Academic journal article Financial Management

IPO Underpricing and Insurance against Legal Liability

Academic journal article Financial Management

IPO Underpricing and Insurance against Legal Liability

Article excerpt

A potential explanation for the pervasive short-run underpricing of initial public offerings (IPOs) of equity relies on issuers' and underwriters' desire to avoid legal liabilities under federal securities laws for material misstatements in the offering prospectus or registration statement. In this paper, we provide evidence which fails to support this "lawsuit avoidance hypothesis": our study suggests that underpricing the IPO is not a very efficient way of avoiding future lawsuits.

The notion that underpricing may reduce legal liabilities was initially suggested by Logue |11~ and Ibbotson |8~. Formal models of this hypothesis include Hensler |6~ and Hughes and Thakor |7~. According to the lawsuit avoidance hypothesis, large positive initial IPO returns reduce the probability of a lawsuit, the conditional probability of an adverse judgment if a lawsuit is filed, and the amount of damages in the event of an adverse judgment. While the lawsuit avoidance hypothesis seems reasonable, it has attracted only limited empirical scrutiny. Tinic |17~ presents evidence consistent with the hypothesis. As we will argue below, however, his evidence is subject to a number of caveats.

This paper presents new empirical evidence on the lawsuit avoidance hypothesis. Our data consists of 93 IPOs of companies which were sued for misstatements in the IPO prospectus or registration statement under the 1933 and/or 1934 Federal Securities Acts over the period 1969 to 1990. Studying this set of IPOs is appealing for at least two reasons. First, it provides direct insight into the nature of litigation risk in IPOs. Second, it represents an alternative setting within which to examine the relation between underpricing and litigation.

The data reveal that, typically, the sample firms are sued several months or even years after their initial public offering. The lawsuits follow large aftermarket price declines often triggered by unfavorable news about the deteriorating financial position of the company. The unfavorable news and the resulting large aftermarket price drop lead shareholders (often prompted by class-action lawyers) to file suit, claiming that corporate insiders knew about the unfavorable developments prior to the IPO, but failed to disclose this information in the prospectus or registration statement.

Models of the lawsuit avoidance hypothesis which claim that underpricing reduces litigation costs do not specify over what time period the underpricing should be observed. Examination of our sample firms suggests that there is a difference between short-run and long-run underpricing. Measured from the offer date to the lawsuit filing date, all but two of our sample firms are quite literally "overpriced." However, if under- or overpricing means the short-run pricing behavior immediately after the IPO (typically one day in most IPO studies), the data show that our sample firms are not overpriced, on average. The average first day initial return of our 93 IPOs is 9.18%, which is significantly different from zero and similar to the underpricing of other IPOs of comparable size. Thus, at least for our sample firms, underpricing the IPO does not remove the threat of litigation. Moreover, the evidence does not support the notion that litigation risk arises from issuers or underwriters overpricing the issue in the short run to maximize offering proceeds.

An analysis of the settlement data for our sample firms further suggests that IPO underpricing is an expensive form of insurance against future lawsuits. Conditional upon being sued, the typical settlement in our sample represents about 15% of the value of the IPO. Even if only part of the underpricing is an attempt at insurance against lawsuits, the prior probability of being sued would have to be unrealistically high for underpricing to be an efficient form of insurance.

Finally, the data indicate that IPO-related litigation typically takes the form of class-action lawsuits, with the length of the class period averaging 14 months beginning at the IPO date. …

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