TCS Daily

Bad for Investors, Bad for the Market

By Stephen Bainbridge - March 9, 2006 12:00 AM

A New York court recently held Clark McLeod, the former chairman and CEO of McLeodUSA, liable under the Martin Act for fraudulently failing to disclose his participation in a stock-spinning scheme with investment bank Salomon Smith Barney.

What is spinning? In return for hiring a given investment bank to do their firm's work, executives of that firm receive preferential allocations of shares being sold in an IPO by another client of that investment bank. The executives then sell those shares almost immediately, typically at a much higher price than then IPO sale price. As the New Yorker explained:

"Salomon Smith Barney, like so many firms on Wall Street, seeks to please its clients. On June 24, 1997, when it was still Salomon Brothers, it offered one of those clients, Bernie Ebbers, the CEO of WorldCom, the opportunity to buy more than two hundred thousand shares in the initial public offering of a telecommunications company called Qwest. At the time, the IPO market was lucrative, and a bet on Qwest was a virtual lock, so Ebbers bought in. Three days later, Qwest's stock price was up twenty-seven percent, and Ebbers began selling. In the end, he cleared almost two million dollars. Clients appreciate this sort of thing, especially when it happens more than once. Between 1996 and 2001, Salomon helped Ebbers earn eleven million dollars flipping IPO shares.

"As it happened, while Salomon was making Ebbers richer, he was sending a lot of business its way. Between 1997 and 2001, according to Thomson Financial, WorldCom paid Salomon a hundred and forty million dollars in fees for its underwriting of the company's debt and equity, and another $76 million in fees for its advice on mergers and acquisitions."

During the dot-com era, this sort of thing was regarded as perfectly normal. Executives saw spinning as one of the perks of office, while investment bankers treated it as a slightly more expensive version of sending a fruit basket to a loyal client.

Spinning is a problem both from the perspective of an individual firm and from that of the market as a whole. As to the latter, spinning apparently accounted for at least some of the persistent problem of under-pricing of IPO stocks. Again, the New Yorker explains that:

"IPOs rose, on average, seven percent on the first day of trading. Between 1990 and 1998, they rose 15 percent. And in the dot-com heyday, between 1998 and 2000, they rose 65 percent. One of the main causes for this surge was Wall Street's desire to keep itself supplied with baksheesh to hand out to coveted clients.

"This, in turn, deprived small companies of money that might have made the difference between life and bankruptcy. It corrupted the efficient allocation of capital, which is supposedly the whole reason that Wall Street exists. And it allowed the biggest investment banks to insulate themselves from competition, by creating a self-reinforcing pattern: the more business the banks did, the more bribes they could hand out, and the more business they got."

As to the effect on individual firms, despite protestations in some circles that cracking down on spinning is unprecedented and despite how often spinning apparently occurs, it is such a basic violation of corporate executive's fiduciary duties that the only surprising thing is how long it took for Spitzer and the trial bar to start filing lawsuits.

As agents of their corporate employer, executives are subject to a fiduciary duty of loyalty to their employer. The comments to Restatement of Agency § 388 thus explain that: "an agent who, without the knowledge of the principal, receives something in connection with, or because of, a transaction conducted for the principal, has a duty to pay this to the principal even though otherwise he has acted with perfect fairness to the principal ...." The improper secret profit might simply be a gratuity, a tip, paid by a happy third party who wants to reward the agent for his or her hard work. Alternatively, the secret profit could take the form of a kickback demanded by the agent (e.g., the agent may refuse to direct the principal's business to the third party unless the third party makes a side payment to the agent.) Finally, as is the case with IPO spinning, the secret profit could come in the form of a bribe paid by the third party to assure that the business will come the third party's way. Regardless of the precise nature of the side payment, however, it still constitutes a breach of the duty of loyalty.

The illegality of IPO spinning under these principles was confirmed by the Delaware Chancery Court in a lawsuit against executives of eBay who spun shares sold to them by Goldman Sachs. The plaintiffs, who were shareholders of eBay, suing derivatively on behalf of the corporate entity, advanced the somewhat clever argument that the executives usurped a corporate opportunity from eBay.

The court agreed, holding that by spinning IPO shares eBay's executives had taken a business opportunity that properly should have gone to the corporation:

  • Investing in securities is within eBay's lines of business. Indeed, because almost all public corporations "consistently invest[] a portion of [their] cash on hand in marketable securities," the court's opinion suggests that spinning IPO shares will be within the lines of business of all firms. Arguably, eBay is unique, in that investing in marketable securities was an unusually large part of its operations, but the court did not so limit its opinion.
  • eBay was financially able to undertake the transactions.
  • The transactions are basically kickbacks which went to eBay's agents rather than the corporate principal. As such, the defendants had placed themselves in a conflict of interest situation, since their judgment as to selection of an investment bank would now be tainted by the kickbacks.

How about the remedy? As Restatement § 388 puts it: "Unless otherwise agreed, an agent who makes a profit in connection with transactions conducted by him on behalf of the principal is under a duty to give such profits to the principal." Accordingly, the eBay executives had to turn over the profits they made from spinning to eBay.

Regular readers of my TCS columns and blog know that I'm no fan of Eliot Spitzer. Even a stopped clock gets it right twice a day, however, and when it comes to IPO spinning Spitzer was on the side of the angels. Spinning's bad for investors and the market. It was long since past time to shut it down.

Stephen Bainbridge is Professor of Law at UCLA. He writes a weekly column for TCS.


1 Comment

Don't be Evil?
Maybe this is why Google bypassed the investment bankers when they did their IPO. They used a Dutch Auction to price and allocate their initial shares. The Old Boy network didn't like this, and they'd love to see GOOG punished for its heresy.

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