Last March the tech-heavy Nasdaq index reached a staggering 5048, prompting venture capitalist John Doerr to claim that we were witnessing "the greatest ever legal creation of wealth in the history of the world."
This week, the Nasdaq fell below 2000. Someone is out a lot of money, and that someone is primarily the small retail investor. Why? Because the insiders _ entrepreneurs, venture capital firms, investment banks and large institutional investors _ pulled out their capital long before the fall, leaving mom and pop investors holding the bag.
Instead of the greatest ever legal creation of wealth, the high-tech financial bubble represented the greatest ever legal transfer of wealth _ from retail investors to insiders. For example, between November 1998 and July 2000, Goldman Sachs, Morgan Stanley Dean Witter and Credit Suisse First Boston each pocketed more than $500-million in underwriting fees for Internet companies. And over the past two years, technology underwriting as a whole brought in close to $1-billion for each bank. According to Thomson Financial Securities Data, this was the most lucrative streak investment banks have ever seen in a single sector.
Some insiders would argue that they too have been hurt by the stock market's decline. And in fairness, it should be noted that not every insider pulled out early. Some held their stock and took a hit. But the fact is not all stock losses are the same, because the insiders get their stock for pennies a share, if that. Thus, while an insider may have recently seen his portfolio slip from $50-million to $5-million, he probably paid only $100,000 for his stock to begin with, so he's still ahead in terms of real money. But when individual investors see their stock portfolios plummet, it's real.
The truth is, little investors never stood a chance, because they simply don't have the same access, both to key information and to early deals, as big investors. One reason is the "quiet period" mandated by the Securities and Exchange Commission, which requires a startup company to shun any publicity regarding its finances for at least three months before its initial public offering. The law was intended to keep a company from hyping its stock, but in reality its main effect is to keep small investors in the dark.
Big institutional investors such as Fidelity and Vanguard are never in the dark. They're treated to what's known as a "road show" just days before an IPO. In this private meeting with company executives, institutional investors are updated on the startup's financial situation. Thus the big investors know if a stock has recently become more risky and can pass on it. Or they may decide to buy it anyway, knowing they can resell the stock on the first day of trading before any bad news about the company is reported. This practice, known as "flipping," became common in an era when Internet stocks were routinely tripling in value on their first day of trading.
Institutional investors weren't the only ones flipping stock during the hot market. Individual insiders did it, too. During the Nasdaq bubble, investment banks would routinely give hot new IPO stocks _ free _ to corporate executives, venture capitalists and other decision-makers sitting on the boards of companies whose business the banks wanted. These privileged decision-makers would then flip their shares on the first day of the IPO for quick profits.
And while the investment banks were giving out free stock to their favored clients, they were also giving out bad advice to their mom-and-pop customers. In a recent study of high-tech stocks, Roni Michaely of Cornell University and Kent Womack of Dartmouth College found that investment banks rarely downgrade a company's stock to a "sell" rating if they have a business relationship with the company. "There is a bias in brokers' recommendations when they have an underwriting affiliation with a company," says Michaely. "But the public doesn't recognize it." In fact, it wasn't unheard of for a bank to issue a "buy" recommendation on a stock that the bank's own fund managers were betting would drop.
But despite these shenanigans, the savvy retail investor could at least take comfort in Rule 144, the SEC regulation that bars a company's owners from selling their stock for 180 days after an IPO. (This type of stock is sometimes referred to as "locked stock.") So if the stock did tank three months after it was issued, at least the small investor could find solace in the fact that the entrepreneur and his venture capital backers had taken a loss as well.
Or did they?
Actually, during the high-flying days of the tech bubble, few insiders were required to take risks. The investment banks devised a new financial service: They would promise to buy a venture capitalist's or tech executive's locked stock as soon as the 180 days were up _ but at the stock's higher early issue price. This special service for favored customers didn't cost the banks a thing, since they would then use a combination of sophisticated financial instruments to "short" the stock. That is, the banks would make money if the stock dropped in value, which it almost always eventually did.
The technology stock bubble is already being compared to previous financial manias: Dutch tulips in the 1600s, U.S. railroads in the late 1800s, etc. But what sets this most recent mania apart is its Ponzi scheme quality. Never before has so much wealth been transferred from one group of people to another in such a short time. Maybe if the Securities and Exchange Commission steps in to restore fairness it never will again.
Michael C. Perkins is a founding editor of Red Herring magazine and co-author of The Internet Bubble. He and Celia Nunez are authors of A Cool Billion, a novel about Silicon Valley.