Underwriters' Law Sidesteps American Mistakes

The Israel Securities Authority (ISA) chairman, Moshe Terry, sent an amended draft of the new underwriting law to the finance minister on Wednesday. The purpose of the law is to make it easier for underwriters to market stock issues via guaranteed allocations to institutional investors, while avoiding the pitfalls that led to a corrupt underwriting system in the United States.

A revolution in the underwriting business is gathering pace. After years of talk and discussions about the underwriting law that will change the primary market, it seems the urgency with which Terry is now promoting the regulatory alterations will bring the new rules, which are similar to the American underwriting rules, into effect within a few months.

The amended draft sent to the Finance Ministry will be presented to the Knesset for approval on its second and third readings, having passed its first reading in the summer of 2002.

The advancement of the underwriting industry will have an effect on all branches of the capital market that were created from the outset as accessories to the primary market, which is meant to help companies raise funds for investment and growth. ISA sources say the restrictions that have so far governed the underwriting market made it difficult for underwriting to function, mainly due to the competition with the other capital markets around the world.

The dual-listing law passed over two years ago was part of an attempt to compete with the stock markets of New York and to import Israeli companies that were issued there. The improvement in the competitive position of the underwriters in the primary market will make it possible for them to attract companies that had previously preferred to skip the Tel Aviv Stock Exchange during the stock issue stage.

Following the serious accounting problems in the U.S. - mainly WorldCom, Enron and Arthur Andersen - and the legislation of the Sarbanes-Oxley law, the ISA wanted to amend some of the relatively lenient clauses that had already been passed during the law's first reading. This is to make the regulations stricter and to prevent similar occurrences in Israel.

Most of the problematic clauses in the draft of the law that was passed on the first reading concern the freedom granted to underwriters to sell as many shares as they want to whoever they want, as is customary in the U.S. The revelation that American underwriters had used the sale of shares during a stock issue as a bribe for decision makers in tertiary companies - those not connected to a specific issue - led the ISA to amend the law somewhat.

The American system is good for insiders - according to indicators known to underwriters after a few long days of a road show, they knew how a share would behave the day after its issue. If it seemed that a certain share would skyrocket, the underwriters would sell it to their friends as part of an issue, and they in turn would sell it on the stock market the following day at a big profit.

In the letter that accompanied the proposal for the law, Terry wrote to Finance Minister Binyamin Netanyahu that the amended proposal creates a balance between the market's needs to let underwriters allocate securities according to their discretion and the ISA's obligation, as the supervisor, to ensure that the allocations will be handled properly and fairly.

In the letter, Terry describes the cases of irregularities in the U.S. that prompted the ISA to make the amendments. "In the past two years it has been revealed that in many cases the underwriters have made improper use of their power to use their own discretion when allocating securities during stock offerings," wrote Terry. "In offerings in which the underwriters anticipated that the price of the securities was much lower than the price at which it was expected to open for trading on the bourse - a "hot issue" - the underwriters allocated some of the stocks to private individuals with whom they had special connections or dealings."

Terry went on to explain that the ISA felt that in light of such occurrences it would be fitting to reexamine the underwriting law, and had therefore discussed various amendments to the underwriting system in Israel with representatives of publicly traded companies, underwriters, the bourse, and academicians, among others.

"Our proposal," wrote Terry, "is a suitable reflection of the economic approach according to which everything is permissible unless specifically stated as forbidden, and there is no need for an arrangement in a matter that the market handles very well. on its own. Basically, the ISA proposes regulations that will distinguish between an allocation to an institutional investor and an allocation to the public.

"Allocations to institutional investors will be at the underwriters' discretion, meaning there will be a much greater certainty as to the relationship between the underwriter and the institutional body. Institutional bodies, which are limited from the perspective of analytical resources and are interested in guaranteeing their order, can purchase the quantity they originally ordered with no fear of an oversubscription and consequently fewer shares.

"In addition to the size of allocations, the underwriter can decide to which institutions to sell and to which not. The allocation to the public will be done according to the orders and a tender on amounts, but the price will be uniform. This means that an investor will order a certain quantity but will ultimately only win a relative share of that order.

"The discretion of the underwriter in allocation to institutional investors refers only to the size of the allocation and the identity of the investors to whom the underwriter will allocate shares, but the price of the allocation will be uniform for everyone. In addition, the underwriter will have the discretion to determine the quantity, if any, that he will offer to non-institutional investors."

All in all, it appears the institutional investor will become an even more important player than before, and that many issues will close at the institutional stage. Furthermore, the ISA is proposing to allow underwriters to stabilize the prices of the securities the issue for a limited time immediately before and after the issue. This means that the underwriters will be able to buy and sell securities on the market without such activity being considered a ploy.

Other substantial changes in the new underwriting law concern the possibility of commencing the marketing of an issue before the approval of its prospectus. Underwriters could interest investors in a planned issue based on a draft of the prospectus, go out on a road show to get an indication of the level of demand and the price that can be demanded. In a prospectus could be approved by the ISA without the price and quantity of shares to be offered being stated. Thus underwriters would not be exposed to a price that is set a week before the issue, during which significant events could take place that would affect the price.