Academic journal article Financial Management

Underwriter Certification and the Effect of Shelf Registration on Due Diligence

Academic journal article Financial Management

Underwriter Certification and the Effect of Shelf Registration on Due Diligence

Article excerpt

In 1982, the Securities and Exchange Commission (SEC) introduced several changes intended to streamline the process of issuing seasoned securities in the US. One effect of these changes was to increase the cost of the due-diligence investigation, primarily because the time allowed for the investigation has been reduced. This effect is especially strong for shelf registration, in which the issuer can sell registered securities at any time during a two-year period, with no advance notice. Under the old system, underwriters were closely involved in the registration process and automatically had a reasonable amount of time for a due-diligence investigation because the registration process was lengthy. With shelf registration, underwriters are not usually involved with registrations and are only contacted when the firm is ready to issue the securities. If one underwriter balks at handling an issue on short notice, the issuer can call another underwriter.

Although underwriters opposed the introduction of shelf registration, potential issuers fought for it. The SEC expected shelf registration to benefit issuers by increasing competition between underwriters and therefore reducing underwriter fees.(1) Early research supported the cost reduction, including that of Kidwell, Marr, and Thompson (1984, 1987) and Rogowski and Sorenson (1985) for bond issues, and Bhagat, Marr, and Thompson (1985) for stock issues. Blackwell, Marr, and Spivey (1990) found evidence that underwriters charged an insurance premium for shelf over non-shelf issues, but even their research suggested that most equity issuers would obtain lower underwriting fees by using shelf registration. Thus, the consensus was that shelf registration made issuers substantially better off, with no apparent drawbacks.

However, this viewpoint is not consistent with the fact that the use of shelf equity issues has declined dramatically since 1983, as shown by Denis (1991). Denis documents that between March 1982 (when shelf registration was first allowed) and 1988, only 15% of all eligible equity offerings were shelf-registered. Of the eligible equity issues after 1983, only 3% were shelf-registered. Denis also demonstrates that during the 1982-1988 period, a significant number of debt issuers chose not to use the shelf method, although shelf is far more popular for debt than for equity. This raised the question: if shelf is so universally advantageous, as research seemed to indicate, why would so many issuers choose not to use it?

Hansen (1986) pointed out that the apparent cost advantages of shelf registration might not be as high as previously thought. He observed that issuers self-select to use shelf rather than the traditional method. Thus, the lower fees and borrowing costs of shelf issuers could be due to the characteristics of the firms that choose to use shelf registration, rather than to the issue method itself. In other words, perhaps those issuers would have had lower costs regardless of their issue method. Allen, Lamy, and Thompson (1990) found evidence to support self-selection bias for debt issues, and Denis (1993) for equity issues. Both studies concluded that the apparent savings in issue costs of shelf users would have occurred regardless of the registration method used.

The fact that shelf does not lower issue costs does not explain why so few firms use the shelf procedure for equity, since shelf still offers at least some potential timing benefit. Thus, some costs must be associated with shelf registration that prevent issuers from using it. One such cost is the reduction in the due-diligence investigation that I model in this paper.

The model in this paper uses a financial intermediary to certify new security issues and uses penalties (either legal liability or loss of reputation) to give the underwriter the incentive to certify accurately. Firms that plan to issue securities choose whether or not to use the underwriter for certification. …

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