Tuesday, May 29, 2012

Facebook and the sad case of ethical investment bankers

In an IPO an investment bank takes a fee from a business to place that stock in financial markets.

Or, more precisely, they take a fee from a business to sell part of that business.

Their customer is the company doing an IPO and they have a legal and moral obligation to get the highest price for the company they are selling. No more. No less.

However investment bankers have, as a practical matter, a desire to expand and improve their franchise. Their franchise consists of a huge number of buy-side investors (some retail, some institutional) who will buy from them whatever they sell so long as it comes in a prospectus.

Investment bankers expand that franchise by making sure the things sold in a prospectus have excess demand. If they can sell for $38 they chose to sell for $33 to guarantee a stag. Every time they do so they build their own franchise as an investment bank at a cost to the client to whom they owe a legal and moral duty and who is paying them fees.

The buy-side customers of investment banks have got used to playing in this little game of theft. We – as buy-siders – like to be able to buy IPOs and have instant stag profits. Indeed in the 1990s the game of giving favours to investment banks in exchange for instant stag profits became the way business was done on Wall Street.

The moral corruption of investment banks not only became accepted but we redefined morality around what investment banks did rather than what they should do. We though the process of systematically ripping off the sellers of IPOs in order to build the buy-side franchise of the investment bank was right-and-proper.

It is not right-and-proper and it never was right-and-proper.

The investment bank owes a duty to the seller of the IPO and that is all. Whining fools who complain otherwise have allowed their own greed to distort their morality until they have become gebbeths. Jeff Matthews argues it was their foolishness that cost them money. I disagree. The idea that Wall Street has an obligation to them (thus guaranteeing stag profits) cost them money. And that idea came from their complacent immorality - a complacent immorality pervasive on Wall Street.

But not only have people with hurt hip-pockets complained about the Facebook IPO their supplicants in the press have been sucked into supporting the buyers same self-interested immorality. The Wall Street Journal (a magazine captured by Wall Street not Silicon Valley) derides Michael Grimes (the Morgan Stanley Banker) for not standing up to David Ebersman (Facebook's CFO) and allowing Facebook to sell too many shares at too high a price. This is tits-up-backward. David Ebersman in this context is the client. He paid the fees. Michael Grimes had a duty to act in Ebersman's interest. Ebersman wanted to sell more shares at a higher price. Michael Grimes and Morgan Stanley obliged even at the cost to their own franchise.

And for that he is being pilloried in the press.

What we have here is an investment banker acting ethically. And the whole financial press is a twitter about it.

And the SEC is investigating.

No ethical behaviour goes unpunished in America.


PS. Joe Nocera seems one of the few people in the financial press who sees this the right way. My respect for Joe rises every year.


Greg Hao said...

John, as always you make a lot of great points and while I agree with the gist of your comments, you did leave out some rather pertinent facts. Such as the fact that Facebook was whispering to its investment banks to revise their earnings forecast for Facebook down. And then these same investment banks only informed the largest of their buy-side clients of this fact. This is the reason why the investment banks are under investigation. Not the fact that they helped Facebook clean up.

CurmudgeonlyTroll said...

You don't think there's a legitimate question as to whether all material info was in the prospectus, or if it was selectively disseminated?

Anonymous said...

They represent both sides of the transaction (at least for many of the investors), so ethically there seems to be a conflict of interest in solely seeking the highest selling price. The objective, if beholden to both buyers and sellers, should be to identify a fair price in that the market does not deviate widely in the immediate future.

Jack said...

Please... The issue is selective disclosure. Busted IPOs happen all the time, including more recent ones like GRPN, ZNGA etc. SEC never came in there. But, how many IPO's had estimates being revised down during roadshow? ALL/Most institutional clients knew about estimate reduction in FB. NONE of the retail knew about it (including accounts managed by MS wealth advisors)


John Hempton said...

Where was the prospectus inaccurate? You have a burden to prove the prospectus was inaccurate.

The rest is forward looking statements. They are absolutely protected under safe-harbor provisions.


John Hempton said...

The only "selective disclosure" appears to be about forward looking statements.

The forward looking statements are protected.

Nobody has pointed out a single historical statement in the prospectus that has to be withdrawn.

And until they do then I see no problem.


Anonymous said...

Every one who lost money in FB IPO deserved it. They are greedy SOBs. Somehow they expected the entrepreneur to sell off part of his baby - a company that he worked hard to make it a success - cheap so they can make a huge profit in no time. These greedy people should ask themselves if they have done anything to share in the success of the company in the first place.

Eric Titus said...

While I agree that those criticizing Facebook for (gasp!) selling their stock at the highest price the market could bear, the whole thing turned into a huge mess. Kudos to Facebook for convincing the market that they might be work $100B. But the issues with Nasdaq and the last-minute and selectively disclosed revision of numbers are legitimate reasons for some griping. As for the SEC investigation, chances are they won't find anything, but I'd like to see the SEC doing its job more often, rather than less.

John Hempton said...

I agree the issue with Nasdaq is intolerable. Some traders did not know their position. They placed orders. The orders may or may not have been executed - but information was not relayed.

The selective disclosure is BS. Firstly it is not able to be litigated - it was all protected forward looking statements covered by the safe harbor.

Second - if you take seriously the projections you are more foolish than I thought. I have no idea at all what the revenue of FB will be in two years and nor do you.


Anonymous said...

John, you're so Randian .

CurmudgeonlyTroll said...

Saying a selective disclosure is legal under a 'forward looking statement' safe harbor provision doesn't make it ethical.

John Hempton said...

Curmudgenly troll says:

"selective disclosure is legal under a 'forward looking statement' safe harbor provision doesn't make it ethical"

If I put my Ayn Rand hat on I am not sure. The obligation was to get the best price period. I have seen people sued for less than that...

But more to the point - the forward looking statement thing is just a furfy - it is something that people have locked onto after the event to explain why the stock price fell so much.

It dropped so much because the IPO was done for the most shares at the highest price possible. And Morgan Stanley sold too many shares at too high a price to guarantee a stag.

And that is that.

Incidentally - the fact that the forward looking statemements were even half-way plausible (despite legal protections) suggests that this was more ethical than most things on Wall Street by that standard.


Anonymous said...

The buy side investors are also clients of the investment bank doing the IPO. Ripping off one client on the behalf of another.... think we have seen this movie before and it didn't end well for GS.

This kind of negates your point a little, although obviously the buyside should do their own analysis and come up with a valuation they are comfortable owning the stock at. If the IPO price is higher, take a walk....

I think the success of the Google IPO helped the Zuck et al cash out at a huge premium to what the company is actually worth. What was it, 10x PSR and 75x PER? Someone is (over)paying for the hope of earnings growth that has eluded the company so far.

Disclosure: nothing to do with the Facebook IPO.

Anonymous said...

The bottom line for the IPO business is maintaining the proper balance. If you screw either the issuer or the buy side, consistently you will be out of business shortly. MS made a hash of this deal. It will cost them and very likely, IPOs in general for a while.

This is the practical truth, I'll leave the philosophy to you.

John Hempton said...

And the FB IPO has made it harder for Twitter...

Amos said...

Why do you think the forward-looking statement safe harbor works the way you say? Doesn't seem right to me that if you tell some customers and not others about revised management projections, that the conduct is immunized because it concerned projections. Maybe there's a concept in the law I'm missing.

Anyway while I agree with your other conclusions, the net effect of this is to push more individual investors out of the stock market because it advances the -- completely accurate -- perception that untrained individual investors don't stand a prayer.

John Hempton said...

The safe harbour status laws are incredibly strong.

Unless I am mistaken they even cover deliberately false projections given to mislead competition even if those projections have stock market effect.

Do not rely on projections unless they are your own and you have a basis for making them.


William M. Connolley said...

I agree with you (or maybe you agree with me, since I said it before you, though not so well: http://scienceblogs.com/stoat/2012/05/22/that-facebook-ipo-in-full/).

All the stuff about forward looking statements just looks like fluff people are picking because the world didn't turn out the way they wanted it.

Anonymous said...


Your points are entirely correct, just makes me wonder why it's not blatantly obvious to everyone.

However, there are snafus in FB that were entirely not right and contribute greately to the drama, specifically, the NASDAQ "nap". As a matter of fact, there was a modest 10% pop right after the opening bell - which would've been entirely OK for the "subscribe and flip" "institutional IPO investors"... wouldn't NASDAQ make it impossible for them to do their trades!

The rest I think is more a matter of shit hitting the fan then any conscious, logical accusations. E.g. what drives the anger is not the "IPO flop" per ce, but the fact that NASDAQ made that flop entirely non-interactive: you started, noted the nice upwards trend, then curtains were pulled and 10 hours later opened to demonstrate the vanishing act.
And by the look of it, NASDAQ is more or less off the hook for it, too - hence the blame game. (My entirely gut-stimation of damages that blackout caused says $100m they are talking about is a tip of the iceberg... but good luck suing NASDAQ for even that!)


Jeff Matthews said...

I have read this post 3 times and I actually do not understand the difference between your take and mine, or Joe Nocera's, for that matter.
Joe has no problem with the bankers' behavior (he essentially says you wouldn't want your daughter to marry them, but they didn't do anything obviously illegal).
You say it was the buyers' "complacent immorality" with a corrupt process that cost them money.
I don't your observation or Joe's as any different from, which was that greed overwhelmed common sense (as it usually does on Wall Street) was almost exactly yours, using different words and only a slightly different lens.
But maybe I haven't had enough coffee yet.

Conscience of a Conservative said...

Great point. Those whining about over-paying have failed to do their own due dilligence and are acting out of an mis-placed sense of entitlment.

Kid Dynamite said...

yes, Jeff Matthews - it seems that you, Nocera, John, and I are all in agreement on this, and yes - all of our posts were similar.

Nice post, John.

It seems that Facebook may have potentially at least created the illusion of impropriety if they told MS to cut numbers, but as i wrote in my post, it wouldn't have mattered an iota if that was in the prospectus - because the greedy pigs who got buried in FB didn't read the prospectus anyway.

Anonymous said...

I think the analysis is missing something. If I am Zuckerberg, what do I care whether Peter Thiel gets the best price? If I am Zuckerberg, what I do care about is the effect on employee morale. I would not want a huge first day pop. If I am paying any attention to CNBC, etc. I am thinking that the stock could open at 50, 60 or who knows how high. If it does that, I would be concerned that it will steadily drop for the next 6 months until the lock ups expire, as my employees get poorer and poorer on paper. What do I do if I am Zuck and I don't want the pop? I allow more insiders to sell and shorten their holding periods. That is what I think was behind the decision to price it high and sell more. I don't think Zuck was trying to get out at the top. I just think he didn't want the first day pop. Obviously in hindsight this was a mistake as the drop hurts morale as well. I don't wnat my employees to be jealous of the guys that sold on second market. I think Zuckerberg wanted it to trade at a small premium to teh ipo price. I think he would have changed the number of shares, the lockups and or the price to whatever he believed was necessary to have the stock stabilize in the mid 40s. Does anyone disagree? The real question in my mind is if there is something Zuck can do to get the stock back above the IPO price. If I were him, I would try to get the bigger outside holders to agree not to sell below 38 until the original lock up date expires. I don't think that would be an impossible task, as I think many of the holders are true believers.

Anonymous said...

I personally do not see a more effective way of being a 'socially responsible' investor than to 'Speak truth to power'.


Lance Paddock said...

I have to agree with Jeff, I don't see any incompatibility between what you are saying and what bhe is saying. Personally you are both right.

However, you do not address my one concern, which is the inappropriateness of the firm representing both sides of the exchange. Typically the seller pays the price in foregone fees, as well as those buyers who hold the stocks because their brokers have convinced them it is priced fairly and not just an old maid to pass in the guise of the fair princess. Here it was just the buyers who were screwed by buying an overvalued stock.

I will say I prefer a world where this is the case. The seler gets ethical representation and the buyers are taught that their brokers job is to sell it to them, and their job to decide if it is a good investement and not a freebie from the firm regardless of investment merits.

Anonymous said...

Your assessment that the investment banker acts in the best interest of the client by maximizing IPO pricing is only correct IF the company will not need to access the capital markets again. Because if a company needs to raise capital in the future, a "busted IPO" would essentially raise the cost of capital of the firm in the future (the argument of whether market pyshcology plays a role in efficient markets can be debated another day). Hence, the banker, acting in the best interest of the client has to balance IPO price maximization vs its impact on its cost of capital in future financings. This is a concept the client may or may not be fully aware of.

Anonymous said...

I agree with you in principle (IB's client was FB, with goal to sell it as high as possible) - and whoever bought, bought on their own stupidity.

My problem with the rest is not forward looking statement or whatever, but the selective dissemination of the information.
Clearly, if you disseminate information (be it forward looking or other) to certain clients only , you consider it important. Now, either the "certain" clients have a special agreement with you, and are explicitly getting better service. In which case though luck to anyone else, you'd have paid for the extra info.

Or they don't in which case it's insider trading (or that's how it was intepreted by FSA in a few cases).

So, the simples (at least ethically, even though it may have been within the letter of the law) is that clients who pay for the same service get the same service - and it's the buy side who pays the analysts, not the sell side (unless it's a rating agency of course ;) )

Gary Moorman said...

I agree with what you're saying about MS selling the most possible shares at the highest possible price. However, I don't see how the supposed selective disclosure that was provided to certain institutional investors during the roadshow could be considered fluff. If you were about to purchase a stock and you legally found out that the company's revenues for the current quarter were coming in below expectations and as a result the company was going to be lowering full year revenue guidance in the coming days, would you buy the stock that day or wait until the reduced revenue guidance became public? The reduced guidance may be fluff when considering the long term value of the enterprise, but it is anything but fluff when considering the near term price.

Tom L said...

You are all missing something. I'm going to leave aside the selective disclosure question and focus on the "highest price" suggestion. The problem is you are looking at the event in isolation rather than systematically.

In one instance the banker is obligated to obtain the highest price possible. However, by doing so, it appears that he is "screwing the buyers". This may hurt his chance of doing so again for the next customer. Therefore, he actually tries to maximize the average price for multiple IPOs over time. (He is obligated to do so to all his companies.) In order to do that systematically on an ongoing basis, he may have to lower the price of specific issues below what he could have gotten, so as not to sour the market.

In other words, you can truly only get the highest price possible if it is the last IPO you ever plan to do.

Anonymous said...

Joe Nocera's and your protestations how an IPO is for the company look sadly out of place regarding FB when a minority of the shares offered in the Facebook IPO were sold by the company. 42.7% by my count. More notable is a vast majority (95%) of the overallotment was offered by selling shareholders, not the company. As such isn't it more rational to look at this as a cashout by early investors and not an IPO who's primary purpose is to raise funds for the company?

Really looks like FB was once again saying screw you to the world and the bankers and investors got chumped.

Anonymous said...

Yes, but please do look at the whole story: Morgan Stanley is not only engaged in the business of bring companies to markets; their brokers do not only speak with brokers for buyers. Rather, MS brokers speak directly with buyers -and so represent them as a fiduciary. If the IPO is sold at the high point of the price spectrum (as it was) - kudos to the brokers who represent the seller. But not the brokers to represent the buyers.

Think of a real-estate broker: the one representing the seller AND the buyer has NOT clearly acted morally if he sells at the highest price point. If I want to buy a house, my broker should not push me to spend as much as I am willing; he should try to get the best value.

Simply enough, MS was on both sides. They acted morally in one case, and immorally in the (many, many) other cases.

At very least, this is clearly NOT clear. You have skipped your own logic.

Absalon said...

Facebook revised its prospectus a week before the IPO. Based on the revision, some bankers revised the bankers projections of future revenue and then the bankers only told some of their customers that the bankers numbers had changed. That is between the bankers and the buy side customers and has nothing to do with Facebook.

The IPO valued Facebook at about $100 Billion - half the value of Google. Does anyone seriously think that Facebook is worth half as much as Google? Does anyone seriously think Facebook is worth $100 Billion dollars? That puts it in a league with McDonalds Pepsi or Disney.

Aharon L said...

This goes for Mr. Hempton and for those he critiques: whenever a very smart person enters the fray of a contentious issue and declares that it's really quite simple, it still isn't.

Anonymous said...

'Think of a real-estate broker: the one representing the seller AND the buyer has NOT clearly acted morally if he sells at the highest price point.'
The same real-estate brokerage can represent both buyer and seller, cos they have different brokers for each. Duh.
Same for MS. ECM and sell side are (supposed to be) separate.
And what is the highest price point anyway?
Today's high? 6-mth high?
1yr-high? Historical high never to be seen again?

Ken said...

Fascinating! As well as Lance, I agree with Jeff, I don't see any incompatibility either.

The interests of buyer and seller are in most things opposed. It is impossible to simultaneously do one's best for both. So for Anonymous May 29, 2012 3:40 PM to suggest "Ripping off one client on the behalf of another" is to ignore this impossibility. I see the real-estate broker example to be a justification of unethical practices that are common in the industry. Too often, the agent promises the world to the seller until they get an exclusive listing and then swaps over to work in the interests of the buyer to get the sale. At no point are they looking after anyone interests other than their own.

Unknown said...

The Epicurean Dealmaker has responded in the negative:


Alex said...

You are making the point that the banker should be getting the stock the highest price. Let's assume (as we should) that the IPO is at either price is way overvalued. The banker, sometimes over the companies judgement, should override their desire to get the highest price if he is looking out for the bigger picture.

When a company is only floating 5-15% of the shares, the real game being played isnt for the (incremental) price of those but the ability to dump the rest after the lockup/secondary. If you bust the market's confidence in the stock and the momo guys who can push it up from the initial pop you kill the golden goose. Everyone loses, it isnt a zero sum game for the insiders/banker rep.

The size and spotlight makes Facebook something of an exception to this whole game, but in general it is the way the game is played. Some of the best examples of insiders looting the buyside/retail suckers game on the backs of "leaving money on the table" on the initial ipo. Molycorp and Youku really stand out to me as awful companies that becomes of ipo pop started with a recency bias of an unrealistic baseline price. Linked In is a better known one but there are a lot of them (still hanging on too).

Anonymous said...

I may be wrong, but I think Government is a means by which different groups strive to impose non-voluntary, non-well-informed contracts upon each other.

What we see here is here that those who suffered (those who bought shares and saw their value drop) are apparently more able in this matter to use Government to impose a contract than those who issued the IPO.

Where the whole mechanism is *about* non-voluntary, non-well-informed contracts, the fact that those who issued the IPO acted ethically is irrelevant. It is a fantasy to imagine Government as an impartial, ethical operator. It is not. It possesses the means to impose contracts and so inherently and unavoidably becomes to everyone a means to an end.

Those who had inappropriate (and indeed unethical) expectations unmet are disgruntled and want their money back. Government is the mechanism in use.

Dope Threat said...

I don't know John. Two or three problems. Firstly, if Facebook were indeed the only "client" here for Morgan Stanley et al, I would argue that the bankers did not maximize value for pre-IPO FB holders. Sure, if they IPOed 100% of the float, my argument would fall on its face, but they only floated a small percentage - and given the disastrous share price behaviour since, the company's ability to do secondaries has been diminished. In a game-theoretic sense, this wasn't a one-off. There are a series of games (secondaries) that still need to be played, and this was poor signalling, which will hurt (did hurt) the NPV for FB shareholders.

And I would argue that FB is not the only client here for Morgan Stanley. The appeal or motivation for using investment bankers in the first place is their ability to create distribution, and to lever off their network of institutional and retail clients. My view is that Morgan Stanley has a lot of clients here, not just one - and MS almost certainly didn't strike the right balance.

And finally, if the accusations are true that FB actually did a clandestine profit warning during the road show, and that only institutional clients were made aware of this while the retail network was left blindfolded - then there is really no way you can remotely describe Morgan Stanley's behaviour as ethical here.

Anonymous said...

John: I believe your understanding of the forward-looking statement safe harbor is, under American law, fundamentally mistaken.

The first reason is that the safe harbor only applies to private suits, I believe.

The second is a statement like "management projects that next quarter..." is only partially forward-looking. It's also a statement of management's current view, which is present-looking and actionable if the statement does not reflect managements true view.

The third is that providing more current projections to some customers would seem to (generally, perhaps the IPO context creates some exception) violate reg FD.

The fourth is that the underwriter would have to disclose the asymmetric information in the prospectus as a risk.

Anyway, I'm not 100% sure, because I haven't looked this stuff up in a while, but Im pretty sure...

Anonymous said...

Anyone who handled the deal knew that the company's revenues had softened over the prior couple of qtrs. In addition to the prospectus containing the info it was ALL OVER THE WEB. The wily folks at Zerohedge were pounding that fact for WEEKS before the deal went off. The 10% pop would have held if the nimrods at NASDAQ had just spent a bit more on IT last year. Next........

Anonymous said...

This whole ordeal is about a changing business model and those affected complaining.

Btw - I can see it from a million miles away - xyz junior PM is sitting there thinking/complaing to his wife my MD boss just bought these dumb dotcom IPOs and made a killing.

Une dilettante. said...

You and Joe Nocera are basically saying the same thing backwards, but his argument completely illustrates the flaw in your logic.

An investment bank's primary responsibility is to raise as much capital for its corporate client as possible. As Joe points out, LinkedIn's IPO technically resulted in lost capital the firm could have raised.

I've heard many professionals say that the Facebook IPO was priced to perfection, in that the company got as much money of the IPO that the market could bear.

This factor illustrates that the incentives for bankers are lined up with those of their corporate clients; the more funds raised results in more fee revenue for the bank. Not only did LinkedIn lose out, but its bankers lost out too.

Regardless, the Facebook IPO is probably one of the most hyped offerings in capital markets history. Any investor who overlooked that in the hope of a quick first day pop instead of doing their due diligence and fundamental analysis deserves the loss which is by no means the fault of the banks.

In addition, some traditional rules just don't apply to IPOs as significant as Facebook's.

Anonymous said...

Only in Politics and Investment Banking are such incestuous relationships allowed. Heck, they are not only admired; they are worshipped!

No wonder Politicians love Wall Street; they understand each other.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.