Negligence versus Strict Liability: The Case of Underwriter Liability in IPO's
DePaul Business & Commercial Law Journal, Vol. 4, pp. 451-496 (2006)
47 Pages Posted: 29 Aug 2014
Date Written: September 19, 2006
The present article focuses on the following question: What degree of liability should be imposed on the leader of the consortium of underwriters (leader) and on the other underwriters of initial public offerings (IPO's) for misleading details in the offering prospectus - negligence or strict liability? The article explores new justifications for imposing liability in terms of negligence rather than strict liability.
In a model representing the problem of hidden actions by the firm and the leader, leading to a moral hazard problem, the present article demonstrates that the negligence rule has advantages over the strict liability rule. The justifications derived from this model focus on the fact that a negligence rule serves the law's function in serving the moral hazard problem optimally, since the rule only obliges the court to ask whether the leader has indeed carried out an optimal due diligence. Moreover, a negligence rule also assists the law optimally in reducing costs due to the effect of the due diligence procedure on third parties, contributes to the creation of a standard due diligence procedure, and has an external positive effect on the private capital raising market.
In an additional model presenting IPO pricing using the bookbuilding method, the leader manages to reach an equilibrium in which she convinces an optimal number of permanent investors to invest in collecting information about the offered security's value. This model shows that the negligence rule is preferable to the strict liability rule, as it helps convince various investors that the leader indeed made the optimal effort in executing due diligence, and therefore allows them to reduce the costs of maintaining the testing and verification system, while at the same time increasing certainty as to the accurateness of the market demand curve presented by the leader. In addition, a negligence rule better serves the post-IPO market in dealing with strategic actions by the leader intended to maximize the latter's profits in that market.
A further justification focuses on the leader's insurance role, and on her ability to be the IPO's 'least expensive insurer'. Arguably, holding the leader liable for negligence can add to the efficiency of the market risk distribution system.
Finally, the above justifications for holding underwriters liable for negligence also apply, at least in part, to the firm and its directors. Additionally, they may have certain implications on laws regarding IPO's, and their proper scope should also be examined in other areas where legal scholars argue for either negligence or strict liability as the optimal basis for liability.
Keywords: Underwriter Liability, IPO, Negligence, Strict Liability
JEL Classification: D82, K13, K22, G10, G24
Suggested Citation: Suggested Citation