Investors needn’t worry that there are serious abuses in initial public offerings (IPOs) of shares in Canada similar to those recently exposed by law officials in the United States.
If stock prices were to jump dramatically following an IPO in Canada as they often do in the United States, things here might be different. But given the approach taken by Canadian investment dealers in pricing new issues, post-IPO price jumps in Canada are rare, and when they do occur, they are modest. As a result, there is little incentive here for the questionable practices that have come to light south of the border.
The key difference between the United States and Canada is that individual employees and brokers working in U.S. underwriting firms traditionally have been able to buy hot IPOs along with other investors at the issue price. In other words, many U.S. brokers also get to participate in the price jump.
In Canada, the situation is much different. While brokerage employees in Canada can legally buy IPOs, policies at the major brokerage houses allow the purchase of IPOs by brokers only after all customer orders are filled.
Thus, in the case of a hot new issue with customers jumping on the bandwagon, the brokers and other employees of Canadian underwriting firms don’t get any shares. The corporate finance team pricing the issue and the retail brokers selling it can’t benefit directly from a post-IPO price jump.
This means the incentives for pricing new issues are different in Canada than in the United States. In Canada, the incentive is to get the highest price possible for the issuing client (a company trying to sell stock into the market). By getting the highest price and generally doing a good job for the issuing client, the underwriting firm not only earns its fee but gets a positive reputation that can attract more issuing clients. The corporate finance officials pricing the new issue benefit directly through higher bonuses for the fees they attract.
Over time, this has created a much different set of market expectations for IPOs in Canada. With a Canadian IPO as likely to see a price decline as a price increase, the process doesn’t invite as much investor speculation or set up a major incentive for abuse.
In the United States, the lead broker in the underwriting instead uses its influence to keep the IPO price as low as possible, thereby yielding a big profit for employees along with other investors as the price doubles or triples after the IPO. The stock-price gains for the corporate finance team and retail brokers participating in the new issue can far exceed the usual 5 to 8 per cent underwriting fee.
The fact that stocks often double or triple in the days following an IPO has generated some questionable practices. U.S. underwriting firms have been caught bestowing hot IPOs to senior executives of companies they want investment banking business from. It is a practice known as “spinning.” Former star investment banker Frank Quattrone is facing obstruction of justice charges stemming from IPO spinning.
U.S. underwriting firms have defended the spinning practice by saying the executives are simply good clients and that is why they got the shares allocated to them. But the executives on the receiving end are obviously in a conflict of interest position in any subsequent decision-making on which underwriting firms to use.
Another questionable practice of U.S. underwriting firms is known as “laddering,” whereby IPO buyers, in exchange for receiving shares at the low IPO price, agree to purchase more shares in the open market at a higher price immediately after the IPO. This, of course, helps drive up the stock price after the IPO and serves to provide buyers at high prices for stock doled out to brokers and their corporate friends.
If stock prices didn’t jump so high after an IPO, these practices wouldn’t make sense. If the chances of losing were as great as the chances of winning on an IPO, and if the gain when it occurred was usually only 5 or 10 per cent, who would want an allocation of shares?
In a market ruled by greed, change the incentives and you’ll change the outcome.
Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.
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©2003 Wayne Cheveldayoff