The IPO process generally consists of three phases: (1) developing the information and documents for submission to SEC, (2) processing these documents through SEC, and (3) marketing and selling the newly public shares. Before the initial sale of their stock is permitted, companies are required to register the IPO with SEC. Companies that want the SEC to declare the IPO effective must first complete a registration statement. The registration statement is to contain basic required information about the offering, such as the name of the company, the number of shares to be publicly traded, and the offer price. The company then submits the registration statement and a preliminary prospectus to SEC. The primary purpose of the prospectus is to inform the investing public of all material information about the company and the security being offered for sale. For this reason, SEC rules require companies to disclose in the prospectus detailed information about the company. Specifically, this detailed information is to include a description of the company’s business and the identity and experience of its management, the risk factors in the company’s operating history and the nature of its business, the names of its current major stockholders, and the company’s financial statements. In addition, the company is required to disclose in the prospectus information on its underwriting firm, including the members of the underwriting syndicate, any relationships between the underwriting firm and the company, and whether the underwriting firm has had less than 3 years of broker-dealer experience. In reviewing the preliminary prospectus, SEC staff are to assess whether the prospectus provides all material information about the issuer, underwriter, and security being offered for sale. SEC has used a working definition, founded on court decisions, that considers information material when there is a substantial likelihood that a reasonable investor would consider it important in determining whether to purchase a security. In their assessment, SEC staff are to use public and nonpublic sources of information to identify areas in the preliminary prospectus that they believe to be incomplete or inaccurate. SEC staff are also to determine whether the financial statements in the preliminary prospectus conform to generally accepted accounting principles. On the basis of its assessment, SEC staff may request that the company revise the preliminary prospectus. When SEC requires no further revisions, the registration process is complete, and IPO securities can be sold to investors. The IPO process is described more fully in appendix I. Underwriters play an important role throughout the IPO process. Companies typically use underwriters, along with lawyers and accountants, to assist them in registering the IPO with SEC. Companies also rely on underwriters to help market and sell the IPO to the investment community. Underwriters can sell IPO shares by either serving as an agent for the company or as owner of the shares. As an agent, the underwriter assumes no financial risk for the sale of the IPO shares since the company retains ownership of the shares. Alternatively, the underwriter can purchase some or all of the newly issued shares to resell to other investors at a maximum price known as the “offer price.” In this case, the underwriter, as the new owner of the IPO shares, assumes financial risk for the issuance of the IPO shares. Underwriters also can be involved in market stabilization of the price of the security during the sales period and the period following the cessation of sales efforts in the offering. While underwriters play an important role in a smoothly functioning IPO process, underwriters could adversely affect an investor’s investment risk through certain activities, such as fraud and market manipulation, which are illegal, and favoritism, which is not. For example, an underwriter can profit from engaging in prohibited practices, such as “free-riding” or “withholding.” An underwriter engaging in free-riding purchases securities with the intent of not paying for them or with the intent of paying for them only if the price goes up by the settlement date. The underwriter can then sell the securities at a price higher than the purchase price and the sales proceeds can be used to cover the purchase obligation. An underwriter engaging in withholding can profit directly or indirectly from a price rise on the sale of IPO shares by withholding a certain number of shares from the market until the market price rises above the offer price. Withholding a sufficiently large number of shares could cause the price to rise quickly in the period following the cessation of the sales offering. Furthermore, underwriters could give certain investors an economic advantage by favoring those investors over others in sales of IPO shares at the initial offer price. Many academic studies have found that investors can profit from buying IPO shares at the offer price. According to a March 17, 1994, study by Prudential Securities, a significant difference exists between the performance achieved by investors able to buy at the offer price and the performance achieved by investors who buy after the first day of trading. Both SEC and the National Association of Securities Dealers (NASD), the self-regulatory body for broker-dealers, conduct periodic examinations of broker-dealers’ underwriting firms to detect rule violations. When violations are found, the regulators can impose a variety of disciplinary actions. For example, minor violations may result in a letter of caution to the violator; more serious violations can warrant a formal disciplinary action, such as a suspension and/or a monetary fine. Individual brokers and their firms are required to report any formal disciplinary actions taken against them to the Central Registration Depository (CRD). These disciplinary actions for violations related to the securities business may be imposed by SEC, state regulators, self-regulatory organizations (SRO), the courts, or employing firms. To obtain information on the factors that influence underwriting firms’ allocation of IPO shares between institutional and individual investors, we interviewed SEC officials responsible for market regulation to determine what rules, if any, govern the allocation of IPO shares. We also reviewed NASD rules to identify those affecting the IPO allocations process. We also randomly sampled 50 of the 952 IPOs that SEC processed from January 1, 1993, to June 30, 1994. For each of these offerings, we identified the underwriting firm from an SEC listing of IPOs. Thirty-four underwriting firms were associated with these 50 IPOs. Of these 34 firms, we judgmentally selected 10 firms to obtain a better understanding of the IPO process and the factors that influence the distribution of IPO shares. Of the 10 firms selected, 6 were large underwriting firms that were each responsible for over $1 billion in IPOs, and 4 were smaller underwriting firms that were each responsible for under $1 billion in IPOs between January 1993 and June 1994. To obtain a perspective on underwriting practices from other than New York firms, 2 of the 10 firms were located outside of New York. One of the two underwriting firms was located in Atlanta, and the other was located in Baltimore. For each of the underwriting firms, we interviewed senior officials responsible for selling IPO shares to investors. We visited officials at the New York and Baltimore underwriting firms; however, we interviewed officials at the Atlanta firm over the telephone. During these interviews, we discussed the IPO allocation process, the pricing of IPOs, and the disclosure of information about underwriters’ disciplinary histories. To determine disclosure requirements for underwriting firms’ disciplinary histories, we first identified existing disclosure requirements that could pertain to underwriting firms. We discussed these requirements with SEC officials responsible for processing IPO registrations in Washington, D.C., and New York. We also discussed these requirements with officials from the underwriting firms during our conversations on the IPO allocation process. We obtained the disciplinary histories of the 34 underwriting firms in our sample from the CRD. Specifically, we obtained information on (1) formal disciplinary actions taken against the 34 underwriting firms for the 5-year period preceding the issuance of the IPO and (2) specific securities violation(s) that gave rise to such actions. We obtained and reviewed the prospectus for each of the 50 IPOs in our sample to determine what types of information were disclosed. In reviewing the prospectus, we determined that information concerning the underwriter’s disciplinary history was not disclosed. We discussed the disciplinary actions and related violations with SEC officials and the 10 underwriting firms’ officials to obtain their views about the benefits from and any concerns about disclosure of such information in the prospectus. Our work was performed in New York, Baltimore, and Washington, D.C., between May 1994 and August 1995 in accordance with generally accepted government auditing standards. We obtained written comments from SEC on a draft of this report, and we have reprinted their letter in appendix II. SEC’s comments are summarized and evaluated at the end of this report. In marketing and selling IPO shares, underwriting firms primarily target institutional investors rather than individual investors. According to officials we interviewed at 10 underwriting firms, 9 of the firms sold the largest portion of IPO shares to institutional investors, such as pension funds, mutual funds, and money managers. Estimates of sales to institutional investors by officials of the nine underwriting firms ranged from 60 to 90 percent—at a large underwriting firm with both institutional and individual clients and at a small underwriting firm with few individual clients, respectively. An official at the 10th underwriting firm said his firm sold primarily to individual investors. This underwriting firm was unlike the other nine in that it had few institutional clients. Underwriters said they allocated their IPO shares predominantly to institutional investors because of economic factors and their business judgment that institutional investors are better suited for IPOs than individual investors. According to the underwriters we interviewed, they preferred to allocate IPO shares to institutional investors because they believed that these investors are better able than individual investors to buy large blocks of IPO shares, assume financial risk, and hold the investment for the long term.