In a recent article by CNBC a loophole in IPO politics was uncovered as Uber launched their Initial Public Offering.
It was reported that Morgan Stanley, Uber’s underwriters, deployed the option ahead of the IPO, so they could provide extra support for the stock due to their worry that the IPO had run into trouble. This was evident as the IPO traded down 18% in its first 2 days.
The tactic used is known as a ‘naked short’, which basically allows those who use it to short stock that doesn’t exist. The practice has been outlawed in most cases but the naked short selling as part of a syndicate in an IPO is still legal.
These positions are generally used where underwriters ‘are concerned that there may be downward pressure on the price of the common stock in the open market after pricing that could adversely affect investors who purchase in this offering,’ Uber said in their filing.
Through these deals an over allotment is created giving the underwriters the power to sell 115% of the available offering to their investors. This effectively opens a short position of 15% which can then be purchased by the underwriters in the open market, thus covering the short position and supporting the stock if it goes down. These are commonly known as the ‘Greenshoe’.
In some cases, the ‘naked short’ strategy is used which allows underwriters to sell shares above the usual ‘greenshoe’ portion and buy them back later if significant sell pressure is witnessed.
The exact size of the naked short is reported to have been ‘fairly small’ and appears to have not helped much as an 18% decline was witnessed and the heavy trading volume quickly ate away at this support.
Based on the 1.3% fee incurred for managing the IPO it is estimated that Morgan Stanley netted over $100 Million in fees. So far neither Morgan Stanley nor Uber have commented on the ‘naked short’ selling activities.
The recent developments was captured In an article written by Caitlin Long for Forbes. The piece highlights some of the loopholes used that would otherwise contradict SEC laws and highlights how these are a ‘win-win’ for the bankers and underwriters but the IPO investors are left with little downside protection
Caitlin also highlighted how these outdated securities laws would not be possible through the decentralized blockchain economy. In Caitlin’s article she states that
Naked shorting is impossible to do when securities are issued natively on a blockchain. Had Uber’s shares been issued on a blockchain rather than through legacy systems, banks simply would not have been able to issue more UBER shares than the quantity of shares outstanding. The price-suppressive impact of the naked shorting–however large or small it was in the Uber case–simply could not have happened. And, had the banks had no way to protect their downside risk by naked shorting, one can only guess how much lower Uber’s IPO price might have been.
The points made by Caitlin clearly highlight how blockchain can provide the integrity needed and obviously missing in today’s IPO market.