Lawsuits are obviously costly, 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 investors, while issuers may face a higher cost of capital in future capital issues.
The basic idea of lawsuits avoidance goes back at least to Logue (1973) and Ibbotson (1975): companies deliberately sell their stocks at a discount to reduce the likelihood of future lawsuits from shareholders disappointed with the post-IPO performance of their shares.
Tinic (1988), Hughes and Thakor (1992) and Hensler (1995) argue that issuers intentionally underprice to reduce their legal liability. They assume that the probability of litigation increases with the offer price: the more overpriced an issue, the more likely is a future lawsuit, and that the solution is underpricing to avoid future lawsuits. Ritter and Welch (2002) give a simple example for this: An offering that starts trading at 30$ that is priced at 20$ is less likely to be sued than if it had been priced at 30$, if only because it is more likely that at some point the aftermarket share price will drop below 30$ than below 20$.
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 1971. As Tinic predicted, average underpricing was lower before 1933 (year of securities enactment).
In spite of this, Drake and Vetsuypens (1993) find that underpricing did not protect issuers firms from being sued, and sued IPOs had higher and not lower underpricing.
They study a sample of 93 IPO firms that were sued and compare them to a sample of 93 IPOs that were not sued, matched on IPO year, offer size, and underwriter prestige. Underpriced firms are sued more often than overpriced firms. Then underpricing does not protect firms from being sued and does not protect them from lawsuits and future legal liabilities.
They also show that average initial returns in the six years after Tinic’s sample period (1972-1977) were actually lower than between 1923 and 1930 which refute his findings.
Ritter and Welch (2002) think that leaving money on the table appears to be a cost-ineffective way of avoiding subsequent lawsuits. But the most convincing evidence that legal liability is not the primary determinant of underpricing is that countries in which U.S. litigative tendencies are not present have similar levels of underpricing (Keloharju (1993)):
The risk of being sued is not economically 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.
After all these findings which refute the suitability and the relevance of lawsuit avoidance as an explanation to underpricing anomaly, we can say that lawsuit avoidance can not be a primary determinant and driver of underpricing, still, it is possible that lawsuit avoidance is a second-order driver of IPO underpricing.
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