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Executive Summary:
 

Consistent with the litigation risk management proposed by Ibbotson (JFE, 1975,)   the authors find that “firms with higher litigation risk underprice their IPOs by a greater amount.” Moreover, they also find that expected litigation costs decrease with underpricing.

Data:
 

The authors took a sample of 1841 IPOs from 1988 to 1995.   Of those, 106 were used.

Quick Review:
 

• Alexander (UCLA Law Review, 1993) argues that expected litigation costs are too low (for starters, only 6 percent of firms are sued) to explain the severe underpricing in IPOs.   However, as the authors point out, this could be “precisely because most firms have used underpricing as a form of insurance and, moreover, the costs of litigation are often unrelated to the degree of underpricing.   That is, underpricing lowers both the probability of being sued and the potential award. 
• Under Section III of the SEC Act, damages are based on the offer price, which is not necessarily the price the investor paid for the stock.
• At first glance, there is no statistical or economic difference in returns of those sued (13.2 percent) and those not sued (14.5 percent.)    This lack of difference may be due to endogenity in pricing decisions.   (that is if there is a greater risk of being sude, there will be greater underpricing which in turn lowers probability of being sued.)
• Firms are deemed to have greater litigation risk if they are young and have high market to book values, such as a technology stock traded on the NASDAQ and have higher insider selling.
• The authors use simultaneous equations to get around the endogeniety problem and rport that those firms that are more apt to be sued do in fact underprice more. (very cool finding!)

1) Methodology – use of simultaneous equation framework to contrast to control the endogeniety problem. 

2) Intuition - more than one IPO underpricing explanation can matter and their relative importance can vary by firm specific characteristics (to which I would also add a time-specific as well.) 

3) Firms that are more apt to be suied, underprice more.

Cool Tidbits:

· Larger firms are more apt to be sued.

· Surprisingly, higher rated internet bankers are associated with a higher probability of a lawsuit.   This may be because of “deeper pockets” or because of high risked clients selecting better rated investment bankers.

· Uses the turnover of a matched firm to proxy for turnover prior to issuance.  (cool!)