Introduction to Corporate Finance

12: Raising Long-Term Financing

12-2a CONFLICTS OF INTEREST FACING INVESTMENT BANKS

The institutional arrangements for selling securities to the public, as described above, confront investment

banks with potential conflicts of interest. Banks are providing advice and underwriting services to

companies that want to issue securities. On the one hand, issuing firms want to obtain the highest

possible price for their shares. But they also want favourable coverage from their investment banks’

research analysts, who produce reports that are intended to advise clients on whether securities are fairly

priced. Investors, on the other hand, want to purchase securities at the lowest price possible, but they

also value dispassionate, unbiased advice from analysts. Investment bankers must therefore walk a thin

line, in terms of both ethics and economics, when attempting to please their constituents. Firms issuing

securities are wise to bear this in mind. Investment bankers deal with investors, particularly institutional

investors such as mutual funds, on a repeated basis. They must approach this group each time they

bring a new offering to market. In contrast, over the life of a firm, there is just one IPO and perhaps a

few SEOs.

Banks struggle with these conflict-of-interest problems; instead, they must price new security

issues to strike a balance between the revenue maximisation goal of the issuing firms and the profit

maximisation objective of their investing clients. Of course, lawmakers and regulators recognise that the

investment banking business is susceptible to conflict-of-interest problems, and so there is an extensive

set of rules that impose constraints on how securities may be sold. The Facebook IPO debacle (discussed

in Chapter 20) provides an example of these issues. As a result of litigation in relation to the Facebook

IPO, Nasdaq OMX Group agreed to settle a class-action lawsuit for US$26.5 million, in addition to a

penalty of US$10 million paid to the US Securities and Exchange Commission.^2 The lead investment

bankers behind the IPO, Morgan Stanley, were also fined US$5 million for their part in allowing

investment bankers to influence the activities of investment research analysts, who were supposed to

provide independent research about the equity issue.

Now we turn to a brief overview of the legal environment surrounding security issues.

12-2b LEGAL RULES GOVERNING PUBLIC SECURITY SALES

The basis for the regulation of the sale of securities is the concept of full disclosure, which means that

issuers must reveal all relevant information concerning the company selling the securities and the

securities themselves to potential investors.

Given the emphasis that securities law places on disclosure, it is not surprising that investment

banks are required to perform due diligence examinations of potential security issuers. This means that

they must search out all relevant information about an issuer before selling securities to the public.

Investors can sue underwriters if they do not perform adequate due diligence; of course, in such cases

the underwriter’s reputation suffers as well. The fact that investment banks are willing to underwrite an

issue provides valuable certification that the issuing company is in fact disclosing all material information.

In Australia, financial markets are regulated by the Corporations Act 2001, which is administered

by the Australian Securities and Investments Commission (ASIC) under the Australian Securities

and  Investments Commission Act 2001. Companies choosing to raise funds in Australia need to

follow the various rules and regulations set out by ASIC, and these are available on the ASIC website

(http://www.asic.gov.au). The principal disclosure document for all public security offerings is the

2 ‘NASDAQ to settle Facebook IPO lawsuit for $26.5 million’. Reuters, 23 April 2015. http://www.reuters.com/article/us-nasdaq-omx-facebook-
litigation-idUSKBN0NE1FD20150423. Accessed 15 December 2015.

full disclosure

Requires issuers to reveal

all relevant information

concerning the company

selling the securities and

the securities themselves to

potential investors

due diligence

Examination of potential

security issuers in which

investment banks are legally

required to search out

and disclose all relevant

information about an issuer

before selling securities to

the public

certification

Assurance that the issuing

company is in fact disclosing

all material information

Tim Jenkinson, Oxford

University

‘There are basically

three ways of doing an

IPO.’

See the entire interview on

the CourseMate website.

COURSEMATE

SMART VIDEO

Source: Cengage Learning