What is Spinning
Spinning is the act of a brokerage firm or underwriter offering shares in an IPO to preferred customers, as a means of retaining or obtaining their business. In theory, spinning benefits both parties; the underwriter or brokerage firm cultivates loyalty and/or a broader client base, while the preferred customer enjoys the benefits, i.e. equity gains, afforded by a dynamic new public company. However, the practice is now illegal, as many considered it unethical. Spinning is also known as "IPO spinning."
BREAKING DOWN Spinning
Spinning is a lucrative means of enticing the business of large companies. By swaying the decision of the top executives, investment brokerage houses can secure a quid pro quo type of arrangement.
Since IPO gains often mostly happen in the first day of trading, demand is very strong for "hot" IPO shares that can easily flipped on the first day of trading for a sizable profit for the underwriting broker. Particularly during the dotcom boom of the late 1990s, the power allocate IPOs created instant profits for underwriters to distribute, and some underwriters took the opportunity to allocate shares to their friends in the business in the hopes of later garnering future investment banking business from them.
According to a 2009 study by professors Xiaoding Liu and Jay R. Ritter of the University of Florida, spinning does accomplish its goals. Liu and Ritter found that "spun" IPOs had first-day returns 23% greater than similar IPOs. The average first-day profit received from hot IPO allocations by the executives was found to be $1.3 million. The ratio of these numbers indicates that only 8 percent of the incremental amount of money left on the table flows back to the executives being spun.
In addition, the companies that were offered IPOs switched underwriters only 6 percent of the time, compared to 31 percent of the time for companies that were not offered IPOs. However, the study's authors also noted that "since 2001 the spinning of corporate executives has largely ceased in the U.S. This is due to both a regulatory crackdown and a dearth of hot IPOs to allocate."
Spinning is Now Illegal
The practice is now now been ruled illegal as it has been judged to be theft by favoritism. The social harm that now is outlawed entails the wrongful delivery of the monetary value of the discounts to preferred investors selected by securities firms. The start-up company selling the IPO could have obtained a higher price by selling directly to ordinary investors if the securities firm had not sold them to selected investors at a discount.