IPO Quid Pro Quo?

Why the Salomon-WorldCom IPO deals are so sleazy.

Even Americans jaded by corporate scandal are outraged by the new disclosures that Salomon Smith Barney allocated huge numbers of shares in hot initial public offerings to investment-banking clients like former WorldCom CEO Bernard Ebbers. In essence, Salomon allowed executives at companies that had paid millions of dollars in investment-banking fees to Salomon to profit personally from quick stock trades.

Such transactions—apparently perfectly legal—smell much worse than some of the illegal acts alleged in corporate scandals. For while the sums involved are minuscule compared with the perfectly illegal frauds at WorldCom and other companies, these deals abuse traditional Wall Street practices in a particularly offensive way. It is difficult to regard them as anything but carefully disguised cash payments. The executives steered their companies’ business to Salomon, then reaped the reward of IPO shares.

On Wall Street and elsewhere, the exchange of perks, services, and other emoluments between companies and the individuals who purchase their services on behalf of other companies is an honored way of doing business. Magazines routinely treat advertising buyers to parties and other entertainment. The Forbes yacht, the Highlander, ferries advertisers on canapé-filled cruises around New York harbor. Dozens of law firms and accounting firms maintain luxury boxes at Madison Square Garden or Yankee Stadium, where they entertain customers. Professional golf tournaments like the Masters are favorite junket destinations.

Investment banking has long led the pack when it comes to perks. Every major brokerage firm and investment bank hosts lavish investors’ conferences—usually at golf resorts—to entertain customers. The most legendary such conference in the ‘80s was Michael Milken’s Drexel High-Yield Bond Conference—aka “The Predator’s Ball”—where clients were treated to live performances by Frank Sinatra and Diana Ross.

In virtually every instance, the goodies doled out at such events are a reward or an inducement. Do business with us, and you can expect to get this stuff in return. It breaks no laws and, in the eyes of most, doesn’t corrupt the system.

To be sure, the dinner at Alain Ducasse or the Bruce Springsteen tickets have a cash value. But by and large, the recipients of such largesse can’t monetize their gifts. They aren’t cash, and they can’t easily be converted to cash. But handing out IPO shares to executives that they can trade in their individual accounts is like giving out goody bags stuffed with $100 bills.

Most investors never get close to an IPO share. When Qwest went public, however, Ebbers was allowed to buy a remarkable 205,000 shares at the offering price of $22. The stock closed the first day at $28, meaning an instant profit of $1.23 million.

Of course, Ebbers didn’t get the stock for free. He had to pay for those Qwest shares and for all the other IPOs he bought into. And he assumed the risk that the shares would fall. Juno Online, in whose IPO Ebbers was permitted to buy 10,000 shares, actually fell about 10 percent in its first trading day.

But given the climate and the companies involved, there was a virtual certainty that Ebbers and other lucky recipients of the IPO allotments in question would get rich quick. If Ebbers had sold the shares of the nine offerings detailed in the Wall Street Journal at the close of their first trading day, he would have earned a $4.89 million profit on a $15.7 million investment—a 31 percent return in one day!

For Salomon and other banks, directing IPOs to favored clients was eminently reasonable. Salomon didn’t actually have to pay for these shares, as it does for Producers tickets. And it could give favored clients a break while still maintaining its ethical standards. After all, Salomon’s obligation to the company whose stock was being sold was simply to place the shares at the offering price. Besides, the tactic plainly worked. The allocations were all about building and cementing relationships. Throughout the late 1990s, Salomon steered IPO shares to WorldCom execs, and WorldCom continually chose Salomon as its lead investment banker.

If any outsider were to imply quid pro quo, the bank and the executives had a ready-made excuse. Many of the executives who received share allotments were also private clients of the investment bank—big, high net-worth clients of the type who one would expect to receive IPO allotments. That’s precisely the defense made by the lawyer for Joseph Nacchio, the obnoxious former CEO of Qwest and another possible beneficiary of Salomon IPO lucre. “It had nothing to do with the corporate connection,” he said. “Joe was a valued client of Salomon.”

That’s remarkably dishonest. A rich investor with a brokerage account of, say, $50 million might generate between $1 million and $2 million in fees for Salomon in a good year. But the CEO of a public company like Qwest or WorldCom will generate tens of millions of dollars in investment-banking fees.

And that’s the conflict. It’s one thing if you get a few hundred shares of an IPO because you trade a lot in your individual account and generate commissions. It’s quite another if you receive hundreds of thousands of shares of an IPO because the publicly held company that you work for generates $50 million in banking fees. For even though he regarded the company’s treasury as his piggy bank, Ebbers didn’t pay the investment-banking fees to Salomon. WorldCom did. If it’s ethical for big-spending clients to receive outsized chunks of IPOs, then it is WorldCom—not Ebbers—that should have received all those shares and then flipped them for a quick profit.