U.S. securities firm regulator NASD has censured, fined, and ordered J.P. Morgan Securities Inc. to pay US$6 million for unlawful profit sharing activities that took place at Hambrecht & Quist LLC prior to its acquisition in 2000.
NASD found that Hambrecht & Quist received millions of dollars in inflated commissions from more than 90 customers who sought and received allocations of “hot” initial public offerings from the firm. Customers paid the inflated commissions on agency transactions in highly liquid securities, with commissions as high as US$1.25 per share when an ordinary charge on these trades would have been US6¢ per share.
From November 1999 to March 2000, Hambrecht & Quist was the lead manager of 12 IPOs and was responsible for allocating the vast majority of shares offered. Most of these IPOs showed gains of over 60% on the first day of trading, with one hot IPO trading at 215% over its offering price.
The immediate increase in aftermarket price provided substantial first-day profits to customers who received the allocations. Hambrecht & Quist profited by receiving inflated commissions from IPO customers on unrelated agency trades. For example, the firm’s commission revenue increased from US$590,000 on the day before one IPO to US$2.2 million on the day of the IPO.
“Managers of hot IPOs are not entitled to capitalize on the immediate increase in the market price of those shares by receiving inflated commissions and sharing in their customers’ profits. Our rules prohibit profit-sharing, and engaging in the practice seriously undermines the integrity of the capital raising process,” said Mary Schapiro, NASD’s vice chairman and president of Regulatory Policy Operations. “NASD will continue to look at all aspects of the IPO allocation process to ensure that it is both efficient and fair to all market participants.”
NASD found that the profit sharing was shown by the pattern of trading in the customer accounts. For example, one customer paid over US$685,000 in inflated commissions in two trades after receiving IPO shares that were worth US$2.9 million in potential first-day profits.
Another account paid inflated commissions with rates as high as US80¢ per share, to generate more than US$575,000 to the firm, when commissions would have been less than US$85,000, had the customer paid the typical US6¢ per share commission. While the large majority of profit-sharing accounts were serviced by Hambrecht & Quist’s Institutional Sales Department, the firm also shared profits with accounts serviced by the high net worth retail Executive Financial Services Department.
The institutional sales traders and sales brokers were aware of the payment of inflated commissions on the same day hot IPO allocations occurred. One sales assistant listed two trades with commission rates of US50¢ per share and noted to her supervisor, “Can you tell I’m smiling … [Customer] has done it again! My baby’s going to college!”
Evidence of profit sharing was also shown through offsetting trades done by at least 20 accounts. In these situations, a customer purchased a highly liquid security through Hambrecht & Quist and paid an inflated commission. At another brokerage firm, the customer sold the security at an ordinary commission rate. These purchase and sale trades resulted in an immediate loss to the customer, but generated high profit-sharing commissions for the firm.
J.P. Morgan neither admitted nor denied the allegations, but consented to the entry of findings.