The Seller's Curse and the Underwriter's Pricing Pivot: A Behavioral Theory of IPO Pricing

VIRGINIA LAW & BUSINESS REVIEW VOLUME 13 SUMMER 2019 NUMBER 2

Notre Dame Legal Studies Paper No. 190915

79 Pages Posted: 24 Sep 2019 Last revised: 29 Oct 2019

Date Written: September 15, 2019

Abstract

Canonical theories of law and economics predict that issuing firms in initial public offerings (IPOs) demand — and that competitive markets produce — a transaction structure that maximizes value to issuers. Yet, since 1980, corporate America has left approximately 19 cents of foregone proceeds on the table for every dollar it has raised in IPOs. Moreover, the standard IPO contract appears designed to exacerbate rather than resolve agency costs, information asymmetries, and other foreseeable causes of IPO underpricing. This Article studies a new puzzle: why don’t issuers anticipate their transactional vulnerability and bargain for a sale of stock contract that protects them against foreseeable causes of underpricing?

To explain this puzzle, I model issuer heterogeneity in a novel way. Some fraction of issuers have managers that — when they engage an underwriter months before the IPO — fail to anticipate their underwriters’ incentives or capacity to impose underpricing when the IPO is priced. The interaction between market forces and managerial psychology at these naïve issuers explains the structure of the standard IPO contract. Conditional on using the standard IPO contract, underwriters pivot between two strategies. In the IPOs of naïve issuers, underwriters hold up and underprice IPOs. In the IPOs of sophisticated issuers, underwriters short sell the issuing firm’s stock and overprice IPOs.

The model predicts efficiency losses and wealth transfers from naïve issuers and one-shot investors to underwriters, repeat investors, and sophisticated issuers in IPO markets. The behavioral theory I present provides a more comprehensive explanation for IPO pricing and practices than existing accounts, and supports arguments for substantive reforms to federal broker-dealer regulation.

Keywords: Initial public offerings, IPOs, broker-dealers, IPO underpricing, behavioral law and economics, law and economics, short selling, naive issuers, shrouded pricing, securities regulation, contracts, auction theory, transaction cost economics, direct listings, hold-up, bargaining model

Suggested Citation

Corrigan, Patrick, The Seller's Curse and the Underwriter's Pricing Pivot: A Behavioral Theory of IPO Pricing (September 15, 2019). VIRGINIA LAW & BUSINESS REVIEW VOLUME 13 SUMMER 2019 NUMBER 2; Notre Dame Legal Studies Paper No. 190915. Available at SSRN: https://ssrn.com/abstract=3454155 or http://dx.doi.org/10.2139/ssrn.3454155

Patrick Corrigan (Contact Author)

Notre Dame Law School ( email )

Eck Hall of Law
Notre Dame, IN 46556
United States

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