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IPO underpricing and insurance against legal liability.

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. Investors potentially entitled to damages are not restricted to those who bought stock at the offer price, but include all investors who purchased shares of the sample firms during the class period. Thus, whether the IPO is underpriced or not on the offer day is inconsequential to aftermarket investors' ability to sue or recover damages.

Although this paper presents new evidence on IPO-related litigation, its conclusions are subject to several limitations. First, our sample may be biased in that we study only lawsuits which are published or appear in publicly available legal databases. Since the publication of a legal decision is perhaps based on the case's legal significance or the size of the issue, our sample may not reflect the population of IPO lawsuits. Second, and more importantly, this paper has studied a set of IPOs which ex post were sued. It is possible that many other IPOs successfully avoided litigation by underpricing, but by the nature of our sample design, we cannot observe such cases. Therefore, we cannot exclude the possibility that more issuers would have been sued had their IPOs not been underpriced.

The plan of the paper is as follows: in the next section, we review the legal foundation for issuers' legal liabilities under the 1933 and 1934 Acts. In Section II, we discuss extant evidence on the lawsuit avoidance hypothesis. Section III describes our data collection procedure. In Section IV, we contrast the offering characteristics of our sample firms with those of other IPOs. Section V discusses the nature of litigation risk in IPOs. Conclusions follow in Section VI.

I. Legal Liability in IPOs

The Securities Act of 1933 imposes liability for material untruths or omissions in the registration statement filed with the SEC or in the prospectus used in an IPO. The purpose of this statute is to provide investors relief against those significantly involved in the distribution of securities to the public with false or misleading information. Section 11 |15 USC 77k~ of the 1933 Securities Act establishes that liability if the registration statement or the prospectus contains an untrue statement of a material fact, omits to state material information which makes the stated facts misleading, or omits material information required by statute or regulation. Courts regard information as material if there is a substantial likelihood that a reasonable investor would consider the information important in deciding whether to buy the security (Corley and Reed |5~).

For a material untruth or omission, Section 11 makes the issuer of the security absolutely liable. That section of the Act makes the underwriter liable unless, after reasonable investigation (due diligence), the underwriter reasonably believed there was no material untruth or omission. There is a similar liability for auditors with respect to the financial statements. To be successful, the investor need prove only the material untruth or omission, not that it was intentional or that he or she relied on it. Damages for violation of Section 11 are determined as the difference between the investor's purchase price and (i) the subsequent sale proceeds or (ii), if held, the security's price at the time of the lawsuit. If the security is sold after the lawsuit commences but prior to judgment and for an amount greater than the price at the start of the lawsuit, the damages are computed by subtracting the higher sale price. In no instance can damages be based on a purchase price greater than the offer price of the security.

Section 12 |15 USC 12L~ imposes a similar liability for a material untruth or omission in the prospectus or in any oral or written communication made by the seller. For a violation of Section 12, the purchase price is refunded to the investor (i.e., rescission). If the investor has sold the security, damages are usually computed as the purchase price minus the sale price. As with Section 11 claims, plaintiffs under Section 12 must prove only the material untruth or omission, not that it was intentional or that the plaintiff relied on it. Only the seller to the investor is liable under Section 12 (privity). Following a recent Supreme Court decision, the courts now construe a seller more narrowly to be someone who solicits the investor, e.g., the broker-dealer who calls the investor.

Section 11 can be used by direct purchasers in the initial public offering. It can also be used by aftermarket purchasers if they can demonstrate their securities are from the SEC registered offering (rather than from previously outstanding shares). Their aftermarket purchase price serves as the basis for calculating damages only if it is lower than the offer price. Section 12 can be used both by direct purchasers in the IPO and by aftermarket purchasers. Their aftermarket purchase price serves as the basis for rescission or damages.

Section 10(b) |15 USC 78j(b)~ and Rule 10b-5 |17 CFR 240.10b-5~ of the Securities Exchange Act of 1934 also impose liability for a material untruth or omission in the registration statement or prospectus. That liability applies to issuers, underwriters, and sellers. Damages are calculated according to a fraud theory. Although no single technique has been established, the typical measure of damages is the difference between the purchase price of the security and the "true value" on the purchase date. The true value is taken to be the (lower) price the security would be trading at if all relevant information about the security had been available to the market (Alexander |1~).

To recover under this section or rule, an investor must prove (i) the material untruth or omission in connection with the sale of the security, (ii) the defendant intended to deceive the investor or was reckless (scienter), (iii) the investor relied on the false or misleading information, and (iv) the investor was damaged by such reliance. Since these requirements are stronger than those of the 1933 Act, any action which can prevail under the 1934 Act should prevail under the 1933 Act as well. However, some defendants (e.g., lawyers, promoters) can be reached under Section 10(b) and Rule 10b-5 that are not reachable under Section 11 or 12.

II. Anatomy of IPOs: A Diagnosis

Tinic |17~ is the first to conduct empirical tests of the lawsuit avoidance hypothesis. Because exposure to lawsuits in IPOs increased substantially after passage of the 1933 Securities Act, Tinic argues that IPOs issued after 1933 should be more underpriced. Tinic compares 70 IPOs issued during 1923-1930 to 134 IPOs issued during 1966-1971, finding the latter to be significantly more underpriced (mean initial return of 11.06% versus 5.17% in the pre-1933 sample). Because factors other than the legal environment that may affect IPO underpricing undoubtedly changed between 1923-1930 and 1966-1971, Tinic's comparisons are difficult to interpret. The existence of "hot" and "cold" markets, which are not well understood, as well as the usually low explanatory power of cross-sectional regressions of IPO returns, cast doubt on the ability to learn much from data sets that are decades apart, as in Tinic's tests.

Furthermore, Tinic does not justify his selection of the 1966-1971 period of post-1933 IPOs. If the post-1933 sample had been chosen from 1972-1977, for instance, instead of 1966-1971, the mean underpricing would be less than one percent (computed from Table 1 in Ibbotson, Sindelar, and Ritter |10~), which would have been inconsistent with the lawsuit avoidance hypothesis. Moreover, Tinic's sample of post-1933 IPOs has a smaller average real issue size than his pre-1933 sample. Because larger IPOs are generally less underpriced (Chalk and Peavy |4~), size differences alone may explain why Tinic's post-1933 IPOs have average higher initial returns than his pre-1933 sample.

Tinic also compares the degree of underpricing before and after the 1968 landmark Escott v. BarChris Construction Corporation litigation. This lawsuit is widely believed to have established stricter standards for IPO due diligence investigation. Tinic finds that IPOs brought to market after this court decision are significantly more underpriced, which he asserts is consistent with the lawsuit avoidance hypothesis.

Interestingly, most of the IPOs in Tinic's post-Escott comparison period occurred in 1968, an unusually "hot" IPO year. Table 1 in Ibbotson, et al |10~ shows an average initial return for 1968 of 55.86%, the highest single-year average return over the entire period (1960-1987) described by Ibbotson, et al |10~. Subsequent years, on the other hand, are much less underpriced. In fact, again referring to Table 1 in Ibbotson, et al |10~, the average underpricing during 1960-1967 (the pre-Escott period) is 17.33%, but the post-Escott period 1969-1987 has average underpricing of 13.95%. Using the broader IPO sample of Ibbotson, et al |10~ reveals the average underpricing to be actually lower after the landmark court case.

Simon |16~, while not formally casting her study as a test of the lawsuit avoidance hypothesis, examines the effects of changes in financial disclosure after the 1933 Securities Act on the distribution of returns earned by investors in new stock issues. Unlike Tinic, Simon compares initial IPO returns in the seven-year periods immediately before and after the 1933 Securities Act. Using a multi-beta asset pricing model, she finds no difference in risk-adjusted returns for seasoned issues traded on the NYSE before and after 1933. However, unseasoned issues traded on regional exchanges earn significantly greater cumulative 60-month risk-adjusted returns in the post-SEC period.

It is plausible that more speculative firms go public on non-NYSE exchanges. The legal remedies provided by the 1933 Securities Act should be a more valuable instrument to IPO investors in speculative firms. Although Simon |16~ does not report initial day underpricing of her sample firms, her finding of greater excess returns post-SEC only for IPOs on regional markets is qualitatively consistent with the lawsuit avoidance hypothesis. This conclusion is based on a small data set, however; Simon's post-1933 sample consists of only 10 non-NYSE IPOs. This small sample reflects the paucity of new issues after the stock market crash of 1929. Thus, it is unclear whether Simon's findings can be generalized.

Alexander |1~ develops a "non-merits-related" theory for class action suits in IPOs. Alexander argues that these suits are filed in anticipation of an out-of-court settlement, not an adjudicated judgment, since less than five percent of all civil cases go to trial. Contrary to existing models of settlements, Alexander opines that the settlement of IPO suits does not reflect the merits of the case. She argues that, given the small range in which settlements in her sample are made (most cases settled for approximately 25% of total damages) and the economic incentives facing each of the lawsuit participants, the merits of the respective cases have little influence on the amount of the settlement. Furthermore, she states, due to the high cost of litigating a security class-action suit, the expected damage recovery must be sufficient to justify the attorney fees and render the lawsuit economically justified. Consequently, according to Alexander, issuers with small offerings or small losses in market values are rarely sued.

In her sample of 17 venture-capital-backed high-technology IPOs issued in 1983, nine IPOs were later sued under the 1933 and 1934 Securities Acts. Alexander |1~ reports that only issuers who suffer the largest aftermarket losses -- at least $20 million in her sample -- are sued. However, two issuers in her sample with an offering size of $6 million each are incorrectly classified in her Table 3 as not having been sued. Thus, a more appropriate description of her evidence would be that issuers with large percentage stock price declines but with small offering sizes are less likely to be sued.

Alexander's claim that small IPOs bear little litigation risk contradicts Tinic's |17~ rationale of why small firms underprice their IPOs more than larger firms. Tinic states that due to the greater uncertainty facing small firms, the risk of litigation is greater. Alexander points out that the cost of bringing such a suit would exceed the potential proceeds from a settlement. However, while the fixed costs of bringing a suit reduce the incidence of suits for small issues, the size of the firm also presumably affects the incentives to mount an aggressive defense. Whether size affects the likelihood of litigation is thus an unresolved issue. Our data will shed additional light on this point.

III. Sample Selection Procedure

To identify potential lawsuits brought against issuers of IPOs and their agents, we examine the following three resources: (i) LEXIS and WESTLAW, two electronic legal research databases which contain virtually all federal and state court cases released by the courts for publication; (ii) the United States Code Annotated, which identifies lawsuits bearing directly on specific sections within the Securities Acts; and (iii) Securities Class Action Alert, a newsletter which tracks class-action lawsuits filed under the Securities Acts of 1933 and 1934.

Each potential lawsuit from this search is reviewed as to the issues, basis of claim, and the participants. The cases involving purchasers of IPOs who brought suit against an issuer and/or its underwriter(s) for a faulty prospectus or registration statement under Sections 11 or 12 of the 1933 Act, or Section 10b(5) of the 1934 Act, are selected for the sample. This criterion eliminates bond issuances, secondary stock issuances, conversions of mutual banks to stock banks, and SEC enforcement actions. A limitation of this approach is that we cannot identify cases which were not released for legal publication nor those IPO suits which are not reported in Securities Class Action Alert. Our data collection procedure perhaps biases our sample towards large IPOs. This bias should be minimal, however, given Alexander's |1~ evidence that small IPOs are rarely sued.

For each case in the final sample, we identify the characteristics of the offering and collect aftermarket prices. Data sources for these variables include the court decisions, Standard & Poor's Corporation Records, the Investment Dealer's Digest, Standard & Poor's Daily Stock Price Record, the Wall Street Journal, and the individual offering prospectuses, when available.

Using the above data sources, we identify a total of 93 firms which were sued for alleged misstatements in the offering prospectus. Exhibit 1 presents a frequency distribution of the IPO dates for these 93 issues. In all but one case, the issuing firm and its officers and directors were sued. Underwriters were sued in 90% of all cases, and in about one-third of our sample firms, auditors were defendants as well. Most of our sample firms' IPOs take place during the 1980s, reflecting the high frequency of new issues in that period. Only 13 IPOs (less then 14% of the total) occur prior to 1980. The year with the most sample firms is 1983, which was also a "hot" issue year with a large number of firms going to market. We identified potential sample firms with IPOs going as far back as 1934, but we were unable to obtain complete data regarding offer and/or aftermarket prices for those issues.

IV. IPO Litigation and Underpricing

Exhibit 2 presents descriptive information on selected attributes of our sample companies. The first row in Exhibit 2 reports summary statistics on offer size. Offer size is defined as the offer price multiplied by the number of shares sold, excluding overallotments. The mean and median offer sizes for the 93 sample firms are $44.0 million and $18.2 million, respectively. These numbers are considerably larger than the corresponding numbers for IPO samples in extant research. For example, the mean offer size in Ibbotson, Sindelar, and Ritter's |10~ IPO database over the period 1970-1987 is $12.6 million. Even after excluding an outlier firm (Lyondell Petrochemical, with an offer size in excess of $1 billion) from our data, the mean offer size of the remaining 92 firms is still large at $30.2 million. Expressed in dollars of constant 1990 purchasing power, the mean and median offer sizes are $55.6 million and $25.7 million, respectively (see row (2)).

The third row in Exhibit 2, labeled "initial return," measures the underpricing of the sample firms and is defined as the percentage price change from offer price to first day bid price, unadjusted for market movements. The average underpricing for the 93 IPOs is 9.18%. This positive initial day return is significant at the one percent level (t = 4.9).(1) Nineteen IPOs out of 93 (20.4%) are overpriced; 18 IPOs (19.4%) have a zero initial return; and 52 (55.9%) have a strictly positive initial return. The median initial return is 1.90%. Thus, our sample firms' IPOs are not, on average, overpriced.
Exhibit 1. Frequency Distribution of Initial Public Offerings
of Companies Which Were Subsequently Sued for Alleged
Misstatements in Their Offering Prospectus or Registration
Statement Under Federal Securities Laws

Year Number of IPOs

1969 1
1970 2
1971 3
1972 4
1973 1
1976 1
1979 1
1980 2
1981 5
1982 3
1983 24
1984 10
1985 8
1986 15
1987 4
1988 4
1989 2
1990 3

Total 93


While our sample IPOs are not overpriced, they are perhaps less underpriced than other IPOs. One of the most widely cited academic studies of IPO underpricing is Ibbotson |8~, who examines offerings during the 1960s with an issue price of at least $3.00 and reports an average initial return of 11.4%. This number is comparable to the mean underpricing of 9.18% for our 93 sample firms. As another benchmark, Ibbotson, Sindelar, and Ritter |10~ report a mean underpricing of 8.6% for a subset of IPOs in 1975-1984 with an offer price of at least $3.00. This number is again very similar to the average underpricing of our 93 sample firms. It appears that issuers of our sample firms are sued in spite of their IPO being roughly as underpriced as other IPOs.

The comparisons between our sample IPOs and Ibbotson |8~ and Ibbotson, Sindelar, and Ritter |10~ are only TABULAR DATA OMITTED suggestive, however. Previous work has shown that the degree of underpricing is time-dependent (see Ibbotson, Sindelar, and Ritter |10~). Allowances must be made for the effects of possible "hot" and "cold" markets. Since most of our sample IPOs occur in the 1980s, we next compare them with the IPO sample analyzed by Muscarella and Vetsuypens |14~ (hereafter MV), which consists of 1,114 issues announced in the Wall Street Journal during 1983-1987. The MV sample selection criterion excludes small issues, thus making the MV sample more directly comparable.

The mean underpricing of the MV |14~ sample is 7.96%, which is less than the average underpricing of 9.18% for the 93 IPOs in this study (the difference in average initial returns between the two samples is not significant). The median initial return of 1.90% for the 93 sample IPOs is nearly identical to the median initial return of 1.79% in MV. The proportion of overpriced issues in the two samples is also similar. For our sample, 19 firms out of 93 (or 20.4%) have overpriced IPOs; in the MV sample, 21.2% of the issues are overpriced. Thus, our sample firms have a distribution of initial returns nearly identical to that of IPOs from 1983-1987 having similar size characteristics.(2)

As an alternative way of comparing our 93 sample firms with the MV sample, we compute the proportion of IPOs which are sued for three subsets partitioned by initial returns: (i) all IPOs with negative first-day returns, (ii) all IPOs with nonnegative first day returns less than ten percent, and (iii) all IPOs with first day returns greater than ten percent. The lawsuit avoidance hypothesis predicts that the frequency with which IPOs are sued is a declining function of the initial underpricing. The data reveal no such pattern, however. Roughly seven percent of the combined sample of IPOs in each of the first two subsets is sued, but more than ten percent of IPOs with first day returns greater than ten percent is sued. It is somewhat surprising that the initial return has so little impact on the probability of a lawsuit: other things being equal, a lower offering price should reduce the probability of the aftermarket stock price falling below the threshold price that triggers a lawsuit.

As a final underpricing comparison, we match each of our sample firms with a control IPO in the same year, with the same Carter and Manaster |3~ underwriter prestige rank and with an offer size closest to that of the sample firm. In light of Alexander's |1~ evidence, it seems plausible that issuers with prestigious investment bankers are more prone to lawsuits. Controlling for underwriter quality allows us to examine whether underpricing by itself affects the likelihood of future lawsuits. The matched IPOs are selected from the MV |14~ database for IPOs occurring during 1983 to 1987 and from the Ritter |15~ database for those of our sample firms whose issues take place in the period 1975 to 1982. The average underpricing of the matched firms is 5.8%, which is less than the corresponding number for our sample firms that got sued. Thus, controlling for offer year, underwriter reputation, and size, our sample firms are no less underpriced than other IPOs.

To summarize, we conclude from our various comparisons that issuers who are subsequently sued for misstatements in their registration statement or offering prospectus have IPOs which are not overpriced, on average. Furthermore, these IPOs are as underpriced as other IPOs of similar size. Finally, the data show that our sample firms are typically quite large. The larger IPO size of our sample firms is by itself an interesting finding. To the extent that this phenomenon is not simply the result of a sample selection bias, it supports Alexander's |1~ non-merits-related view of litigation: lawyers who are compensated based on a percentage of the settlement can increase their expected fees by urging investors in large offerings to bring suit against such issuers.

V. Litigation Risk in IPOs: Why are Issuers Sued?

The nature and timing of the lawsuits against our sample firms provide additional qualitative insights into the nature of litigation risk in IPOs. Plaintiffs in IPO lawsuits almost always petition the court to certify the suit as a class-action lawsuit. Class-action status allows a single suing stockholder (and his/her attorney) to represent all other plaintiffs with similar legal claims and increases its bargaining position against the defendants.

The class-action nature of most IPO-related litigation casts doubt on the effectiveness of short-run underpricing as a device to avoid litigation. In our sample, the courts generally define the plaintiff class as all investors who acquired the defendant's stock not only at the IPO, but also during an extended period of time in the aftermarket (the rationale is that investors' purchase prices were influenced by information contained in the prospectus). As the fourth row in Exhibit 2 indicates, the mean and median length of the class period for our sample is 14.7 months and 11 months, respectively, starting at the IPO. Thus, plaintiffs can and do sue for damages regardless of whether they purchased the stock at the IPO or in the aftermarket. Whether the IPO is therefore underpriced on the first day is irrelevant to investors who bought in the aftermarket.

Analysis of the lawsuits facing our sample firms reveals why class periods extend many months and even years after the IPO date. Legal action is typically triggered not by a disappointing initial day price performance, but by news of the deterioration of the firm's financial condition in the aftermarket, long after the IPO. A typical chain of events is for the issuing firm to unexpectedly announce unfavorable company news (e.g., disappointing earnings or an inventory writedown) which pushes the stock price down. The fall in stock price causes some shareholders to sue, claiming that corporate insiders knew about the unfavorable developments prior to the IPO but failed to disclose this information in the prospectus.

For example, Activision, a California manufacturer of video game cartridges, went public on June 9, 1983, selling four million shares at an offer price of $12. The issue was initially neither underpriced nor overpriced: at the end of the first trading day, the closing bid price was $12. Three months after the IPO, however, the company announced that it expected a pre-tax loss between $6 and $10 million. Following this disclosure, the price of the stock declined to $6 a share. Four investors in Activision filed suit, claiming that the company knew that the video game industry in general and Activision in particular were experiencing difficult financial conditions at the time of the IPO but failed to disclose this information in the prospectus. A plaintiff class was certified by the court, consisting of all investors who purchased Activision stock between June 9, 1983 and September 16, 1983.

For 78 firms in our sample with sufficient data, we computed the price decline from the IPO offer price to the end of the class period (the class ending date often corresponds to the date when the unfavorable information is released). As the fifth row in Exhibit 2 shows, the average aftermarket decline in the stock price (unadjusted for market movements) from the offer price to the class end date is 56.7%. The median aftermarket price decline is 59.8%.(3) Combined with our earlier evidence, this data suggests that the decision to sue appears to be driven by large stock price declines in the aftermarket, not by whether the issue was initially overpriced at the initial public offering. This finding is consistent with Alexander's |1~ results. Her evidence, based on a sample of nine IPOs issued in 1983, indicates that only IPOs involving the largest aftermarket losses were sued. For comparison with Alexander |1~, we computed market losses suffered by our sample firms since the offer price (see row (6)). In dollar terms, the value lost in the aftermarket averages $18.7 million, with a median aftermarket loss of $10.7 million. These numbers are somewhat smaller than Alexander's $20 million figure, but are qualitatively consistent with her argument that larger IPOs are more prone to attract litigation.

Row (7) of Exhibit 2 reports settlement figures for 61 lawsuits for which this information was available. On average, the settlement fund available to plaintiffs (and their attorneys) is $4.7 million, with a median value of $2.4 million. These settlement numbers are significantly positively correlated with the offer size of the IPO, but they are unrelated to the magnitude of the first day return. In proportional terms, the mean value of the ratio of the settlement fund relative to the aftermarket losses averages 31.7% (see row (8)), with a median value of 23.8%. These figures are very similar to Alexander's results: in her sample, all cases were settled with judicial approval prior to going to jury trial with a settlement typically ranging from 20% to 27% of potential damages.

Finally, row (9) in Exhibit 2 describes the percentage ex post liability (i.e., the settlement amount divided by the offer size) for 61 sample firms with sufficient information. The mean and median values of the ratio of the settlement amount to the offer size are 17.0% and 12.4%, respectively. These numbers cast doubt on the lawsuit avoidance hypothesis for two reasons. First, there is no correlation between the first day return and ex post liability in our sample: greater first day underpricing does not reduce subsequent legal liability. Second, the relatively low magnitude of the ex post liability figures suggests that underpricing the IPO is an expensive form of insurance against lawsuits. Assuming a conditional liability in the event of a lawsuit of roughly 15% of the value of the IPO, even if only part of the underpricing is an attempt at insuring against lawsuits, the probability of a lawsuit would have to be unrealistically high for underpricing to be an efficient form of insurance. It would seem that a more careful due diligence investigation by the underwriters and auditors would be a more efficient way of minimizing legal costs.
Exhibit 3. Classification of Circumstances Surrounding the
Lawsuits, If Known, for 93 Companies Which Were Sued Under the
Securities Act of 1933 and the Securities and Exchange Act of
1934

Basis for the Lawsuits Number of Firms

(1) Company lowers initial
financial/operational projections 23

(2) Improper accounting treatment 16

(3) Failure to fully disclose all the risk
factors or operations of the company 13

(4) Company is engaged in illegal activity 8

(5) Change in company strategy 5


Although the specific allegations made in the lawsuits vary, they share common characteristics. In Exhibit 3, we report the circumstances surrounding the lawsuits of our sample firms. We compiled this information from the court records available on LEXIS and from the description of the lawsuits in the Securities Class Action Alert, and we subjectively assigned our sample firms to the summary categories listed in the exhibit.

Row (1) in Exhibit 3 shows that the most frequent type of litigation is triggered by disclosure of a general deterioration of the company's financial condition. For example, on March 15, 1983, TeleVideo, a manufacturer of video display terminals, went public, selling 6,250,000 shares at an offer price of $18. The stock went up by more than 20% during the first day of trading to $21.625. By June of 1983, the stock sold for over $40 per share. The company was sued almost two years after the IPO following public revelations that the company was experiencing significant financial problems. By the end of the class period, the stock had fallen in price to $5.50 a share.

The next most frequent motivation for lawsuits (see row (2) in Exhibit 3) are allegations of improper accounting treatment. For example, Kaypro Corp was sued following the disclosure, a year after its 1983 IPO, that it was unable to account for inventory valued at several million dollars. The resulting accounting adjustment eliminated the entire operating profit for the first nine months of the fiscal year.

For thirteen issuers in our sample (see row (3)), plaintiffs allege that the offering prospectus failed to fully disclose all relevant risk factors affecting the company's operations. For example, a lawsuit filed against Eagle Computer alleges that the company concealed the fact that one of its products infringed on IBM patents.

Finally, rows (4) and (5) of Exhibit 3 reveal that a small number of lawsuits in our sample were triggered by various allegations of fraud (for instance, Medi-Rx, a mail order drug store, was sued following a news story in the financial press linking the company's management to illegal drug diversion activities), and by unexpected changes in the company's business strategy (for example, Cable Funding Corp. stated in its IPO prospectus that its business strategy would be to lend funds to cable TV companies; after the IPO, the company announced that it would instead operate as a cable TV company itself; this announcement caused a drop in the company's stock price). Clearly, the distinctions among the five categories of allegations in Exhibit 3 are somewhat arbitrary. Nevertheless, Exhibit 3 suggests that litigation typically results from some unfavorable company-specific news in the aftermarket, not because the IPO is overpriced on the first trading day.(4) This conclusion is further supported by a joint analysis of the first day underpricing and the length of the class period. Under the lawsuit avoidance hypothesis, we would expect lawsuits with a short class period to be more likely to have been triggered by unfavorable initial price performance. We would therefore expect a positive association between class length and underpricing. However, the correlation between class length and underpricing is not significantly different from zero.

VI. Summary

This paper examines the IPOs of 93 issuers and their underwriters who were subsequently sued under the 1933 and 1934 Securities Acts relating to their IPOs. These 93 IPOs are not overpriced, on average, but are as underpriced as other IPOs of similar size. Our sample firms tend to be larger than typical IPOs, however. Litigation appears to be driven by large aftermarket price declines long after the IPO, not by whether the IPO was initially overpriced. Furthermore, IPO litigation often takes the form of class-action lawsuits. In our sample, plaintiffs entitled to damages include investors who bought stock in the aftermarket for up to 14.7 months, on average, after the IPO. Underpricing the IPO at the offer date is irrelevant to these aftermarket investors' incentive to sue and has little effect on the issuer's potential damage payments.

Our sample may be biased in that we study only lawsuits which are published in legal databases. Since the publication of a legal decision is perhaps based on the case's legal significance, our sample may not reflect the population of IPO lawsuits. In addition, we cannot disprove the claim that more issuers would have been sued had their IPOs not been underpriced. Given these caveats, our data show that underpricing the IPO is not a sufficient condition to avoid lawsuits, nor does it appear to be a very efficient way to do so. Our results complement those of Beatty |2~ who finds that IPO underpricing is insufficient to eliminate the litigation risk faced by the auditor in the IPO. Our results are also consistent with Alexander |1~ who argues that lawsuits against IPOs are a function of the aftermarket decline in value of the issuer.

Finally, our conclusions are also supported by the international evidence on short-run IPO underpricing. Ibbotson and Ritter |9~ report the results of numerous studies showing that IPOs in foreign countries are generally significantly underpriced as well. These countries typically have investor protection laws less stringent than those of the United States |Longstreth |12~~. Therefore, just as the lawsuit avoidance hypothesis cannot easily explain IPO underpricing in the U.S., as this paper has shown, the hypothesis also seems inconsistent with the pervasive underpricing of IPOs globally.

1 Because initial returns are skewed, this t-statistic is upwardly biased. As a robustness check, we follow a simulation procedure similar to that found in Ibbotson |8~ and Muscarella and Vetsuypens |13~. The results of this procedure (not reported here) indicate that skewness does not affect our conclusion that the initial return is different from zero at conventional significance levels.

2 As a robustness check, we replicated our tests using market-adjusted initial returns instead of raw returns, obtaining qualitatively similar conclusions.

3 The negative "raw" aftermarket performance of our sample firms contrasts sharply with Ritter's |15~ findings. Ritter documents substantial long-run IPO underperformance relative to a variety of benchmark portfolios, but in contrast to our sample firms, the mean three-year holding period return of his IPOs is 34.47% (measured relative to the first closing price). Ritter's median holding period return of -16.67% is also considerably less negative than the median 58.3% price decline for our sample firms.

4 To verify the robustness of our finding that firm-specific stock price declines trigger litigation, we replicated our analysis excluding sample firms with IPOs in 1986 and 1987. The aftermarket price declines of these firms could conceivably be explained in part by the October 1987 stock market crash. However, our results remain qualitatively unchanged when we exclude these IPOs.

References

1. J. Alexander, "Do the Merits Matter? A Study of Settlements in Securities Class Actions," Stanford Law Review (February 1991), pp. 498-598.

2. R. Beatty, "The Economic Determinants of Auditor Compensation in the Initial Public Offerings Market," Unpublished Manuscript, Southern Methodist University, 1992.

3. R. Carter and S. Manaster, "Initial Public Offerings and Underwriter Reputation," Journal of Finance (September 1990), pp. 1045-1068.

4. A. Chalk and J. Peavy, "Understanding the Pricing of Initial Public Offerings," Research in Finance, Greenwich, CT, JAI Press, 1990.

5. R. Corley and O. Reed, The Legal Environment of Business: Briefed Case Edition, New York, McGraw-Hill, 2nd edition, 1989.

6. D. Hensler, "Litigation Costs and the Underpricing of Initial Public Offerings," Unpublished Manuscript, University of Texas at Arlington, 1992.

7. P. Hughes and A. Thakor, "Litigation Risk, Intermediation, and the Underpricing of Initial Public Offerings," Review of Financial Studies, (Vol. 5, No. 4), pp. 709-742.

8. R. Ibbotson, "Price Performance of Common Stock New Issues," Journal of Financial Economics (September 1975), pp. 235-272.

9. R. Ibbotson and J. Ritter, "Initial Public Offerings," in Handbooks of Operations Research and Management Science: Finance, R. Jarrow, V. Maksimovic, and W. Ziemba (eds.), North-Holland, 1991.

10. R. Ibbotson, J. Sindelar, and J. Ritter, "Initial Public Offerings," Journal of Applied Corporate Finance (Summer 1988), pp. 37-45.

11. D. Logue, "On the Pricing of Unseasoned Equity Issues, 1965-69," Journal of Financial and Quantitative Analysis (January 1973), pp. 91-103.

12. B. Longstreth, "Global Securities Markets and the SEC," University of Pennsylvania Journal of International Business Law (Spring 1988), pp. 183-185.

13. C. Muscarella and M. Vetsuypens, "A Simple Test of Baron's Model of IPO Underpricing," Journal of Financial Economics (September 1989), pp. 125-135.

14. C. Muscarella and M. Vetsuypens, "Firm Age, Uncertainty and IPO Underpricing: Some New Empirical Evidence," Unpublished Manuscript, Southern Methodist University, 1990.

15. J. Ritter, "The Long-Run Performance of Initial Public Offerings," Journal of Finance (March 1991), pp. 3-27.

16. C. Simon, "The Effect of the 1933 Securities Act on Investor Information and the Performance of New Issues," American Economic Review (June 1989), pp. 295-318.

17. S. Tinic, "Anatomy of Initial Public Offerings of Common Stock," Journal of Finance (September 1988), pp. 789-822.

We thank Mead Data Central for access to their LEXIS database. We are indebted to Janet Cooper Alexander, Chris Barry, Randy Beatty, Alan Bromberg, Chris Muscarella, Zoe-Vonna Palmrose, John Peavy, Dave Williams, three anonymous referees, Jay Ritter (the editor), and participants at the Ohio State Accounting Research Colloquium and the University of Texas-Arlington Accounting Workshop for helpful comments on earlier drafts.

Philip D. Drake is an Assistant Professor of Accounting and Michael R. Vetsuypens is an Associate Professor of Finance at Southern Methodist University, Dallas, Texas.
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Title Annotation:initial public offerings
Author:Drake, Philip D.; Vetsuypens, Michael R.
Publication:Financial Management
Date:Mar 22, 1993
Words:6942
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