June 21, 2012 / By JEAN EAGLESHAM And TELIS DEMOS/ WSJ
A bipartisan group of lawmakers called on regulators to overhaul the way initial public offerings are conducted, concerned that last month's flubbed stock sale by FacebookInc. FB -0.97% shows the current system unfairly punishes small investors.
In a letter to Securities and Exchange Commission Chairman Mary Schapiro, Rep. Darrell Issa (R., Calif.) prodded the agency to revamp rules for pricing and disclosure in IPOs.
Mr. Issa, who wrote the letter on behalf of the House Oversight and Government Reform Committee, said the social-networking company's steep share-price decline since its May 18 offering is a sign that investment banks are able to "dictate pricing while only indirectly considering market supply-and-demand."
Separately, the Democratic chairman of a subcommittee of the Senate Banking Committee said regulatory changes are needed to bolster investor confidence sapped by Facebook's botched debut.
"The perception today, and perhaps in too many cases the reality, is that the retail investor comes in at a disadvantage" in IPOs, said Sen. Jack Reed (D., R.I.), in an interview with The Wall Street Journal after the subcommittee held a hearing on this issue.
The lead underwriter of the Facebook IPO, Morgan Stanley, MS -0.42% allocated to retail investors 26% of shares, much higher than the 15% allocation in a typical IPO. The shares skidded by more than 30%, though the stock price rebounded during the past week.
The prodding from lawmakers puts pressure on the SEC to rev up its scrutiny of the Facebook deal. Officials are examining technical glitches on the Nasdaq Stock Market that caused chaos during the stock's first day of trading that left some investors unsure of how many Facebook shares they owned—and at what price.
The SEC is also looking at whether the underwriters broke any rules by allowing warnings from research analysts about Facebook's business prospects to be passed along to handpicked clients, but not the general public, according to people familiar with the SEC probe.
The SEC declined to comment on the letter. Morgan Stanley has insisted it behaved entirely within the rules. The company also has said Facebook's initial stock-price rise to $42 on May 18 from the offering price of $38 is proof that the $16 billion deal was priced effectively.
On Wednesday, Facebook shares slipped 31 cents, or 1%, to $31.60 at 4 p.m. Facebook's stock-market value now is $86.6 billion, down from $104 billion at the time of the IPO.
The lawmakers said fundamental changes are needed, even if that means rewriting parts of the landmark Securities Act of 1933, which created the SEC and the existing regulatory framework for overseeing IPOs.
The Facebook deal "taught us that, at a minimum, the IPO process suffers substantial flaws," Mr. Issa wrote in the 15-page letter on behalf of the House committee. The 79-year-old federal law is "fraught with conflicts of interest and incentives to misprice shares."
Ms. Schapiro was told to hand over by the end of July 3 answers to 34 questions.
Mr. Issa, the committee's chairman, was a major force behind the Jumpstart Our Business Startups Act, or JOBS Act. The April law followed support from lawmakers in both political parties to make it easier for closely held companies to issue stock.
House committee members expressed concern in Tuesday's letter to Ms. Schapiro that investment banks working on IPOs can "dictate" the price at which the shares are first sold to investors, based on input from large institutional clients.
The current system seemed to generate "outsized losses for ordinary investors" in Facebook, the letter said, given the high allocation to retail investors. Some hedge funds and other sophisticated investors also bet against the stock.
In the letter, Mr. Issa asked Ms. Schapiro if she would support a change to current U.S. law that would ban the current "book building" system of investment banks setting IPO prices. A better alternative, the letter said, was used by Google Inc. GOOG -0.69% in its $1.9 billion stock-market debut in 2004. This option, called a "Dutch auction," allows anyone to place orders for the number of shares they want and at what price. The bids are used to work out the final share price.
Mr. Reed said a move to an auction system was one option for change. At his committee's hearing, experts also backed the approach used by some countries of setting aside a fixed-price tranche of shares for retail investors.
Changes are needed to assure small investors they will be treated fairly, Mr. Reed said. "If they feel the system is pitted against them, they won't participate and we'll lose their contribution to capital formation," he said in the interview.
Some experts question if a Dutch auction system is needed or would work. Since 1999, just 22 U.S. companies have gone public through a Dutch auction, according to Dealogic.
"An IPO is not quite the same thing as buying a painting at Sotheby's BID -1.02% . Usually the seller doesn't care who buys the painting. But the company does care who buys its shares, because it wants long-term shareholders," said Joseph McLaughlin, a partner at law firm Sidley Austin LLP who represents underwriters.
"I think the process works pretty well, and I don't know if it would work better with a black box," Mr. McLaughlin added.
David Weild IV, chairman of consulting firm Capital Markets Advisory Partners, said banks play an important role in IPOs. "With a Google, it's easier to do, because it's a big brand. But for everybody else you still have to have the underwriting bank's salesmen on the phone" finding buyers for the shares, he said.
The number of U.S. IPOs has dropped to an annual average of about 130 since 2001 from an average of 503 during the 1990s, Dealogic said.
The oversight committee said U.S. capital markets could get weaker if the law continued "to protect, over-regulate and coddle our financial institutions."
Nasdaq OMX Group Inc., NDAQ +0.41% which owns the Nasdaq Stock Market, has apologized for the first-day flubs and plans to offer $40 million compensation to affected firms. On Wednesday, Nasdaq postponed the deadline for brokers and traders to submit claims for the exchange operator to make up some of the losses.