Anatomy of Initial Public Offerings of Common Stock

Abstract

Proposes that the underpricing of securities in initial public offerings (IPOs) serves as insurance against legal liability and reputation damage on the part of issuers and underwriters. The Securities Act of 1933 subjected issuers and investment banks to increased risks of litigation and reputation damage. Underpricing would reduce the probability of litigation being commenced and the probability of an adverse judgment as well as limit the amount of legal damages. Previous explanations of the phenomenon are reviewed and shown to be inadequate to explain the data; these include: the risk-averse-underwriter hypothesis, the monopsony-power hypothesis, the speculative-bubble hypothesis, and the asymmetric-information hypothesis due to Baron and Rock. Pre- and post-SEC IPO empirical data gathered from the Commercial and Financial Chronicle are analyzed to assess the insurance hypothesis. The reputations of the underwriting banks were identified by classifying banks as ranked (sub-major or higher bracket) or nonranked (all others). Mean excess returns of pre-SEC IPOs were less than those of post-SEC IPOs. Nonranked investment bank IPOs offered higher excess returns in the post-SEC era than ranked investment bank IPOs. This is consistent with the greater risks of litigation, and thus higher premiums, faced by nonranked investment banks when originating new securities issues. Differences in size and offering prices of IPOs underwritten by the two classes further support the proposition that ranked investment banks have intentionally limited their underwriting activities to less speculative IPOs. Such market segmentation is also consistent with the insurance hypothesis. Data from before and after the legal case of Escott v. BarChris Construction Corp., which is thought to have set a high standard for due diligence, is also reviewed and found similarly to support the insurance hypothesis. After-market performance of new issues is analyzed to bolster support for the insurance rationale over the speculative-bubble and manipulation hypotheses. Finally, the increased market share of nonranked banks during hot-issue periods, which tend to be characterized by unusually large numbers of speculative small firms going public, is demonstrated to support the insurance role played by underpricing. (CAR)