Many business practices employed during the late 90’s are the investigation du jour now. Improper use of special purpose entities, capacity swaps and outright fraudulent accounting has led to scandals and bankruptcies and has shaken the foundation of the financial markets. The latest practice to come under regulatory, Congressional and media scrutiny is the allocation of shares in initial public offerings.
The revelation that Salomon Smith Barney allocated thousands of shares of several IPOs to officers and directors of WorldCom have only added to the perception that the markets benefit only insiders-to the detriment of individual investors, employees and pensioners.
Wall Street has argued that the allocation of IPO shares was common practice and there were no rules against it, but that argument is being poorly received by Congress and the Securities and Exchange Commission.
On July 28 the National Association of Securities Dealers’ (NASD) Board of Governors approved new rules governing initial allocations of securities that would ban the practices of spinning, laddering and quid pro quo agreements.
Code of Conduct
The National Venture Capital Association promulgated a standard of conduct for “directed shares” six years ago. Every NVCA member firm has recently received a new copy of the standard. The association’s message is simple: The renewed focus on “hot issues,” new NASD rules and ongoing investigations by the SEC should heighten our commitment to integrity and to careful adherence to our fiduciary obligations.
As you well know, the IPO market is critical to our industry. If our conduct as participants in the IPO market is not above reproach, we undermine confidence in the IPO market and cripple our industry.
In furtherance of our commitment to an IPO market that is efficient and fair beyond reproach, the NVCA recommends every venture capital firm adopt a code of ethics that includes standard fiduciary principles, including all or some of the following:
* Implement appropriate restrictions on trading by a firm’s partners and employees.
* Establish an internal committee or appoint an internal compliance officer to address conflict of interest issues and monitor compliance with the policies and procedures established by a venture firm.
* Avoid actual or potential conflicts of interest in all personal securities transactions.
* Consider requiring that any hot issue shares be held for a minimum period (for example, 60 to 90 days) to avoid the appearance of impropriety associated with flipping for short-term profit and to demonstrate investment intent.
The NASD’s proposed rules, which are open for comment and subject to SEC approval, will prohibit the following actions:
* Quid pro quo agreements. The rules would prohibit the allocation of IPO shares in exchange for excessive compensation relative to the service provided by the underwriter. This provision would expressly prohibit not only IPO allocations in return for inflated commissions. It also would prohibit an allocation in return for a “pay-up” for any service offered by the investment bank.
* “Laddering” or aftermarket tie-in agreements. The rules would prohibit the solicitation of aftermarket orders for the allocation of IPO shares.
* Inequitable penalty bids. The rules would better ensure a level playing field by prohibiting NASD members from penalizing registered representatives whose retail customers have “flipped” IPO shares when similar penalties have not been imposed with respect to institutional accounts.
Lead by Example
Venture capitalists are the most hands-on board members. This is surely done out of necessity to shepherd and help young portfolio companies. But the current environment gives our industry the opportunity to lead by example as responsible, involved, independent directors.
Integrity and good governance are imbedded in the culture of a company. The culture of the company is set in its infancy. VCs are in a unique position to instill and set a fundamental solid base of ethical conduct that will hopefully continue as the company matures. It is of the utmost importance that we examine our dealings and the practices of our portfolio companies and ensure that we conduct ourselves in a manner that is above reproach.
Thomas C. McConnell is a general partner at New Enterprise Associates. He is a past chairman of the NVCA and current chairman of its Standards and Bylaws Committee.