Implications of Auction Theory for New Issues Markets (2002)

Implications of Auction Theory for New Issues Markets Lawrence M. Ausubel Imagine attempting to explain to a visitor, from another era or another planet, the economic rationale behind various institutions in the American economy at the start of the twenty-first century. Few practices seem more difficult to justify to the outsider than the current procedure for the issuance of equity securities. The share price in initial public offerings (IPOs) often bears little connection to the equating of supply and demand, so IPOs are sometimes massively oversubscribed and the share price increases by as much as a factor of five from the offering price to the close of the first day of trading. Shares in these oversubscribed offerings are rationed, not according to willingness to pay but to favored clients of the underwriting investment banks. Often there is at least the appearance that clients receive their allotments in exchange for returning value to the investment banks in other transactions; and recently there have been allegations that some allotments have been made in exchange for agreements to buy additional shares on the open market after the IPO. Although the associated returns forgone by the sellers (that is, the companies going public) would be easier to justify if the explicit fees for the service were [End Page 313] commensurately discounted, the explicit fees charged for IPOs seem quite high, generally a 7 percent commission on proceeds from the new shares.1 The main objective of this paper is not to hammer away at the inefficiencies present in the current system of new equity issuance or to explain what prevents the current system from being swept aside. Rather, this paper seeks to draw from new developments in market design—both theoretical results and new practices in other sectors—and to highlight alternative procedures that may be best suited to supplementing or replacing the current flawed system. Comments on Current Practice for New Equity Issuance The years 2000 and 2001 have seen Securities and Exchange Commission (SEC) investigations into two alleged abuses in the current practice for new equity issuance, a $100 million tentative settlement of charges by Credit Suisse First Boston, and a plethora of private lawsuits. In May 2001, the Economist provided an early, well-written, and somewhat skeptical synopsis:2 Were investment banks crooked when they made billions of dollars from the Internet bubble? It [Wall Street] enjoyed the dotcom party as much as anyone. But now that the whole thing has ended messily, Wall Street has become everybody's favourite scapegoat. Its analysts are accused of abandoning objectivity to tout shares that their investment banks underwrote. Underwriters are said to have set the share price too low in initial public offerings (IPOs), so as to ensure a huge jump in the price when trading began. That jump in turn enabled investment banks to reward favoured clients who were allocated shares in the IPO, which clients could instantly sell at a fat profit. To compound the rascality, the banks shared in those profits by demanding return favours from the clients. No matter how far-fetched or corrupt this scenario seemed, by early 2002 substantial evidence had accumulated supporting some of these claims. Credit Suisse First Boston had reached final agreement on a $100 million settlement of government charges. According to published [End Page 314] accounts, "The regulators singled out First Boston, accusing it of demanding that customers pay back some of the profit they made from trading new stocks in the form of inflated commissions on other stock trades. Investigators gathered evidence, including e-mail messages, that indicated that the firm's sale representatives had told some customers to pay the firm at least $1 in commissions for every $3 of new-stock trading profits."3 Furthermore, "Plaintiffs' lawyers have filed more than 1,000 lawsuits against First Boston and about four dozen other securities firms, asserting that they manipulated the prices of new stocks in various ways. Those suits contend that sales representatives at First Boston gave relatively big allocations of new stocks to professional investors in exchange for a share of the profits those buyers made by reselling the stocks. They also contend that other investment banks, including Goldman...