Facebook’s IPO was not a financial disaster for everyone. According to the Wall Street Journal, Morgan Stanley and other underwriters made a profit of about $100 million stabilizing Facebook stock since the start of trading.
How did Main Street investors do? Not so well. The value of Facebook stock purchased at the initial price of $38 lost well over $600 million in value. Facebook stock closed at $31.91 on Friday.
It gets worse. There are published reports that analysts at Facebook’s underwriters cut earnings estimates for the company in the middle of its IPO roadshow. That would be bad enough, but here’s the kicker: This information was reportedly conveyed to large institutional potential buyers of Facebook stock, but not to Main Street investors. Clearly, this is material information which, if known, would have affected not only the price at which investors would have been willing to pay for the stock, but also whether they would buy it at all.
The Financial Industry Regulatory Authority is reportedly reviewing these allegations. Morgan Stanley defended its conduct, noting that the procedures it followed were the same ones it used for all IPOs. That’s a scary observation.
This is not the first time Morgan Stanley has been in hot water over its handling of IPOs. In 2003, the SEC alleged that Morgan Stanley created conflicts of interest for its research analysts. The conflict arose because of Morgan Stanley’s goal of generating investment banking business (so that it could be lead underwriter in profitable IPOs), and the responsibility of its analysts to generate objective research reports. If these reports were unfavorable, it could prevent Morgan Stanley from winning the IPO business.
In 2005, the SEC filed a complaint against Morgan Stanley relating to its conduct from March, 1999 to November, 2000, in allegedly inducing customers to place orders for shares in the aftermarket of IPOs, in violation of SEC Regulations. And in 2006, the SEC accused Morgan Stanley of failing to produce tens of thousands of e-mails relating to its practice of allocating shares of stock in IPOs and alleged conflicts of interest between its research and investment banking practices.
I don’t mean to single out Morgan Stanley. It’s no better or worse than its brokerage colleagues. The SEC settled its analyst conflicts case against ten of the largest Wall Street firms in April, 2003. Among those settling (in addition to Morgan Stanley) were Credit Suisse, Goldman Sachs, JP Morgan, Citigroup, and Merrill Lynch.
The reality is that the brokerage model is fundamentally flawed and rigged against small investors. Regulatory actions frequently result in penalties that amount to little more than a slap on the wrist. These settlements are carefully worded. The brokers don’t admit liability and promise not to violate the securities laws in the future. Yet they continue to do so and the charade continues. Jed Rakoff, a U.S. district court judge in the Federal District Court in Manhattan, has been outspoken in his criticism of these settlements. He recently observed that defendants in SEC settlements repeatedly violate their agreement to comply with the securities laws. He pointed out that the SEC has not brought any contempt charges against large financial firms in the past ten years.
Main Street investors in IPOs are lambs waiting to be slaughtered. Don’t expect protection from regulatory agencies. Never has the maxim of “caveat emptor” been more appropriate.
Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.
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