Filmmaker Martin Smith (Frontline)

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'Dot Con'
With Martin Smith
Producer/Filmmaker, "Frontline"
Friday, Jan. 25, 2002; 11 a.m. EST

When the Internet bubble burst in March 2000, unlucky investors watched more than $3 trillion of their money disappear. What spurred the incredible dot-com bull run on Wall Street? Was the public blinded by dreams of small fortunes and easy living or did the nation’s investment banks manipulate the IPO market and exploit public trust?

FRONTLINE's "Dot Con," airing on PBS Thursday, Jan. 24, at 9 p.m. EST, investigates the financial forces behind the unprecedented rise and seemingly overnight fall of the Internet economy. Award-winning producer and reporter Martin Smith produced the program, and was online Friday, Jan. 25.

The transcript follows.

Smith, who served as Frontline's senior producer from 1990 to 1994, produced, directed and co-wrote "Hunting bin Laden," which was re-broadcast on PBS on Sept. 13. He also produced "The Saudi Time Bomb" and "Looking for Answers" in 2001. (He discussed the films on washingtonpost.com.) For Frontline, he also produced the Emmy Award-winning "Drug Wars," in 2000, a look at 30 years of American drug policy; "The Real Life of Ronald Reagan"; "Who Pays for AIDS?"; and "The Bombing of West Philly." He also investigated private funding for the Nicaraguan contras in "Who’s Running this War?" and produced "Revolution in Nicaragua" for the Peabody Award-winning Frontline series "Crisis in Central America."

The transcript follows.

Editor's Note: Washingtonpost.com moderators retain editorial control over Live Online discussions and choose the most relevant questions for guests and hosts; guests and hosts can decline to answer questions.

washingtonpost.com: Good morning, Martin, and welcome. With the bankruptcy of Enron grabbing the headlines recently, people's minds are on investing, business and their personal portfolios. When the Internet boom came on, people jumped into the market and on IPOs at an unprecedented rate -- average folk got on board more than ever before. Then the spectacular implosions of some Internet companies left many investors holding the bag. Were things that badly mishandled, or did the investors simply not keep in mind that this was a crap shoot?

Martin Smith: I think things were badly mishandled by the banks and the venture capitalists, because never before have so many unprofitable companies been offered to the public as good investments and touted by so many stock analysts. The financial media explosion of recent years added to this, and the public was woefully misinformed. Ultimately, the public has to take responsibility, but the people who knew better weren't helping educate the public. They were exploiting them.

Lynchburg, Va.: If you were to compare the extent of public (governmental) versus private investigation of the bubble exploitation what observations would you make? Are they comparable in vigor, in motivation, in their potential for reform?

Martin Smith: Initially, the government investigation was quite vigorous. It's unclear whether it will continue to be. The private attorneys are more like opportunists who come to the table when they know that Washington is on the case. Without vigor from Washington, not a lot will happen.

Scottsdale, Ariz.: Having been an investor since 1998, we have thoroughly taken the ride. My husband and I have lost our entire life's savings to the tune of several million dollars and can never hope to recover at this age. Your program has put to words the innuendo, the wink, the conspirators "edge." There seem to be many laws to "protect" the investor, but no "policeman." Now it seems, they want to close the barn doors after the COW has left. We, the public, the citizens, have been screwed again -- with our government's help. So, will you be doing a follow up program with the remedies or "medicine" that exposes the harder issues? Who is going down? Or can you only go so far -- fearing your own professional financial censorship? Will you find the governmental collusion and show it? Our tax deduction for loss is $3,000 a year -- carry over. At that rate it would take a thousand years -- an example of government consideration? There is much more to be revealed; don't stop. You are doing an excellent job. And luck has little to do with it.

Martin Smith: Thank you for the compliment. But I'm very saddened by your tale. I have received many e-mails this morning describing similar woes. Frontline will continue to cover this and similar stories.

The government regulatory agencies don't have a lot of muscle, and that's by intent. Our system of capitalism is founded on the idea that the free and unfettered markets are best. They are, however, disastrous for investors who don't fully understand the risks that they're being sold.

Sacramento, Calif.: Hello Martin,

Thanks for the "Dot-Con" -- it will definitely contribute in preventing a sequel.

I was curious to know why even a head of the highest regulatory authority for stock markets have to be politically correct and circumvent questions or answer in a roundabout way? I mean, where does the common investor go for the right answer if even the good guy is afraid to be forthright?

Martin Smith: You're referring to Arthur Levitt, the former chairman of the SEC. He answered questions only hypothetically because he felt that it would be inappropriate for him to comment on ongoing investigations. I don't think he was trying to dodge the issues. I do, however, think that the SEC is underfunded and lacks muscle. But that's the way Washington and Wall Street like it.

Sterling, Va.: Martin, I do think that investment banking hype had a lot to do with the failure of the .coms. But what about people like Mike Saylor at MicroStrategy? Don't you think he generated much more hype then his investment bankers? Which led to the company's near-collapse? I think failure on the part of company heads and board of directors is to blame as well.

Martin Smith: I'm not familiar with the MicroStrategy case. But of course it's true that there were a lot of entrepreneurs who joined in the hype. But I felt in setting out to produce this report that that aspect of the tech bubble had been well covered. I thought what people had not looked hard enough at were the big-money insiders, who are the real fishermen in this game. The companies are more like the bait.

Winnipeg, Manitoba, Canada: I can only assume that the manipulation identified in the Dot.Con program carried over to the large investment bankers in Canada (Why miss out on a sure thing?). As a small investor, I too got caught up in the dot.com frenzy and lost a good deal of money (for me). I knew going in that I was taking a risk and was prepared to live with my decisions good or bad. This program shows however that the rich and powerfull groups including the media conspired to fleece the public. Is there any hope of getting our money back from these thieves?

Martin Smith: Credit Suisse First Boston has paid $100 million in fines to regulators, and there are several thousand private lawsuits pending. But I would doubt whether individuals who joined these lawsuits are going to see anything close to an adequate return. The prospectuses that nobody ever reads have lots of warnings in them. The companies and the banks are legally well protected.

Los Angeles, Calif.: Mr. Smith: What do you think of the Dutch auction approach to IPOs? Could this approach solve the problem of the unfair allocation process?

Martin Smith: Everybody I talked to seems to agree that the Dutch option makes a lot of sense. But traditional investment bankers all complain that the process of taking a company public cannot be made into a mechanical process. They claim it's an art, which of course makes you wonder if they're talking about con artists or what.

Orlando, Fla.: In your expose dot.con you asked Bill Hambrecht the following question: What happens during an IPO like VA Linux -- which had the biggest first-day gain in Wall Street history? Where does the money go?

And he answered: First of all, by fiat and SEC law, all the stock has to be sold to public buyers at the offering price. So all the stock is sold at that -- I've forgotten the exact price, but it was $30 some-odd per share, something like that. Suddenly you get this huge surge where the stock leaps seven times, creates a billion dollars or $1.2 billion of market value. That's profit to the person who got the IPO allocation. And if you trace it out, I think you'll find that anything that goes that high, almost all of it is flipped, because it just doesn't make sense not to. So effectively the underwriter parceled out $1.2 billion of guaranteed profit to his clients. As you can imagine, that's a very nice thing to happen.

My question is if all of the IPO stock must be sold "by fiat and SEC law" at Mr. Hambrecht's estimated price of $30 and something per share (to the public) and then increases in value seven times over then the first of the public buyers of the stock have realized a 700 percent gain and not the underwriter of the stock, right? So how does the underwriter realize a $1.2 billion profit?

Martin Smith: That's a very good question. If the bank simply takes the shares from the company and puts them out for sale, under current practices, the shares are allocated to the bank's best customers, or favored clients. If these customers are allocated a million shares at $30 a share, the bank then returns $30 million to the company. The bank takes a 7 percent fee of that $30 million and keeps it for itself. So whatever happens to the stock after that in the public markets doesn't affect the bank. The bank makes money whether the stock goes up or down. They make however much is raised in the offering.

When the stock pops high, the bank can decide to advise the company to issue a secondary offering. So let's say, six months down the road, that company that raked in $30 million minus the 7 percent for the bank issues a secondary offering of stock, the bank now can make 7 percent of the number of shares offered times the new price, during which the Internet bubble was considerably higher. In the case of VA Linux, the stock remained around $200 for some time. This was very profitable for the banks.

Alexandria, Va.: Don't you think it is a little melodramatic for The Washington Post to speak of "the seeming overnight fall of the Internet economy?"

I buy books, software, plane tickets and other goods on the Web. I peruse newspapers and view their ads. I purchase computers for the primary purpose of connecting to the Web. I pay people to host my Web sites and myself collect commissions on book sales.

What fall of the Internet economy are people talking about?

Martin Smith: You're right; the Internet is here to stay. But with all the frenzy and hype created around its debut, there was a lot of fraud. We're not trying to impugn the Internet; we're just pointing out that like in the California Gold Rush, a lot of people lost their shirts. The fact that California was created as a by-product was a good point.

Washington, D.C.: Do you think that the Internet boom of the '90s is comparable to the "junk bonds" of the '80s?

Martin Smith: Yes I do. Wall Street is a money-raising machine. In the '80s, they did it with junk bonds. In the '90s they did it with IPOs. I wonder what's next.

Lexington, Mass.: What has the SEC done to protect investors from having this happening again? It seems as if we are equally as vulnerable as ever.

Martin Smith: That's a question for the SEC.

Skokie, Ill.: Clearly, the fortunes made from IPOs could not have been possible without the input of the media hype. While it is nice to know that the SEC hasn't been asleep at the wheel regarding the investment banking community, it appears that the serious abuse of the public airwaves and other information purveyors is getting no attention from the toothless FCC or the public. Will there be any regulatory attention paid to conflicts of interest in media reporting? Should there be?

Martin Smith: Arthur Levitt made this a major point during his tenure at the SEC. But as much as he cajoled and pressured producers, he could only go so far, given constitutional guarantees of freedom of the press. Unfortunately, if the press wants to mislead people, to a certain extent they can. It's going to be very difficult to regulate my colleagues. But they certainly should take a look at their practices themselves.

My biggest complaint here would be not simply the failure of journalists to disclose conflicts of interests of their guests, but the fact that stocks were made into some kind of form of entertainment. The problem is that nobody should combine entertainment with matters as serious as their childrens' college fund or their IRA. Unfortunately, people were invited to do so, and they did.

One of the most shocking documentaries I saw on CNBC was titled "Watch and Make Money." You should request it. But don't heed its advice.

Boston, Mass.: It surprises me that in your otherwise informative documentary, the culpability of the public in this Internet bubble was not given the fair weighting that it deserved. Do you have any thoughts on how much blame can be rested on the public for creating the demand for these shares, which ibankers and VCs gladly supplied?

Martin Smith: We decided to pick on the people who should know better, and have a fiduciary responsibility to the public. The banks have been broadcasting commercials about trust, integrity, reliability and all sorts of other virtues for many years. Yeah, the public should know better too. But they're not the professionals. We wanted to hold the professionals up for examination.

Arlington, Va.: Your show was great. "Dot Con" perfectly summarizes what went on. I was aware of the conflict of interest at investment banks with their analysts but wasn't aware of the truly fraudulent nature of IPO process.

My question, however, is was there anyone at the time willing to expose this? Or was this voice simply drowned out by all the other voices of greed? As you stated the media was part of the problem. Were there any hard-hitting journalists willing to expose this at the time? Or are we left today with major media outlets with no journalistic backbone to work for the public interest?

Martin Smith: Two reporters at the Wall Street Journal, Susan Pulliam and Randall Smith, were on to this story earlier than anyone I know, and have done superb investigative reporting. Other major newspapers seemed to give the allocation process short shrift. I applaud the Journal for its coverage. As Bill Hambrecht, the investment banker, said in the program, he spoke up about the problems with the allocation process, and ended up feeling like the designated driver at a New Year's Eve bash. Nobody really cared; they were all getting too rich.

Orlando, Fla.: Referring to your show dot.con: How about this scenario as an allocation process? The underwriter must first hold a private auction for the shares in an IPO and not just be able to dole out the shares to his best customers. Then the opening price for the stock will be set by the previous private auction?

Martin Smith: That is the exact idea of Bill Hambrecht, and is explained both in the program and on the Web site (http://www.pbs.org/wgbh/pages/frontline/). That solution is a challenge to traditional investment banking methods. We don't know if it will take hold or not.

East Hampton, N.Y.: After an allocation has been made to a firm's best customer of stock and the day of the IPO arrives, are there not restrictions upon how soon that customer can sell the stock?

How do they get around these restrictions and how do the company insiders get around these restrictions?

Martin Smith: If a mutual fund manager or hedge fund manager or someone is allocated stocks by the bank, there are no restrictions on when they can sell them. They can flip them within 10 minutes. There are restrictions on stock owned by insiders, such as the venture capitalists and the executives of the company. This is why after-market allocations are so valuable -- because they can be flipped immediately. Company executives and the venture capitalists do everything they can to keep the price of the stock pumped up until their lockup expires. You often see stocks take a big dive after their lockup period ends -- six months after the stock trades publicly.

Houston, Tex.: Outside of investment television, did you find a lot of similar circumstances of "dual interest" when looking at publications -- such as Business Week editorials, investment guides, etc.? I am always skeptical about their analysis.

Martin Smith: I'd say the same conflicts of interest apply to the print media.

Atlanta, Ga.: Why weren't charges ever brought against the analyst and firms that continued to tout these IPOs even after they were at unsupportable prices? It seems obvious that they were doing so in their best interest and not the investors best interest. If charges and fines are not the solution, then why not put these underwriters and analysts in the spot light and force them to justify their recommendations?

Martin Smith: I think you have to look it up, but Henry Blodgett's firm, Merrill Lynch, was sued over a conflict of interest involving an Internet company by a Long Island doctor, and settled for an amount in the six figures. There are other lawsuits pending.

Holland, Mass.: Thank you for telling a few chapters of this ongoing saga. Is not the worst crime in all of this that certain individuals have misused their roles within those institutions that are supposed to engender trust and a sense of credibility in society?

The big law firms (a.k.a. the oracles of corporate America) are packed full of former Department of Justice attorneys who can dive right through the very loopholes that they built their reputations on defending. Should we allow this in our Republic?

Martin Smith: That's the revolving door, isn't it? I think you raise a good question as to how much of this can or should be regulated.

Lynchburg, Va.: In researching this project, what other dubious financial trends did you glimpse that you feel are worthy of public address? How difficult was this investigation? Please compare its difficulty to those yet to be completed.

Martin Smith: It's difficult in that the bankers were resolutely mum. I heard complaints of many kinds and types of abuses -- none seemed as significant to us as the allocation process. But Frontline will continue to beef up its financial coverage, since the business of America is business, after all.

California: When the economy gets hot again and subsequently the IPO market, do you think anything will change?

Martin Smith: Good question. I think once the market heats up, people's memories will become very short. It's human nature. But I think in the last 10 years, we've entered a new phase of the public's direct involvement in the markets. And over time people will learn the hard way how to make money and how to lose it. The more the media does to cover these issues, the better I think it is for the public.

washingtonpost.com:

That wraps up today's show. Thanks to everyone who joined the discussion.