A Nefarious Wall Street Practice Quietly Makes a Comeback

By Pam Martens: April 8, 2014

Most Americans are traveling with a blindfold on Wall Street’s rigged superhighway. Until bestselling author, Michael Lewis, blanketed the airwaves last week with the news that yet another cartel has formed on Wall Street to front-run the stock trades of ordinary investors with a super-speedy fiber-optic line financed by private investors, the public remained in the dark about the latest weapon in Wall Street’s high-tech arsenal for transferring the little guy’s wealth into the hands of the one percent.

The plan was so insidious that it reminded us of the stealth practices carried out by Wall Street in the tech boom of the late 1990s to line the pockets of the corner offices while separating the small investor from his life savings.

One of those practices is benignly called a “penalty bid” (every trick on Wall Street has some indecipherable name to disguise what’s really going on). And quietly, without news media coverage, the dirty practice is back. It made its comeback on November 27, 2013 in an equally questionable maneuver between the Securities and Exchange Commission, now hobbled with a pack of former Wall Street lawyers running the place, and the Financial Industry Regulatory Authority (FINRA), a self-regulatory body that also runs a private justice system for Wall Street that is devoid of the legal protections afforded in a court of law.

Here’s how young stockbrokers on Wall Street typically learn about the penalty bid: a client calls to see if they can buy 200 shares of a company that is going to start trading for the first time (an Initial Public Offering or IPO). The young broker is told his client can have only 100 shares because it’s a “hot” issue (expected to rise in price). On the first day of trading, the stock pops 40 percent and the client calls and tells the broker to sell his shares. But when the trader attempts to place the order to sell, he is told by a superior in his office that his commission will be taken away if he “flips” the trade within 30 days. The young broker takes his order back from the wire operator and heads for his office – presumably to call his client and talk him out of selling his shares.  (I personally observed this exact scenario in a Wall Street brokerage firm.)

The SEC has known about this dirty practice for at least two decades. On April 4, 1994, BusinessWeek published an article, Beware the IPO Market, quoting Lynn A. Stout, professor of securities regulation at the time at Georgetown University Law Center. Stout says: “The IPO market is rigged. It’s rigged against the average investor.” Stout goes on to explain that the penalty bid was “devised by a group of top Wall Street firms during Securities Industry Association meetings in the 1980s.” Effectively what is going on, says Stout, is that Wall Street’s large, lucrative institutional clients are allowed to cash out when the stock price soars while the little guys are left “holding the bag” and serving as a prop under the price of the shares.

As more clients complained, the Wall Street Journal took up the issue. On December 2, 1996, Deborah Lohse wrote: “Even though penalty bids are taken out of brokers’ commission, many investors gripe that they are the ones being penalized, since their brokers exert subtle, or not so subtle, pressure on them not to sell their IPO shares while the penalty bid is in place.”

As the bull market in tech shares boomed, the practice got worse. Michael Siconolfi and Patrick McGeehan wrote in the Wall Street Journal on June 26, 1998, “It’s one of Wall Street’s best kept secrets: While securities firms allow big institutional investors to dump hot new stocks at their whim, often within hours or minutes of the stock’s first trade, they try to persuade investors to hold on to IPOs, for better or worse.”

In 1999, after small investors had been thoroughly fleeced, the SEC told Congress in its annual report that it was studying the problem: it said it had “Examined the practice of ‘flipping’ whereby recipients of shares in an initial public offering sell immediately in the aftermarket.  The examination focused on the extent to which flipping occurs, how often penalty bids are assessed, and the types of issues where penalty bids are used.”

The SEC continued its studies right through the year 2000 and the market crash in tech stocks, many of which were still being held by clients whose brokers were following rigged research by their firm’s telecom analysts.

The SEC finally got around to proposing to eliminate the penalty bid entirely in 2004. It’s proposal said:

“Penalty bids raise three troublesome issues. First, because Rule 104 does not require the assessment of a penalty bid to be disclosed to the market, penalty bids can function as an undisclosed form of stabilization by discouraging immediate sales of IPO securities that would otherwise lower a stock’s market price. Second, we understand that some sales representatives may fear losing a sales commission if their customers sell their IPO shares. The salesperson’s concern may result in improper interference with a customer’s right to sell securities when the customer chooses to do so. Third, there is evidence that the assessment of penalty bids at the syndicate level results in discriminatory effects on the syndicate member’s customers. In particular, we understand that institutional salespersons are not penalized when their institutional customers flip their shares, but retail salespersons often are penalized.”

The SEC said that it believed the “likelihood of harm through the use of penalty bids is significant” and it proposed language stating “it shall be unlawful to impose or assess any penalty bid in connection with an offering…”

The SEC was then swiftly pummeled by Wall Street industry insiders in public comment letters and behind the scenes lobbying. We hear no more about the proposed elimination of the penalty bid until a notice appears in the Federal Register on April 30, 2007. The wording makes it sound like eliminating the penalty bid is still just a “proposal.” The SEC writes: “The proposal seeks to enhance the transparency of syndicate covering bids and prohibit the use of penalty bids.”

According to the law firm Shearman & Sterling, on November 27, 2013, the SEC approved a change to FINRA’s IPO Rule 5131, where penalty bids are still okay, providing that they have been imposed on the member firm by the managing underwriter of the IPO.

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