Litigation Risk and IPO Underpricing Revisited (Grace)

This paper explains why the evidence on the relation between litigation risk and initial public offering (IPO) underpricing is mixed. Two reasons are behind the nonstationary relation. First, the increasing usage of Directors and Officers’ liability insurance arguably reduces the need to use underpricing to insure against litigation liability to a limited extent. Second, class action lawsuits over IPOs almost always include claims under both the Securities Act of 1933 and the Securities Exchange Act of 1934. While damages under the 1933 Act are related to underpricing, damages under the 1934 Act are not. It is not the potential damage under each claim that determines the likelihood of being sued under each Act; instead, it is the total damage under both claims that determines the likelihood of being sued. When the damage under the 1934 Act is much greater than the damage under the 1933 Act, underpricing cannot insure against litigation risk effectively. I use the IPO laddering cases during 1998-2000 to illustrate when and why IPO underpricing does not deter litigation. JEL classification: G24; K22