Underwriters' Civil Liability for Ipo'S: An Economic Analysis

46 Pages Posted: 7 Nov 2006

See all articles by Noam Sher

Noam Sher

Ono Academic College - Faculty of Law

Abstract

This article explores new justifications for imposing liability on underwriters. The article discusses whether civil liability should be imposed on the leader of a consortium of underwriters (the lead or, more commonly, managing underwriter) and other underwriters of initial public offerings (IPOs) for misleading information in the offering prospectus. The justification of such liability is based on two new models that simulate the decision-making process of managing underwriters. The first model indicates that a statute imposing liability on underwriters plays a crucial role in solving the problem of hidden action by the managing underwriter, in which the degree of effort that the managing underwriter makes in performing due diligence is not revealed in the aftermarket. The second model shows that the managing underwriter acts strategically in setting the offering price and in allotting securities to investors, and that the law plays a central role in reducing the offering-related costs. This model describes the convergence of supply and demand in the bookbuilding method.

The principal thesis of the study is that in the current structure of capital markets, the strategic behavior of the managing underwriter of a consortium of underwriters creates substantial costs through its method of distributing securities in the primary market and that this phenomenon justifies imposing civil liability on managing underwriters. In the first model, the moral hazard problem cannot be solved without statutory backing. In the second model, the managing underwriter cultivates a two-way relationship with potential investors during the course of marketing the offering. In this model, the managing underwriter determines the offering price and the allotment of securities to investors in a way that maximizes its profits. In equilibrium, only some of the regular investors perform valuations of the offered securities to the degree that enables efficiency in building a market-demand curve. The model indicates that imposing civil liability on the managing underwriter using the bookbuilding method can increase the efficiency of the allotment mechanism operation.

Imposing liability on the managing underwriter is also expected to put some restraints on its strategic behavior in the aftermarket. Another aspect of efficiency that results from imposing liability, is that the managing underwriter's power to effectively supervise company directors, such as providing oversight of executive hirings and personal interest agreements, is strengthened. Imposing civil liability on managing underwriters is further justified by the fact that managing underwriters are the least expensive insurers, particularly in the distribution of systemic risks.

Keywords: Securities regulation, Underwriters' Liability, IPO, Misleading Details, Moral Hazard

JEL Classification: K13, K22

Suggested Citation

Sher, Noam, Underwriters' Civil Liability for Ipo'S: An Economic Analysis. University of Pennsylvania Journal of International Economic Law, Vol. 27, p. 389, 2006, Available at SSRN: https://ssrn.com/abstract=942810

Noam Sher (Contact Author)

Ono Academic College - Faculty of Law ( email )

104 Zahal St.
Kiryat Ono, 55000
Israel
972-52-6309102 (Phone)

HOME PAGE: http://www.ono.ac.il

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