Access to hot IPOs is one of the ways hedge funds gauge the quality of the service supplied by their prime brokers. News today that he Securities and Exchange Commission had filed charges against Credit Suisse First Boston Corporation (CSFB) for abusive practices relating to the allocation of stock in “hot” initial public offerings (IPOs) may therefore give some cause for concern on both sides of the market – especially since the revelation that IPO share prices were artificially inflated has led to a raft of class action law suits. A separate probe into the after-market in IPO shares has already embroiled other leading investment banks.
The SEC announced simultaneously that CSFB had agreed to pay a total of $100 million to resolve the charges and a related action by NASD Regulation, Inc (NASDR), the regulatory arm of the NASDAQ stock market. CSFB also agreed to be enjoined from future violations and to institute wide-ranging new procedures designed to prevent a recurrence of the sort of misconduct that gave rise to the SEC action.
“In today’s enforcement action the Commission has obtained one of the largest civil penalties ever imposed against a broker-dealer,” said Stephen M. Cutler, Director of the SEC’s Division of Enforcement. “CSFB improperly took advantage of its position as underwriter by allocating shares of hot IPOs to customers who agreed to share their IPO profits by paying excessive commissions,” he added.
In a complaint filed in U.S. District Court for the District of Columbia, the Commission charged CSFB with violating certain conduct rules of the National Association of Securities Dealers, Inc. (NASD) which prohibit profit-sharing in customer accounts and unjust or inequitable conduct. The Commission also charged that CSFB violated the SEC’s books-and-records requirements for broker-dealers.
“The Commission has taken the unusual step of seeking a federal court injunction to enforce NASD rules in view of the nature and scale of the misconduct alleged in the complaint,” said Wayne M. Carlin, director of the Commission’s Northeast Regional Office. “In contravention of the applicable rules, CSFB wrongfully obtained for itself tens of millions of dollars of its customers’ IPO profits.”
The complaint, which is being made available on the SEC’s website, includes the following allegations:
CSFB, as the lead underwriter of hot IPOs for companies such as VA Linux Systems Inc., Selectica, Gadzooks Networks, and MP3.com, had control over the allocation of most of the shares in these IPOs. In exchange for some of the highly-coveted stock in such hot IPOs, CSFB wrongfully extracted from certain customers a large share of the huge profits those customers made in quickly selling (or flipping) the IPO stock bestowed on them by CSFB.
Specifically, CSFB allocated shares of IPOs to more than 100 customers who, in return, funneled between 33 and 65 percent of their IPO profits to CSFB. These customers typically flipped the stock on the day of the IPO, often gaining tremendous profits. They then transferred a share of their flipping profits to CSFB by way of excessively high brokerage commissions (ranging from $0.19 per share to $3.15 per share – in contrast to the typical rate of about $0.06 per share). The customers paid these commissions on uneconomic, limited-risk trades in highly liquid, exchange- traded shares unrelated to the IPO shares – trades that they effected for the sole purpose of paying IPO flipping profits back to CSFB.
* The profit-sharing activity was pervasive at CSFB. Senior executives who were in managerial and supervisory roles knew of the practices described in the complaint, encouraged many of the practices described in the complaint, directed CSFB employees to urge customers to maintainspecified ratios of commissions to IPO profits, and, in some instances, personally engaged in some of the practices described in the complaint.
* CSFB employees informed the relevant customers, both implicitly and explicitly, that they were expected to pay back to CSFB a portion of profits earned on their IPO flipping in order to continue to receive allocations. Customers who refused to funnel a portion of their profits to CSFB received smaller allocations, and in some instances were denied allocations altogether. The prevalence of CSFB’s abusive practices is reflected in numerous e-mail messages and other communications, examples of which are cited in the complaint.
* The profit-sharing customers received no more than 10 per cent of the IPO stock allocated by CSFB in each offering. IPO flipping was so profitable, however, that CSFB wrongfully obtained tens of millions of dollars in IPO profits through this improper conduct.
“In the midst of the hot IPO market between April 1999 and June 2000, CSFB extracted a significant sum of money from a relatively small segment of the marketplace,” Carlin said. “CSFB saw that some people were willing to do just about anything to get IPO stock, and CSFB improperly took advantage of the circumstances to take for itself a share of its own customers’ profits.”
CSFB has agreed to settle this matter, without admitting or denying the allegations in the complaint – which the firm must be hoping will render it immune to the many class actions now in hand on the same issue. The settlement terms are subject to approval by the court. CSFB has agreed to pay a total of $100 million to settle the Commission’s action and a related action announced today by NASDR. Specifically, CSFB will pay disgorgement (of profits) totalling $70 million. In addition, CSFB will pay civil penalties and fines totaling $30 million.
CSFB has consented to be enjoined from violations of NASD Conduct Rules 2110 (prohibiting violation of just and equitable principles of trade) and 2330 (prohibiting sharing in the profits of customer accounts), as well as Section 17(a) of the Securities Exchange Act of 1934 and Rule 17a-3 thereunder (broker- dealer books and records).
Finally, CSFB has undertaken to change its methods of allocating IPO stock, as well as its supervision of those activities.
Among other things, CSFB will (1) implement extensive new policies and procedures relating to the allocation of IPO shares, the customer account opening process, commission levels, and related supervisory practices; (2) retain an independent consultant to conduct a review of CSFB’s new policies and procedures after one year; and (3) adopt the recommendations of the independent consultant.
“This matter was a model of effective cooperation and parallel investigation by our staff and the staff of NASDR,” Cutler said. “We are most grateful for NASDR’s extraordinary work on the enforcement actions announced today.” The Commission also acknowledged the invaluable ssistance provided by the Office of the United States Attorney for the Southern District of New York in the investigation of this matter.