402 A. Ljungqvist
Usually, companies announcing seasoned equity offerings experience negative
announcement-date returns. In the signaling framework, we would expect a less negative
stock price reaction in response to SEO announcements by ‘high-quality’ companies,
which under separation means companies that underpriced their IPOs by more. Both
Jegadeesh, Weinstein, and Welch (1993)andSlovin, Sushka, and Bendeck (1994)find
evidence consistent with this prediction.
Spiess and Pettway (1997)add an interesting observation to the empirical literature
on IPO signaling models. In their data, pre-IPO shareholders sell personal shares at
the IPO in half of all IPOs, and such insider selling is no less common among the more
underpriced firms. This suggests that insiders at high-quality firms do not wait to realize
the benefit of their underpricing signal by delaying their sales of personally held shares.
Such behavior seems inconsistent with the logic of the signaling models.
- Institutional explanations
We now turn to three ‘institutional’ explanations for IPO underpricing. First, the liti-
giousness of American investors has inspired alegal insuranceorlawsuit avoidance
hypothesis. The basic idea, which goes back at least toLogue (1973)andIbbotson
(1975), is that companies deliberately sell their stock at a discount to reduce the likeli-
hood of future lawsuits from shareholders disappointed with the post-IPO performance
of their shares. This explanation is somewhat U.S.-centric, in that underpricing is a
global phenomenon, while strict liability laws are not. The risk of being sued is not eco-
nomically significant in Australia (Lee, Taylor, and Walter, 1996), Finland (Keloharju,
1993 ), Germany (Ljungqvist, 1997), Japan (Beller, Terai, and Levine, 1992), Sweden
(Rydqvist, 1994), Switzerland (Kunz and Aggarwal, 1994), or the U.K. (Jenkinson,
1990 ), all of which experience underpricing. Still, it is possible that lawsuit avoidance
is a second-order driver of IPO underpricing.
The second institutional approach is based on the practice of price support. One of
the services that underwriters provide in connection with an IPO isprice stabilization,
intended to reduce price drops in the after-market for a few days or weeks. Perhaps
surprisingly, such ‘price manipulation’ is legal in many countries, including the U.S.
(1934 Securities Exchange Act, Rule 10b-7, since replaced by Regulation M). Statis-
tically, price stabilization results in fewer observations of overpricing, and so shifts up
the observed mean initial return.
Third, there may be tax advantages to IPO underpricing. This results in a trade-off
between the tax benefit and the dilution cost of underpricing. Depending on their tax
situation, managers may prefer more or less underpricing.
4.1. Legal liability
Stringent disclosure rules in the U.S. expose underwriters and issuers to considerable
risk of litigation by investors on the grounds that material facts were mis-stated or omit-
ted from the IPO prospectus.Lowry and Shu (2002)estimate that nearly 6 percent of