Academic journal article Financial Management

The Effect of the Trading System on the Underpricing of Initial Public Offerings

Academic journal article Financial Management

The Effect of the Trading System on the Underpricing of Initial Public Offerings

Article excerpt

Two major trading systems in common stocks in the United States are (i) the exchange auction markets of the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX), and (ii) the negotiated dealer markets of the National Association of Securities Dealers' Automated Quotations (NASDAQ), National Market System (NMS) and non-NMS. These trading systems are further distinguished by their initial and continued standards for stock trading (i.e., listing).(1) The objective of this study is twofold. First, we examine whether the underpricing previously documented for initial public offerings (IPOs) on NASDAQ also applies to IPOs on the AMEX and NYSE. Second, we examine the effects of these trading systems on the pricing of IPOs.

A firm that is going public is surrounded by substantial informational asymmetry and the extant theoretical and empirical literature suggests this leads to the underpricing of IPOs (Baron |5~, Beatty and Ritter |6~, Grinblatt and Hwang |12~, Rock |25~, Smith |26~, Tinic |27~, and Welch |31~). We advance a trading system certification proposition which posits that the initial and continued listing standards imposed by a trading system provide investors with reliable information about the quality of new issues, reduce uncertainty about their prospects, and thereby lower the expected underpricing of IPOs.

Using a sample of IPOs which went public on the various systems over the period 1983-1987, we show that IPOs on all four trading systems display significant underpricing, on average. We also provide support for the certification proposition. After controlling for other factors previously shown to be associated with the underpricing of IPOs, namely, offer size, ownership retention, age of the firm, standard deviation of returns in the aftermarket, prestige of the underwriter, and auditor reputation, we show that NYSE, AMEX and NASDAQ/NMS IPOs are associated with significantly lower underpricing than NASDAQ/non-NMS IPOs. Further analysis indicates that no significant differences in underpricing exist between the NYSE, AMEX and NASDAQ/NMS trading systems, after controlling for other ex ante uncertainty proxies.

The rest of the paper is organized as follows. In Section I, we examine the role of initial and continued listing standards in certifying the quality of new issues and develop our certification proposition. We present the empirical results in Section II, while Section III contains several robustness checks on our main results. Section IV sets forth a summary of our findings and conclusions.

I. Trading Systems and the Underpricing of IPOs

In this section, we develop a certification proposition regarding the impact of trading systems on the underpricing of IPOs. We begin by summarizing the listing standards of the four market systems and then discuss how these standards mitigate uncertainty about the quality of new issues through certification.

A. Listing Standards

An important distinguishing characteristic of a trading system is its listing standards. There are two types of listing standards: quantitative and qualitative. Also, there are initial as well as continued listing standards. Exhibit 1 summarizes the minimum quantitative initial and continued listing standards for the NYSE, AMEX, NASDAQ/NMS, and NASDAQ/non-NMS markets. Clearly, there is wide variation in the requirements related to income, public ownership, firm size, and stockholder equity across the trading systems. Notably, size, distribution of ownership and earnings standards are substantially higher for the NYSE, somewhat comparable for the AMEX and NASDAQ/NMS, and least stringent for the NASDAQ/non-NMS.

In addition, the listing agreement includes numerous qualitative standards designed to protect shareholders from agency problems ensuing from the separation of ownership and management of a firm. These standards are meant to (i) ensure timely disclosure of information that may affect security value or influence investment decisions, (ii) encourage and enforce certain business practices aimed at maintaining sound standards of corporate responsibility, integrity and accountability to shareholders, and (iii) provide the trading system with timely information to facilitate the maintenance of a fair and orderly market in the firm's securities. …

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