By Pam Martens: August 18, 2012

Yesterday, at 1:29 p.m., the following headline appeared at the on-line Wall Street Journal: “Morgan Stanley Distributes Facebook IPO Profits.”  The headline was curious, because at 11 a.m. Facebook was trading at 19 bucks a share, exactly half its initial public offering (IPO) price in May. (The stock closed at $19.05, a nickel beyond half its IPO price of $38.) 

The article was written by Lynn Cowan, an outstanding veteran Wall Street reporter.  Cowan writes the “IPO Outlook” column for the Wall Street Journal, graduated magna cum laude from Montclair State University and received a Master’s degree in journalism from Columbia University.   If Cowan says Morgan Stanley had profits to distribute, she must be on to something. 

As it turns out, the profits, according to Cowan, were a whopping $100 million or thereabouts and were not fees or commissions from the IPO underwriting but trading profits from what effectively amounts to Morgan Stanley covering its short position in Facebook as the stock  plumbed new lows over its three month downward spiral.

As Cowan explains: “In IPOs, underwriters are allowed to sell about 15% more shares than the total deal size to investors the night before a stock begins trading. This creates a short position of shares sold that the banks don’t actually own, and it can stay on the bankers’ books for 30 days. The short position is created to allow underwriters to stabilize the stock in its early days of trading.” 

Here’s the heads they win, tails you lose part of the benign sounding stabilization process for IPOs as reported by Cowan: “If investors are selling the stock after the IPO launches, pushing the price lower, bankers can step in and buy shares at the IPO price in an attempt to keep it from falling below its issue price. This also serves to cover their short positions. If a short position remains on their books and the stock keeps falling—which was the case with Facebook on subsequent trading days—the underwriters can continue to cover their short positions by buying back shares at prices below the IPO price, netting a profit.”

But what if an IPO goes in the other direction, up instead of down? “There is no risk to the banks in this effort. If the stock only trades up, the short position is covered when banks exercise what is known as an overallotment option, buying more shares from the newly public company at the IPO price.”  The words “minting money” come readily to mind.

You are no doubt thinking, how is this legal.  (You might also be correctly thinking, how far would Facebook’s share price have fallen without that artificial short covering support offered by Morgan Stanley.)

As I’ve previously reported, the manipulations which occur during an initial public offering have had a no-law zone chiseled out for Wall Street by none other than the U.S. Supreme Court.  In its 2007 decision,  Credit Suisse v Billings, the Court effectively ruled that Wall Street is untouchable by the U.S. Justice Department for any illegal acts in the issuance of IPOs. 

In the Credit Suisse case, investors had filed suit alleging that the investment banks, acting as underwriters, violated antitrust laws by forming IPO syndicates for hundreds of technology-related companies. The suit charged that the underwriters unlawfully agreed that they would not sell newly issued securities to a buyer unless the buyer committed to buy additional shares of that security later at escalating prices (laddering); agreed to pay unusually high commissions on subsequent security purchases from the underwriters; or agreed to purchase less desirable stocks (tying). The investment banks moved to dismiss the complaint, claiming that federal securities law preclude application of antitrust laws to the conduct in question. The District Court dismissed the complaints, but the Second Circuit Court of Appeals reversed the decision. It was then accepted to be heard by the U.S. Supreme Court. 

The Supreme Court ruled as follows, effectively putting the SEC (which can only bring civil cases, not criminal) in charge of Wall Street IPO collusion and removing the U.S. Justice Department and its criminal powers from the equation: 

“We believe it fair to conclude that, where conduct at the core of the marketing of new securities is at issue; where securities regulators proceed with great care to distinguish the encouraged and permissible from the forbidden; where the threat of antitrust lawsuits, through error and disincentive, could seriously alter underwriter conduct in undesirable ways, to allow an antitrust lawsuit would threaten serious harm to the efficient functioning of the securities markets…We therefore conclude that the securities laws are ‘clearly incompatible’ with the application of the antitrust laws in this context.”