In today’s Wall Street Journal, an editorial applauded the Supreme Court for ruling in Credit Suisse v. Billing that investors could not sue investment banks under anti-trust law. They like Justice Stevens’s concurring opinion:

After the initial purchase, the prices of newly issued stocks or bonds are determined by competition among the vast multitude of other securities traded in a free market. To suggest that an underwriting syndicate can restrain trade in that market by manipulating the terms of [initial public offerings] (IPOs) is frivolous.

This is a red herring. If the underwriting syndicate can get super normal profits through commissions during the IPO, subsequent trading is moot.

The main finding in the Breyer Opinion (6 joining, 1 concurring, 1 abstaining and 1 dissenting):

In sum, an antitrust action in this context is accompanied by a substantial risk of injury to the securities markets and by a diminished need for antitrust enforcement to address anticompetitive conduct. Together these considerations indicate a serious conflict between application of the antitrust laws and proper enforcement of the securities law.

I agree that there is a fundamental conflict between Justice and/or FTC pursuing anti-trust claims and SEC regulating securities. But this is not saying that there should be no anti-trust enforcement. SEC should enforce anti-trust laws.

Here’s what they can expect to reap.

The IPO market has a signaling property in addition to a fund-raising property. If there is a big share price rise (“pop”) on the first day of trading, investors take this as a good sign. If there is a pop in the price of corn, people buy less corn, but for behavioral, psychological and signaling reasons, if there is a pop in an IPO share price, people want more shares. This creates a substantial windfall for investors with access to buying shares in the IPO. Thus taking hot IPOs to market are a plumb job for investment bank syndicates.

Investment banks are not particularly competitive. The securities underwritten by one need to ultimately be marketed to all investment banks’ clients. By working together, they offer monopoly access to their own clients in exchange for access to the other bank’s clients when its their turn to market a security. As an analogy, ESPN isn’t shown exclusively on Time Warner Cable. That wouldn’t make sense. Cox Cable customers want to see it too. So it is in the cable companies’ interest not to exclude other cable companies from content because they do not geographically overlap.

There is a strong incentive for the investment banks to cooperate to broaden the market for shares. This allows them to make the “pop” nice and big and pocket a super competitive portion of the commissions.

SEC should figure this out and impose structural anti-trust remedies. Since there is a market failure to prevent a “pop” because the seller and the buyers want it, the SEC should do something to prevent the investment banks from capturing it and dividing it. I propose that the SEC divide the IPO into stages. In the first stage, investment banks should individually bid cash to the for the right to be lead underwriter. In the next stage, the non-winning investment banks should bid cash individually for the share quota that they will be able to offer to their customers. Then in stage three, the firms will market those shares to their customers as they do now. This would allow the firm IPO’ing to collect a competitive portion of the pop while preserving the investment banks’ incentives to maximize the post-IPO share price.

An alternative choice would be for SEC to have an open IPO like Google’s where at least one broker allows all self-selected investors to participate in the IPO. This would give the pop to the investors in a non-discriminatory way.

By draining the excess profits from the IPO process, firms would get more net proceeds. This would encourage more firms to IPO and make markets more efficient. It would also create an incentive for innovation in investment banking. By breaking up the collegial atmosphere, there would be more opportunity for the creation of proprietary systems, intellectual property and experimentation by individual investment banks.

With business as usual, the only competition will come from outside the IPO market: staying closely held, selling to private equity funds, or being bought by a public firm. Since these options do not have the pop which signals a rush to new broad-based ownership, they cannot stop supernormal profits from being harvested in the IPO market as long as there is no anti-trust action.