Ipo Fraud Using Nominee

Ipo fraud using nominee

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IPO fraud

Introduction

There are cases of securities fraud in all areas of the investment world, and the IPO market is no exception. Cases of IPO fraud occur mainly when the company which is going public, as well as the investment banks who represent them, mislead the public about the true health of their business.

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Although these situations are usually not black-and-white examples of fraud, other times they are. Here is a fictional example of how it plays out.

Our fictional company, "Disappointment Inc.", plans on doing an IPO.

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Before the IPO, the company will submit thousands of pages of documents to the SEC prior to the IPO under the guise of full disclose. These documents, however, will leave out one key facet about the condition of the business. A couple months later "Disappointment Inc." announces much lower-than-expected earnings due to the omitted factor, which they first reveal in the disappointing earnings report. Sometimes it will be a situation where the company's growth was decelerating rapidly.

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When investors process this new information, the stock drops 20-50% in one day. The investors who got burned now realize that the company's management knew about the problems, so they file a class action lawsuit - notifications of which you will see on the company's Yahoo Finance news section.

Conditions that support IPO fraud

  • SEC being too lax - The SEC is too lax in general when it comes to securities fraud.

  • investor infatuation with IPOs - Overall, investors tend to believe in the misperception that IPOs are somehow special investment opportunities.

    This is partially because these IPO companies were previously private companies, so investors think they are getting in on an exclusive opportunity.

  • single-date IPO - Although this may seem inconsequential, the fact that IPOs occur on a single date leads investors to become overly-excited and can lead to hype.

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    Because all of the stock gets dropped on the market at once, getting in on the IPO becomes a race (in investors' minds) because everyone wants to get in on the first-day pop that IPO stocks often have. The situation is similar to Black Friday shoppers busting down doors because they think they will miss out on a special deal.

  • big investment banking fees - The big fees that investment banks make on IPOs, which can be up to 7% of the capital raised, creates a lucrative reward system which is prone to fraud.

  • less information available - Although laws require a company going public to provide historical financial information and other disclosures, there is still less information available from them compared to companies that have been public for some time.

  • less scrutiny - Because the company was a previously private company, there is less public scrutiny of the company and its conditions (there are fewer analyst opinions, fewer channel checks, etc.).

  • syndication support for a stock in the aftermarket - After a company goes public, the syndicate (which is the group of investment banks that brings the company public - as explained in my introduction to IPOs page) comes into the aftermarket and supports the IPO stock if it drops below a certain level (usually the issue price).

    Not only does this artificial support for the stock qualify as market manipulation, but it also helps hide (by deferring) the ultimate drop in the stock price which is the proof of the fraud.

  • unfair allocation of IPO stock - Most investment banks give IPOs to their preferred customers - mostly institutional investors (and, rarely, wealthy retail investors).

  • relationships with mutual funds - A lot of IPO stock is purchased by mutual funds, which are the main stock market investment vehicle for the masses (mostly the American middle class).

    Given the intertwining and interdependence of various financial institutions, situations may arise where mutual funds feel pressured to purchase an undesirable IPO from the underwriting investment bank solely to benefit its business relationship with the bank.

  • systematic IPO mis-valuation - There has been a moderate amount of evidence that IPOs are systematically mispriced, mostly underpriced.

Situations prone to IPO fraud

IPO fraud is more prone to occur in certain situations.

These are usually situations where a stock is prone to a sharp change in valuation over a short amount of time, such as:

  • fast-growing companies - companies with high growth rates usually have higher much valuations.

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    When growth decelerates, these valuations constrict, along with the stock price.

  • fast-changing industries - stocks in fast-changing industries (like technology) are more prone with sharp changes in price.

  • event-driven companies - companies where a single event can affect the value of a company. One example is biotech stocks (especially small biotechs) where the approval of one drug can make a huge difference in the price of a stock.

  • certain industries - certain industries make it easier to commit fraud - like natural resources (gold, silver, oil) - because they may have an investor base which is more prone to taking large risks.

    Ipo fraud using nominee

    When the IPO company is very small in size (such as a gold miner or oil driller), then this is also an example of "event-driven" fraud because these companies are often marketed as having some massive, soon-to-be-announced resource discovery.

  • frothy investment environments - people are generally much more blind during bull markets, whether it is a:

    • broad-market bullish environment like the late 1990s.
    • sector-specific frothy market like Chinese IPOs during 2007.
    • company-specific frothy environment, such as a Facebook IPO.

Real-life example: Vonage IPO

One of the most well-known IPO lawsuits was related to the Vonage IPO of 2006, which raised $531 million for the company.

Vonage took the unusual step of offering about 13.5 percent of its IPO stock to customers. After the IPO, Vonage stock promptly lost 30% of it's value in the first week alone.

Ipo fraud using nominee

Investors brought a class-action lawsuit, claiming that Vonage, its officers, and underwriters misled investors.

The complaint alleged that Vonage decided to offer shares to directly customers because they knew institutional investors who normally buy IPO stock would be reluctant to buy it.

The lawsuit alleged that Vonage and its underwriters (Deutsche Bank, UBS, and Citigroup) violated a securities law that "requires a company recommending the purchase or sale of it's securities to a customer must have a reasonable basis for believing that the recommendation is suitable for the customer." Vonage settled the lawsuit in principle in 2009.

Regarding the Vonage IPO debacle, a naive commenter, "jasonemanuelson1" wrote:

"Not too many companies would bother to offer a first shot of stock to its customers, especially in this thankless world of markets, but Vonage did just that -- they wanted to give back to customers that made it what it is today."
This comment doesn't show a lot of intelligence.

Understanding IPOs and IPO Scams

Not only does it show naiveté in thinking that Vonage was "giving back" to its customers, it also shows a bias towards IPOs, which, as I wrote on my IPO risks page, is a classic mistake that amateur investors make.

Real-life example: GroupOn IPO

With the "deal market" nearing saturation and GroupOn not even profitable, the company decided to do an IPO to essentially monetize their massive top-line growth rate.

But along the way, they had to restate their financial statements multiple times, both before and after the IPO which the SEC.

Ipo fraud using nominee

There were major problems with the way the company accounted for their revenue and marketing costs. One thing GroupOn tried to do was to book the whole value of the deals they sold as revenue.

Ipo fraud using nominee

There have been plenty of examples of companies in the past who have provided what is, essentially, a broker function make failed attempts to try to recognize the cost of the goods they are brokering as revenue. GroupOn's restructured revenue recognition lead to them changing their 2010 stated revenue from $713.4 million down to $312.9 million - a drop of 56%.

These kinds of accounting problems are especially troubling considering how extremely simple GroupOn's business is.

There is a lot more understanding from investors when a company like GE has accounting issues, considering that it earns tens of billions of revenue, in many different industries, and in many different countries.

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But GroupOn's accounting problems are much more morally troubling. These problems along with others (questions about whether or not their financial statements were audited, and unconventional accounting metrics) made the GroupOn IPO resemble an outright scam

What can be done?

  • Harsher penalties for securities fraud. This is more of a general solution and not an IPO-specific solution.

    This won't happen anytime soon.

  • A "Last Minute Confirmation of Business Conditions" right before the IPO. Companies would be forced to give a last minute confirmation or update. This may even exist already. I don't know.

My Opinion

Although IPO fraud is not a pervasive enough or broad enough to be near the top of the list of issues for regulators to worry about, I think the unique characteristics of the IPO process (namely, investor infatuation with IPOs mixed with huge investment banking fees) make it a situation where there is considerable potential for abuse.

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Historically, there have been more securities lawsuits related to IPOs (relatively speaking) than companies that are already public. I wouldn't be surprised if a high-profile IPO scam or meltdown occurred in the future which causes a major investor backlash and sparks new regulations about securities fraud and how the IPO process works.

Just as there have been high-profile failures which defined other aspects in securities fraud (like Enron with accounting), I think there will be some type of incident in the future which will come to define IPO fraud.