Ch. 7: IPO Underpricing 403
companies floated in the U.S. between 1988 and 1995 subsequently were sued for vio-
lations relating to the IPO, with damages awarded to plaintiffs averaging 13.3% of IPO
proceeds.
Tinic (1988), Hughes and Thakor (1992), andHensler (1995)argue that intentional
underpricing may act like insurance against such securities litigation. Lawsuits are ob-
viously costly to the defendants, not only directly—damages, legal fees, diversion of
management time, etc.—but also in terms of the potential damage to their reputation
capital: litigation-prone investment banks may lose the confidence of their regular in-
vestors, while issuers may face a higher cost of capital in future capital issues. Hughes
and Thakor propose a trade-off between on the one hand minimizing the probability
of litigation, and hence minimizing these costs, and on the other maximizing the gross
proceeds from the IPO (and thus the underwriter’s commission thereon). Crucially, they
assume that the probability of litigation increases in the offer price: the more overpriced
an issue, the more likely is a future lawsuit. In addition, they predict that underpricing
reduces not only (i) the probability of a lawsuit, but also (ii) the probability of an adverse
ruling conditional on a lawsuit being filed, and (iii) the amount of damages awarded in
the event of an adverse ruling (since actual damages in the U.S. are limited by the offer
price).
As a point of legal fact, the amount of damages that can be awarded in lawsuits filed
under Section 11 of the 1933 Securities Act increases in the difference between the
offer price and the subsequent (lower) trading price. Thus, underpricing reduces the
likely damages. This in turn reduces the probability of litigation assuming the size of
expected damages affect class-action lawyers’ incentives to file a suit.
4.1.1. Testable implications and evidence
Tinic (1988)proposes that the enactment of the 1933 Securities Act represents a regime
shift that potentially allows us to test the legal liability hypothesis. Prior to the 1933 Act,
the principle ofcaveat emptorlargely protected issuers and investment banks against
litigation risk, and so underpricing should have been low. After 1933, litigation risk
should have featured more prominently when investment banks priced deals, and so
underpricing should have increased. Moreover, banks with a comparative advantage
at due diligence might, post-1933, feel less need to insure against lawsuits by means
of underpricing, leading to a negative relation between a bank’s experience and initial
returns.
Tinic identifies a sample of 70 IPOs completed between 1923 and 1930 and compares
their average underpricing to that of a sample of 134 IPOs completed between 1966 and
- As predicted, average underpricing was lower before 1933, but the difference is
not particularly large: 5.2% in 1923–1930 versus 11.1% in 1966–1971. Moreover, it is
well-documented that underpricing varies immensely over time (seeIbbotson and Jaffe,
1975 andFigure 1in Section2 of this chapter), so we cannot rule out that Tinic’s results
are driven by factors other than increased litigation risk.Drake and Vetsuypens (1993),
for instance, show that average initial returns in the six yearsafterTinic’s sample pe-