What is an Underwriter?
When a company is planning to go public, they typically enter into an agreement with an underwriter to help them prepare for the Initial Public Offering (“IPO”). The most common type of underwriting agreement is one in which the underwriter agrees to assume the risk of buying the entire inventory of stock issued in the IPO and sell it to the public at the IPO price. The underwriter serves as an intermediary between the company and investors.
The underwriter is also responsible for filing a Form S-1 registration statement with the U.S. Securities and Exchange Commission (“SEC”). The form outlines the business of the company, the planned use for the capital raised, the basics of the IPO, any material business dealings between the company and its directors or outside counsel, and any legal issues the company may have.
While the SEC is reviewing the registration statement, the underwriter creates a preliminary prospectus to take on a roadshow. During the roadshow, the underwriter generates excitement for the IPO and tracks indications of interest from potential investors. A pricing recommendation (how many shares can be sold at what price) is then determined based on the level of demand for the stock.
If the pricing recommendation is acceptable to the company’s Board of Directors, an initial price for the offering is set and the IPO date is solidified. A final prospectus is created and distributed to potential investors and filed with the SEC before the stock is open for trading.
Why JP Morgan?
JP Morgan’s IPO underwriting business only accounts for a quarter of its total revenue and trails Goldman Sachs and Morgan Stanley’s practices. But JP Morgan’s strong shareholder support and positive balance sheet have allowed the bank to expand its investment banking operation. In an effort to win big IPO deals, JP Morgan’s CEO, Jamie Dimon, has pitched the bank as a soup-to-nuts operation.
With WeWork (“We”), a cash bleeding startup, the bank participated in a funding round that valued the company at $5 billion in 2014, followed with a $650 million credit line in 2015, and an additional $500 million two years later. JP Morgan is We’s third biggest investor, behind SoftBank and Benchmark Capital. The bank has also extended nearly $100 million in mortgages and other loans to We’s CEO, Adam Neumann. In fact, JP Morgan is one of the banks behind the $500 million credit line that allowed Neumann to cash out a portion of his shares.
Goldman Sachs, Morgan Stanley, and other major investment banking firms were also courting Neumann, but in the end Dimon won. That win was short-lived, as We was forced to pull its IPO and may run out of cash by the end of the year. JP Morgan stands to lose millions not only as We’s lead IPO banker, but its main commercial lender.
Did JP Morgan Know? Does it Matter?
Some claim that JP Morgan knew or should’ve known that some of the money intended for the company was going to Neumann’s pocket because of the due diligence required to provide commercial loans. In its role as commercial lender, JP Morgan had better access to both We’s finances and Neumann’s personal finances. The bank did push We and Neumann to disclose personal conflicts, which led to investor backlash and the eventual shelving of the IPO. However, not everything was disclosed.
As mentioned above, JP Morgan was responsible for drafting the prospectus which includes information on corporate governance. JP Morgan worked with Skadden Arps Meagher & Flom LLP and Simpson Thacher & Bartlett LLP to prepare the prospectus. According to a representative for Neumann, the company hired the best lawyers and bankers in the world to manage the filing and he was extensively involved in the drafting process. However, “the IPO prospectus was poorly written, delivered muddled messages about the business,” and left unanswered questions about the company’s finances. Given the importance of the prospectus in setting an IPO price and ultimately receiving SEC approval, the lack of attention is surprising.
Maybe it doesn’t matter because the system worked – the IPO was ultimately shelved due to JP Morgan pressing Neumann to disclose his personal conflicts. On the other hand, it matters because it is well known that “prospective investors look to the underwriter . . . to pass on the soundness of the security and the correctness of the registration statement and prospectus.” JP Morgan shouldn’t have filed the registration statement or drafted a prospectus knowing what it did about We’s and Neumann’s finances.
“Consequences” for JP Morgan
As We’s commercial lender, the bank couldn’t pull out like a traditional investment bank whose responsibilities end when an IPO is pulled. With the IPO off the table, JP Morgan was going to lose money if We didn’t raise cash. But for a megabank like JP Morgan this isn’t much. So why did Dimon offer a rescue package?
Part of it is to save face. JP Morgan was the underwriter for the worst unicorn of 2019, Smile Direct Club, whose shares are down nearly 60% since it went public. JP Morgan was also the underwriter for Lyft, which at its lowest has shed about $25 billion in market value. Dimon wants to continue growing JP Morgan’s investment branch and is sending the message that the bank believes that “throwing capital at a business concept with no profitability in the foreseeable future is still an effective strategy in the fantastical world of unicorns.”
If the registration statement had become effective and shares had been sold, JP Morgan could be liable under the Securities Act of 1933 (“Act”). Section 11 imposes liability if any part of the registration statement, at the time it became effective, contained material misrepresentations or omissions. Section 12(a)(2) of the Act imposes liability on any person who offers or sells security in a registered offering via a prospectus or any oral communication which contains material misrepresentations or omissions.
JP Morgan could assert a due diligence defense if it can show that it exercised reasonable care and did not and could have not known of the violation. However, asserting or rebutting this defense is a gamble because courts have not provided clear guidance as to what steps are sufficient and who really knows what is reasonable in a world of unicorns.
Putting liability aside, JP Morgan did enable Neumann. Underwriters act as gatekeepers in the IPO process and it’s reasonable that they have responsibilities in a Pre-IPO world. But asking underwriters to be the adults in the room just shifts responsibility allowing companies and CEOs to continue avoiding the consequences of their actions. Let’s not forget that We and Neumann are the ones who approved and engaged in this behavior. Yet We just received a billion dollar bailout from Softbank, which included a large payout for Neumann.
*Daniela Sanchez is an Associate Editor on the Michigan Technology Law Review.