IPO UNDERPRICING AND INSURANCE AGAINST LEGAL LIABILITY

Initial public offerings (IPOs) of equity are typically underpriced on the day of the offering. A frequently mentioned explanation for this puzzling phenomenon relies on issuers' desire to avoid legal liabiliti es under federal securities laws for misstatements in the offering pro spectus or registration statement. According to this ''lawsuit avoidan ce hypothesis,'' large positive returns from offer price to early afte rmarket trading reduce (i) the probability of a lawsuit, (ii) the cond itional probability of an adverse judgment if a lawsuit is filed, and (iii) the amount of damages in the event of an adverse judgment.This p aper explores the validity of this hypothesis and studies the nature o f litigation risk in IPOs. We examine 93 IPOs by issuers who were subs equently sued under provisions of the 1933 and/or 1934 Securities Acts in the period 1969 to 1990. In contrast to the views of a number of p revious researchers. our evidence suggests that the lawsuit avoidance hypothesis cannot easily explain why IPOs are underpriced. First, the data show that our 93 sample IPOs are just as underpriced as other IPO s of similar size. Thus, IPO underpricing is not a sufficient conditio n to avoid lawsuits. Furthermore, an analysis of the settlement data f or our sample firms shows that IPO underpricing is an expensive form o f insurance against future lawsuits. Conditional upon being sued, the average settlement in our sample represents about 15% of the offering value. Prior studies have documented that the underpricing of the typi cal IPO is also roughly 15%. Therefore, even if only part of the under pricing is an attempt at insurance against lawsuits, the prior probabi lity of being sued would have to be unrealistically high for underpric ing to be an efficient form of insurance. Second, the nature of the li tigation process itself casts serious doubts on the lawsuit avoidance hypothesis. Typically, our sample firms are sued several months or eve n years after their IPO. The lawsuits follow large aftermarket price d eclines often triggered by unfavorable news about the deteriorating fi nancial position of the company. The unfavorable news and the resultin g large aftermarket price drop lead shareholders to file suit, claimin g that corporate insiders knew about the unfavorable developments prio r to the IPO, but failed to disclose this information in the prospectu s or registration statement. Thus, litigation results from some unfavo rable company-specific news in the aftermarket, not because the IPO is overpriced on the first trading day. Furthermore, IPO-related litigat ion typically takes the form of class-action lawsuits. In our sample, class-action plaintiffs entitled to damages include investors who boug ht stock in the aftermarket for up to 14.7 months, on average, after t he IPO. Underpricing the IPO at the offer date is irrelevant to such a ftermarket investors' incentive to sue and has little effect on the is suer's potential damage payments. In summary, our study has shown that the litigation risk arising from accessing public capital markets app ears not to be related to whether the issue was initially underpriced or not. Minimizing legal liabilities by ''leaving money on the table'' through underpricing appears to be a very expensive form of insurance against IPO-related litigation.