Moral Hazard and the Initial Public Offering

Abstract

Although intense scrutiny has been focused recently on investment banks, initial public offerings, research analysts, and market makers, regulatory reforms have stopped short at criticizing wholesale the initial public offering process in the United States. This paper argues that the bookbuilding process, the almost exclusive method of distributing IPO shares in the U.S., is the root cause of the abuses that occurred in the IPO market in the 1999-2000 bubble. Although investors have tended to view an IPO led by a Wall Street firm as an attractive product with a trusted brand name attached, these firms were taking issuers with questionable potential to the market, gleaning profits for their cronies and customers, then leaving the retail investors to sell their shares after the market reached equilibrium below the original IPO share price. To place the customary practices of the IPO industry in context, this paper compares the legal practices of Wall Street investment banks that restrict supply and create artificial demand to illegal pump-and-dump schemes conducted by fly-by-night brokerage houses.

In the bookbuilding process, agency problems and conflicts of interest abound between and among the participants, including the underwriter, the issuer, the founders, the institutional investors, the analysts, and the retail investors. The moral hazard created by these agency problems results in the underwriter manipulating the IPO market for the purpose of benefitting regular customers and potential investment banking clients. The most extreme abuses involve underwriters allocating IPO shares in return for outrageously excessive commissions. In addition, the founders' own self-interest causes them to manipulate the IPO market for the benefit of themselves, their relatives and friends, and the company's potential allies.

To improve the IPO process in the U.S., regulatory institutions should abolish the bookbuilding system in favor of more transparent, democratic processes, such as the Internet auction. The Google IPO will utilize a Dutch auction system and represents an issuer-led sea change in the IPO process. However, few, if any, issuers have the market power of Google to negotiate with investment banks to change the traditional IPO process. Without regulatory reform, the bookbuilding process, which benefits the investment banks to the detriment of the retail investor, will continue to dominate the U.S. IPO market.

Keywords: Initial Public Offering, Investment Bank, Research Analyst, Moral Hazard, Bookbuilding, Google

JEL Classification: D44, G14, G24, K22