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Officials Suspect IPO Manipulation

May 21, 2001 | USA Today Joseph Schacherer feels he was cheated by Wall Street.

Like so many small investors who chased a share of the Internet dream, the Oceano, Calif., resident hoped to invest in the hotly anticipated initial public offering of Red Hat, the software vendor that went public in August 1999 for $14 a share.

"I tried to buy at the IPO price, but I couldn't," says Schacherer, a small investor who, with his wife, Janet, ultimately lost nearly $70,000 on Red Hat shares bought for as much as $57.25 each. "There was too much competition, I guess."

Schacherer says he suspects the lucky buyers might have had a secret and possibly illegal inside edge that shut out average investors. So do federal investigators and securities industry regulators.

The Securities and Exchange Commission and the Manhattan U.S. Attorney's Office are investigating evidence alleging that competition for shares of Red Hat, VA Linux Systems and hundreds of other firms that went public since 1999 may have been artificially manipulated by the Wall Street investment banks that managed those stock offerings.

In interviews with USA TODAY, employees of major Wall Street firms and securities officials provided inside details of how the IPO market operated during the tech frenzy.

The investigating agencies, which also include the regulatory arm of the National Association of Securities Dealers (NASD), are focusing on whether the investment banks demanded kickbacks in the form of higher commissions in exchange for coveted IPO shares. Investigators are also weighing evidence that the banks fueled the Internet bubble by pressuring some large investors who got IPO shares to buy more at higher prices after the stock began trading.

Both practices are illegal.

In a parallel attack, Schacherer and other investors who bought in after the value of the IPOs zoomed 100% or more have barraged federal court in Manhattan with dozens of civil class-action lawsuits. The investors say the suspected manipulation cost them millions on stocks that initially soared, only to collapse when the IPO bubble burst last year.

The investment banks ordered to turn over records to investigators include Credit Suisse First Boston, Goldman Sachs, J.P. Morgan, Morgan Stanley, Lehman Bros. and Bear Stearns, according to officials and public filings. All of the investment banks deny wrongdoing and say they are cooperating with prosecutors and regulators. The investigators, citing grand jury secrecy, refuse to discuss the cases.

Howard Sirota, a New York City attorney whose firm has filed many of the class-action lawsuits, says stock manipulation once was confined to a relatively small group of renegade firms. "Now, it's the top-tier firms manipulating IPOs in the aftermarket, just like boiler rooms," Sirota charges.

A license to print money

The investigations focus on the initial stock offerings issued by companies seeking to raise investment capital from the public. Investment banks underwrite the offerings by buying the shares at a fixed price and selling them to investors at a profit in the initial public stock offering. The next day, the shares begin trading on the open stock market, in what Wall Street calls the "aftermarket."

Credit Suisse First Boston (CSFB), which handled one out of four Internet IPOs last year, has taken the brunt of the investigation so far. A little more than a year after it celebrated its success with a grand fireworks display in Aspen, Colo., three of its executives have been placed on administrative leave. Additionally, CSFB and about six of its employees are expected to be charged by the NASD with violating securities rules, according to a source familiar with the matter.

In response, a CSFB spokeswoman quoted from a recent public filing, in which the firm acknowledged that the NASD "has notified CSFB Corp. that it is contemplating bringing a proceeding against CSFB Corp. based on the initial public offering allocations and the commissions and alleged practices by certain customers that had received such allocations."

But in interviews with USA TODAY, several current and former CSFB employees, securities regulators and professional money managers provided details of what they characterized as IPO manipulation. They agreed to speak only on condition of anonymity.

"It was rape and pillage," says one CSFB employee, who had a front-row seat at many sizzling IPO offerings, including VA Linux, and

The CSFB employees, securities regulators and professional money managers say managing IPO offerings during the 1998-2000 height of the bull market was a virtual license to print money. Everyone from seasoned traders to first-time investors elbowed for new issues that were certain to soar in the first days of trading.

But individual investors rarely got shares in IPOs. As is custom, investment banks parceled out IPO shares to influential corporate VIPs and large mutual funds and hedge funds, which generate the most business for the banks. The second-tier customers, smaller mutual funds and money managers, tried to snare allotments by paying higher commissions and agreeing to buy additional shares at higher prices, once the stocks began trading in the aftermarket, the CSFB employees tell USA TODAY.

"You could chart our commissions like a bell curve," says one CSFB employee, tracing a finger in the air for emphasis. "They rose a few days before a hot IPO and for a few days after, and then went back to normal."

The employee says he saw commissions as high as $1 a share cross his desk, far above the usual commission of 5 cents per share. Another employee with first-hand knowledge says other institutional investors would simply churn stocks — buying shares and immediately selling them — as a tactic to increase the amount of commissions paid to CSFB.

Launching an IPO into orbit

Trying to reconstruct these transactions, federal prosecutors requested records for all large trades in numerous IPOs, according to an attorney familiar with the issue.

"People know the higher they say they are willing to buy the stock (in the aftermarket), the bigger the allocation they are going to get," says Michael Sola, portfolio manager for T. Rowe Price's Developing Tech fund.

At CSFB, traders and supervisors made sure aftermarket buy orders were lined up to assure a strong performance after the IPO was launched, the company employees tell USA TODAY. They say the investment bank kept track of the aftermarket pledges, and any investor who didn't place expected orders got a reminder call.

"I would call (an investor) and say, 'The market is about to open, and we don't have your order yet,' " says a CSFB employee.

Those who reneged got shut out of the next IPO, the employee says.

CSFB knew there weren't enough shares available to fill all of the buy orders, which would cause the price to soar. That, in turn, would prompt institutional investors who got original IPO shares to sell their shares quickly to lock in gains, in a practice known as "flipping."

That may help explain why almost 22 million shares of, for example, changed hands on the first day of trading, when only 5 million shares were sold in the IPO. In essence, each share changed hands the equivalent of about four times, as the price of stock, which was priced at $14 a share, almost doubled on the first day.

Starting around early 1999, all CSFB institutional traders were issued monthly reports that detailed how many IPO shares their institutional customers received, how much the value of those stocks increased, and how much the clients had paid the company in commissions. If the commission levels seemed low, a CSFB representative would call or visit the investor to press for increased business, according to an employee and a hedge fund manager.

Securities laws prohibit quid-pro-quo commission deals.

Victoria Harmon, a CSFB spokeswoman, would not comment on the monthly reports.

Around the time of the VA Linux deal in late 1999, the employee says, CSFB issued a memo reminding traders that the NASD guideline for commissions says anything above 5% of the stock price is presumed "improper." As for that memo, Harmon says, "Part of the firm's responsibilities includes periodically reminding employees about the rules of the road. This appears to be no different."

One reason for the initial investigative focus on CSFB appears to be its lucrative role in bringing more Internet companies public last year than any other investment-banking firm.

Frank Quattrone heads CSFB's technology group. After he joined the investment bank in 1998, CSFB's 1999 Internet IPO business jumped to No. 1 in the industry, totaling almost $4 billion, up from a No. 10 finish the year before, according to Thompson Financial Securities data.

Quattrone, who declined to be interviewed, works with two of the senior CSFB executives who were placed on administrative leave. In a statement, CSFB said: "Frank Quattrone is responsible for delivering the firm's investment banking services to technology clients. He is not and was not responsible for overseeing brokerage accounts or commissions, nor is he or was he responsible for IPO allocations."

The analysts' role

After the IPOs started trading, stock analysts at the investment banks often published euphoric research reports with sky-high price predictions for these newly minted public companies. Many justified their assessments with newfangled valuation models, such as "share of mind," or "price to concept." The standard metrics of stock valuation, such as earnings and cash flow and sometimes even revenue, were often dismissed as "Old Economy."

"The Internet bubble completed the prostitution of Wall Street analysts," says Ron Glantz, a former Wall Street stock analyst and former managing director for the Tiger Management hedge fund.

Many investors might not realize the added motivation for analysts to make optimistic projections following an IPO. While analysts are required to disclose certain conflicts of interest, such as their firm's investment banking relationships, the stock pickers don't reveal how much of their paycheck is linked to these investment-banking deals.

At CSFB, analysts got a discretionary bonus, payable quarterly, for investment banking deals they worked on, from IPOs to mergers and acquisitions. Bonuses could range up to $1 million a year above what the analyst was guaranteed in compensation. By contrast, there was no set payout at CSFB for stock picking.

When choosing an investment bank for an IPO, an Internet company would naturally prefer an investment bank with an analyst who was upbeat about the Internet company or the industry. Analysts with "buy" recommendations were well positioned to earn investment-banking bonuses.

Congress has scheduled hearings in June to examine concerns about the abundance of "buy" ratings from analysts on Internet stocks that later tanked. The hearings will also examine the role investment banks played in the Internet boom.

"Where there is evidence of disparate treatment of the small, individual investor, we will address it," says Rep. Richard Baker, R-La., chairman of the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises.

And it appears institutional investors knew when it was time to stop paying attention to Wall Street analysts' bullish projections for Internet stocks. By the time the IPO craze cooled last year, many large investors had already bailed out. Today, individual investors own about 75% of the shares in Internet companies, compared with about 44% of the shares of General Motors, according to Value Line.

Among the average investors who got burned by holding new issues bought in the aftermarket is Idarto Tanumihardjo. The computer consultant at the University of Wisconsin-Madison says he bought 250 shares of PlanetRx stock when it traded in the $20 range, roughly $4 a share above the online pharmacy's October 1999 IPO price. The stock hit $36.50 on the first day of trading, then hovered in the mid-$20s before slumping to its current 27 cents a share.

"It's not worth anything now," laments Tanumihardjo, a small investor who has filed a class-action suit that alleges the IPO was manipulated. "It's junk."

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