.comment: Something Wicked This Way Comes - page 2
Wrong Time, Wrong Place
Because once the stock market had reached the stratosphere many investors thought they had been left out, initial public offerings -- IPOs, which are the first time a company offers shares of itself in public trading, as opposed to venture capital investment -- were seen by many as perhaps the only way to get in at bargain prices. IPOs at that time typically tripled or more in value the very first day. (Red Hat, for instance, was offered at $14, but by the end of the first day was at $54.) But there is always a finite number of shares available, not enough for everybody who wants them (which is why the price rises, all else being equal, which in this case it wasn't). Who gets to buy shares at the IPO price? That is determined by the "underwriters," brokerage firms hired to administer the IPO.
Those who were paying attention will remember that Red Hat set aside a block of shares for those in the community who had contributed to the things in their distribution. And they will remember further that there were all kinds of irregularities as community members sought to exercise their options to purchase those shares. They were angry about it at the time. Most of the shares, though, were distributed by underwriters. Here is where the allegations of illegality are raised.
Though I have no patience at all with plaintiff's lawyers, this time they may have a case, according to federal investigators and people in the investment community with whom I've spoken. Their case, though, isn't limited to Linux securities -- it could be brought against just about any company that had an IPO during that era.
Here's why: The underwriters, investigators and investors say, were making all kinds of demands in return for permission to buy shares at IPO prices. The abuses -- which such demands certainly are -- covered a wide range, all of which stink to the high heavens. Investors were required to purchase shares in other, less attractive companies. They were required to purchase an equivalent number of shares of the IPO stock later, at a higher price. They were required to keep their shares after the price rose, rather than sell them at a profit. They were required to pay in commission a percentage of their profit on the IPO stock. None of this was in writing, but in each case it was understood that violating these demands would lock the investor -- typically a mutual fund -- out of future IPOs, which was tantamount to a death threat at the time for fund managers who needed to show huge profits on paper.
These things tend to force the share prices to artificially high levels. Anyone who later bought shares -- which means almost everyone who invested in the company -- would be buying stock at a price based not on the actual or anticipated value of the company but instead on the manipulations of the underwriters. This is illegal. Indeed, I am told, we can expect to hear of indictments of brokerage houses involved in 1990s IPOs, or perhaps some of those houses agreeing to pay huge fines as part of settlements with the government. We can also expect more class-action lawsuits. (For those who do not follow the law, a little primer: The SEC may well indict some underwriters. This is about punishment, not repairing the damage. Damage repair is the bailiwick of civil law, which is where people file lawsuits.)
Okay, so what does this have to do with the companies themselves? Even if the underwriters are in the wrong, why sue the companies? Aren't they as much victims as the investors were?
Imagine that you buy a new carpet. You sign a contract with the rug company, who hires a different company to install the carpet. The carpet installers come and, while installing the carpet, help themselves to the silver. Who do you go after? The carpet company with whom you have the contract. It's up to them, then, to go after the company with whom they had the contract. (Yes, it's a grossly oversimplified example. For instance, you'd also call the police. And perhaps the individual carpet installers would go to jail. But you want your silver -- or its value in money -- back, and that's a civil action.)
When a company offers shares to the public, it must publish a document called the Prospectus. This is supposed to detail the company's prospects for making money as well as the terms and conditions of the offering. The officers of the company must affix their signatures to the Prospectus, certifying that what it says is true. The company and its officers are the ones doing the certifying; the underwriters are just the hired help -- the carpet installers. It's up to the company to go after them if they think they can. (The playing field is by no means level: Red Hat will run out of money to pay lawyers long before the underwriters, big investment houses, will. This figures in in another way: The company is more likely to settle quickly, to make the whole thing go away. This means paying practically nothing to the plaintiffs and a great deal to their lawyers. This stinks as badly as anything the underwriters are accused of having done, but it's perfectly legal. Absent membership in the bar or a position as head of Rainbow-PUSH, it would be called "extortion.")