar's hot IPO to the personal discretionary trading account maintained by Mr. Cayre with Pixar's lead underwriter, Robertson Stephens.

      Item 508 of Regulation S-K (regarding the issuer's plan of distribution) generally requires disclosure of the underwriter's plan for the distribution of the registered public offering. In the context of the IPO for GT Interactive Software, this would be the plan for distribution of the common stock of GT Interactive Software. Specifically, Item 508(a) requires disclosure of any material relationship between the issuer, GT Interactive, and the company's underwriter, Robertson Stephens. (21) As a threshold matter, Item 508(a) requires a determination whether Robertson Stephens's prior allocation of Pixar shares to Mr. Cayre's personal trading account gives rise to a material relationship between the underwriter and the registrant. (22) Since Item 508(a) does not directly focus on the relationship between the company's officers and the lead underwriter, this seems to be a fairly attenuated analysis. It would seem that disclosure would be required only if there is some suggestion that the prior allocation was made under circumstances that--either explicitly or implicitly--obligated Mr. Cayre to use the services of Robertson Stephens. "Absent such an agreement, it would seem difficult to establish that there is a `relationship' requiring disclosure." (23) Most securities lawyers would probably conclude that disclosure of prior spinning activity is not directly called...