Come On and Take a Free Ride

Mod Note: Blast from the Past - "Best of Eddie" - This one is from June 2011.

Freeriding : The illegal activity of buying a stock and selling it before paying for the purchase. - Investopedia

While I was thinking about writing a post about the power once wielded by Series 7 stockbrokers, I started to think back to some of the funnier episodes from back then. It occurred to me that, while a great many things have changed, some have remained the same. What specifically came to mind is the recently bubblicious nature of the tech IPO market, and how similar it was to the IPO market of 1993-95.

Back then, I worked for a firm with a very hot hand in the IPO market. You could say it was our specialty. In 1993 we brought 15-18 deals (I don't remember the exact number), and they each rose an average of 52% (later verified by USA Today). The public had IPO fever; you could literally dial a US phone number at random and if an English-speaking male answered (we didn't do business with women), there was a 50/50 chance you could sell him an IPO on that phone call.

Now, there's any number of reasons why you wouldn't do that, chief among them the unsuitability of an IPO for the average investor's portfolio. But you could do it if you really wanted to, as my buddy Sean once proved to me.

While the hot IPOs always went to your best clients, the lukewarm IPOs (ones we expected to jump 20-30% on the open) were perfect for landing new business. Let's say you had been working a wealthy prospect or a small institution for a while, but they hadn't thrown you any business yet. Dangling a piece of even a lukewarm IPO was often enough to bring them into the fold.

These IPOs were also a nice insurance policy for the broker, in case the new client decided not to pay. Keep in mind that 20 years ago there was no Internet, everything was done by telephone and snail mail, and you had to invest a certain amount of trust in a new client because you executed orders on their behalf before they ever paid you for them. In fact, they had a full seven days after the trade to pay for it.

If the stock went down in that period and the client decided not to pay, the stock would be sold on Day Eight and the broker would have to personally cover any losses. Bud Fox dealt with this in Wall Street when a client "DK'ed" him on a trade and he had to borrow money from his dad to cover it. IPOs were ideal for new accounts because they almost never went down in the first week, so even if you got sold out by a new client you wouldn't have any losses to cover.

Anyway, we're booking a new deal that looks pretty decent, and I notice my buddy Sean is struggling to place his allocation. He'd already gone A-Z in his book, and I think he had about $25,000 in IPO left over. I tried to get him to give it to me, since I'd already place all of mine, but he wasn't willing to give up the $2,500 in commission (IPOs paid 10% gross back then). So he starts Cold Call Closing.


The Cold Call Close

Cold Call Closing was one of the dumbest things a broker could do back then, because you had absolutely no idea who you were dealing with on the other end of the line. Normally, you would have had three or four or more conversations with a potential client over the course of a couple weeks before you asked for any business. That way, you had a sense of the kind of guy he was and how much he had in the market and most important - how likely it was that he'd actually pay for the trades he placed with you.

The Cold Call Close went something like this:

Prospect answers phone.

"John Smith, please."

"This is John."

"Hey John. This is Joe Shit the Ragman with XYZ Firm. We spoke about six weeks ago (a blatant lie, but plausible because wealthy people were getting calls from brokers every day back then), and I promised you I'd get back in touch with you when I had something really exciting. You indicated to me then that you were interested in getting in on the ground floor of an IPO. Is that still the case?"

Boom. Better than 50/50 chance of John Smith answering in the affirmative.

So Sean starts Cold Call Closing and before long he gets a guy on the phone who wants to play ball. Sean goes through his whole pitch, gets the guy fired up, and the guy takes the whole $25,000 allocation that Sean has left. He gives Sean his SSN, his home and work addresses, all his personal information, and Sean opens an account for him and puts the IPO shares in it.

The IPO debuts and I think it went up around 40% on the first day, and then started meandering lower. Sean calls the guy to chase in the check and the guy starts stalling on him. After three or four days, he just flat tells Sean that he's not going to pay. Sean explains that the stock is still up, and all he has to do is pay for it to lock in a profit. But the guy is adamant that he's not paying. So Sean hangs up the phone and sells the stock for about a 20% profit from the IPO price.

Now what normally happened in cases like this was that Operations would match the sell with the buy and see that the trade hadn't been paid for. This was known as freeriding, and it was (and remains) illegal. But it wasn't like you got in trouble for it. Operations would just back out the trade like it never happened, you'd lose your commission, and the firm would keep the profit on the trade. Obviously, if the trade sold out at a loss you'd have to cover it (and you'd lose your commission on the original trade - a double hickey), but this was rarely the case with IPOs.

So a couple weeks go by and Sean notices that they haven't dinged his commission $2,500 for the bogus trade. We only got paid once a month back then, so it wasn't unusual for the firm to take their sweet time making commission adjustments. But payday rolled around and Sean got paid for the trade. On top of that, the client's account had a $5,000 cash balance in it. Operations had completely missed the free ride.

Sean waits another month or so to see if they're going to catch it, and when they don't he comes to me and asks me what I think he should do. I laughed and said, "Fuck it. Send the guy his money."

Sean calls him up and actually gets into an argument with the guy because the guy doesn't believe him and thinks Sean is trying to scam him somehow. Sean finally says, "Look dude, I'm gonna send you a check for five grand and that should answer the 'how full of shit am I' question. You're welcome." And with that he sent the guy the balance in the account.

A couple weeks go by and Sean's phone rings. It's the guy, he received the check, and the check cleared his bank. So now he's totally confused. He never sent Sean a penny, but Sean sent him five grand. Sean hits him with whatever the 1994 equivalent of, "That's just how I roll" was and tells the guy not to look a gift horse in the mouth. Then he hangs up.

The guy calls back a few days later and asks Sean if he can get any more IPO stock. Sean laughs and tells him to get bent. But the guy says, "What if I wire over $100,000 before we do anything else?" Sean is stunned. Nobody ever paid for trades in advance back then. So Sean tells him he'll believe it when he sees it.

To make a long story short, the guy ended up being one of Sean's biggest clients (and still is today, for all I know).

Part of what makes the story so funny to me was knowing Sean. He was just a goofy drunken Mick from Boston who thought Doug Flutie was the second coming of Christ. He lived paycheck to paycheck, and I once watched him put a note that read, "I'll catch up with you next week." in an empty ATM deposit envelope before withdrawing the $200 he told the machine was in there (obviously this was before banks got wise to the immediate withdrawal scam). We promptly took that $200 and drank it.

So you see, kiddies, some stories of SEC violations do have happy endings. If I had to figure out who got screwed in this deal (because in the market someone always gets screwed when someone else gets over), it would have to be our firm, but only because they missed an opportunity to rape an employee (one of upper management's favorite pastimes). The client certainly didn't get hurt, and neither did Sean. The company that IPO'd got all their money from my firm. So, yeah, I guess the firm took it in the shorts.

Chalk one up for the good guys.

 

Seems kind of bogus that you as the broker would have to cover the losses if a client didn't pay and the stock cratered, but when the stock goes up the firm keeps the profit AND takes back your commission? Brutal.

- Capt K - "Prestige is like a powerful magnet that warps even your beliefs about what you enjoy. If you want to make ambitious people waste their time on errands, bait the hook with prestige." - Paul Graham
 

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