The problem with venality in business is that getting outraged about it makes it easy to miss the systemic problems that venality often disguises. And that's exactly what's happened in the uproar over the Wall Street practice called "spinning."
"Spinning" has, apparently, been common on the Street for as long as anyone can remember, and yet it had never really been written about until a November 1997 article in the Wall Street Journal broke the story. The mechanics of it are simple: An investment bank that's underwriting an initial public offering gives shares in that IPO to corporate executives at companies with which the investment bank is either doing business or would like to do business. The executives can then "spin" the shares, which is to say, sell them for a quick profit as the stock's price bounces higher, something most IPOs have tended to do on their opening days of trading. Robertson Stephens, for instance, gave one client 100,000 shares in the IPO for Pixar, the company responsible for Toy Story; the client spun those shares into a $2-million profit. The assumption, of course, is that an executive who receives a gift like this will be more likely to direct his company's business toward the investment bank that proffered the shares. Quid pro quo.
If that's not unsavory enough for you, in some cases the investment banks don't give the shares to the executives until the stock has started trading well above the offering price. In other words, if an IPO's opening price is $20, and within a couple of hours of the opening bell it's trading at $35, a bank will choose that moment to allocate the shares to the executive's account. The executive gets the shares at $20 and sells them at $35, all in one fell swoop. Banks are able to do this only by abusing a regulation that permits them to cancel a mistaken allocation of IPO shares before the first trading day ends. The conversation, one imagines, goes a little bit like this: "Now that the stock's price has risen, I realize I didn't mean to give them to this person's account. I meant to give them to you! Now, about that deal we were discussing ..."
Well, it's probably not quite that crude, but spinning does seem unquestionably to violate state laws that prohibit corporate executives from taking personal advantage of financial opportunities that they get because of their position at a company. One columnist recently wrote that "America's unique strength has always been that the path to success isn't totally rigged, that it's not simply about being a member of some inner circle that cuts you in on the action for life," and that spinning threatens this strength. But though he deserves a nice pat on the back for the graduation-speech rhetoric, thinking in terms of fairness doesn't really get us very far. Spinning is unfair, but then so is life, as our parents told us. To see why spinning really should be eliminated, you have to look at the question from a hard-nosed efficiency angle.
Why, after all, do we have laws against bribery? If someone really wants my company's business, why shouldn't he be able to do everything he can--including paying me off--to get that business? Because bribery encourages people to make decisions based on the wrong criteria, which means in the business world that it distorts the efficient allocation of resources. Absent the bribe, I would decide to give my company's business to Investment Bank A. But because Investment Bank B allowed me to spin shares in a new Internet IPO, I give my company's business to them instead.
This is bad in two different ways. First, I'm violating my fiduciary responsibility to my company, because I'm making a decision based not on what's best for it, but rather on what's best for me. Second, investment banks that already do a lot of IPO business will tend to get more business, simply because they have more shares to spread around. The rich get richer, not because they're more efficient but because their ability to bribe is greater.
Ordinarily, of course, bribery tends to be somewhat self-limiting, in the sense that you don't want to spend more on bribes than the revenue that you generate through them. But spinning costs investment banks nothing at all. Once an investment bank has underwritten an IPO--which means that it has committed to selling all the company's available shares at a set price--all it has to worry about is making sure those shares get bought. Needless to say, people are anxious to buy shares when they know they can sell them seconds later for an easy profit. So while a company that bribes customers is typically hurt by the fact that money that could have gone toward profitable investments instead goes toward bribes, in the case of spinning, both briber and bribee win.
The fact that some investment banks are getting more business than they otherwise might is a good enough reason for regulators to step in. But spinning has still worse consequences. The practice works only if the price of an IPO bounces significantly higher on the first day. That gives investment banks an incentive to set opening prices lower than they should be. Instead of taking a company public at $30 a share, and watching it trade at $30 all day long, an investment bank can take a company public at $20 a share, watch it jump to $30 right after the opening bell, and allocate those now-profitable shares to its clients.
It's possible, of course, that investment banks just keep getting surprised over and over again by the strong demand for IPOs, and that they really make their best effort to match opening prices with market demand while giving themselves reasonable insurance against getting stuck with unsold shares. But somehow it seems unlikely that spinning would have become such an institutionalized practice if investment banks didn't have a pretty good sense that a stock's price was going to jump on its opening day. And that means the real losers are the companies whose IPOs end up underpriced.
Underpricing an IPO, of course, deprives the newly public company of capital. When Pixar went public, the money raised from that very first sale of its shares was what it used to run its business in the future. But Pixar went public at a price 77 percent lower than the highest price people paid for its shares on the opening day of trading. And while it would be a mistake to say that the stock could have opened at that highest price, it's safe to say that if Robertson Stephens had done a better job of gauging demand, millions of dollars that went into traders' pockets would have gone into Pixar's vaults instead.
What's frustrating about all this is that the moment when a company goes public is when the stock market should function most efficiently. That's the only time when the money you pay for a stock goes right to the company, rather than to another trader. The price of an IPO, then, should reflect as nearly as possible what investors really think about a company's prospects. And yet everything about the IPO process--from spinning to the fact that shares are distributed mainly to large institutional clients to the fact that some investors are fed information before the IPO that other investors never see--works against the market's efficient operation. Wall Street has come a long way from the insider-dominated world that was blown apart by the Great Depression. But spinning is an excellent reminder of how far toward real transparency the Street still has to go.