IPO liability and entrepreneurial response.

• Author: Spindler, James C.
• Position: Initial public offerings

This Article explores how legal liability in the IPO context can affect an entrepreneur's decision of whether and how to take a firm public. Liability under the Securities Act of 1933 effectively embeds a put option in an IPO security, forcing the entrepreneur to insure shareholders against poor firm performance, inflating the price of the security, and exposing the entrepreneur to risk. This may cause IPO firms to appear to underperform relative to non-IPO firms as the option value decays, and may lead the entrepreneur to undertake strategic (but destructive) responses to minimize the put value and his exposure to risk. Because of the value-destroying characteristics of these responses--which include initial underpricing, entrenchment, lower net present value projects, asset partitioning, and reduced disclosure--the present state of affairs is inefficient compared to a system where the entrepreneur can simply allocate the risk to shareholders.

INTRODUCTION I. A NOTE ON THIS ARTICLE'S CONTRIBUTION TO THE LITERATURE II. EMBEDDING PUT OPTIONS THROUGH DISCLOSURE LIABILITY A. Liability for Inaccurate Disclosure B. Option Characteristics of Securities Act Liability III. UNDERPERFORMANCE, EMBEDDED PUTS, AND THE IPO DECISION A. The Decision of How To Fund a Project B. The Addition of an Embedded Put Right C. Price Movements with an Endogenous Put: Initial Underpricing, Long-Term Underperformance D. Can This Theory of Embedded Options Explain Observed Patterns of Long-Term Underperformance? 1. Timing 2. Magnitude IV. STRATEGIC REACTIONS TO EMBEDDED PUT LIABILITY A. Risk Reduction: Information and Investment Choice B. Insurance and Hedging C. Managerial Entrenchment D. Removal of Assets from the Firm E. Reduced Information F. Firm-Level Diversification and "Empire Building". CONCLUSION INTRODUCTION

Mandatory disclosure rules are often perceived as a no-lose quick fix. After all, what's the harm in simply requiring one party to a transaction to give information already in her possession to another party? Such a requirement appears to promote fairness with little, if any, overall social cost, and, based largely on this premise, disclosure rules are a popular choice among academics and legislators. But there is a fallacy here: information is costly to obtain, and certainty may be impossible to achieve. There are thus hidden costs to disclosure rules: when information is incomplete or uncertain, the party burdened with making accurate disclosure is made to bear the risk that those disclosures will prove incorrect. Beating that risk may well affect the party's substantive behavior in socially undesirable ways.

Such a situation arises in the securities context, which is the focus of this Article. Sellers of securities--such as founding entrepreneurs--are required under the Securities Act of 1933 to make full and complete disclosure to purchasing investors (the public shareholders) in public offerings. (1) As I will show, the imposition of this disclosure requirement apportions risk in a way that the parties to the transaction--the shareholder and the entrepreneur--likely find suboptimal, and this distorts their incentives in undesirable ways.

To begin with the basic framework, consider the stylized "bargaining" that takes place between a selling entrepreneur and purchasing shareholders. When an entrepreneur who has founded a firm and developed its business decides to take it public in an initial public offering (IPO), he gets to choose many things about the firm's initial setup. For instance, he may decide to embed takeover protection in the firm's charter, retain voting control and issue only nonvoting stock, or partition the firm's assets and sell only a part thereof to the public shareholders. These choices are subject to the shareholder's valuation of the resulting structure: a shareholder will be willing to pay more or less for the firm's shares depending on whether she finds the entrepreneur's choices agreeable. With this ability to "bargain," in general we expect to see the selling entrepreneur and purchasing shareholders reach efficient outcomes in the structure and form of the firm and the firm's IPO.

One such area of bargaining between entrepreneur and shareholder involves the assignment of risk. Because the entrepreneur lacks the ability to diversify away idiosyncratic risk, while the shareholder can diversify completely, the firm is actually worth more in the hands of the shareholder than it is in the hands of the entrepreneur. (2) Thus, when the entrepreneur sells a share of the firm to the shareholder, one basic area of agreement between the two is that the shareholder will bear the risk on the shares that she purchases. This is perhaps such an obvious concept as to appear almost trivial: we suppose that when a shareholder purchases shares of, say, IBM on the open market, the shareholder is fully aware that she bears the risk of a decline in the value of those shares.

The argument of this Article, however, is that the U.S. securities laws do not allow this simple risk-sharing bargain to be struck in the IPO context, (3) with negative consequences for shareholder and entrepreneur alike. The reason is that the material misstatement or omission liability standard of section 11 of the Securities Act (4) effectively grants the shareholder the right to "put" back the shares to the entrepreneur for their purchase price in the bad state of the world in which the firm performs poorly. (5) The shareholder relies on information provided by the entrepreneur--including the entrepreneur's expectations about future performance--to make her purchase decision, and if, in hindsight, this information appears to have been wrong, the shareholder has the legal right to recover her losses from the firm, wiping out the entrepreneur's stake. The entrepreneur ends up bearing idiosyncratic risk that could be more efficiently borne by the shareholder. There are two principal implications of this risk allocation.

First, because the shareholder purchases not just the firm's equity but also a "put option" exercisable in the bad state of the world, the shareholder pays more for the share-cure-option than she would have paid for just the share. This means that the firm initially appears to be valued in excess of the net present value of its future cash flows, and, over time, as the value of the option component of the security declines, the firm will tend to appear to underperform relative to non-IPO firms. This relative underperformance is exacerbated when the shareholder exercises her put option in the bad state of the world, pulling assets out of the firm. Underperformance of IPO firms, which has sometimes been held up as evidence of market inefficiency, may in fact be an artifact of regulatory distortion.

Second, and more importantly, because this allocation of risk is undesirable to the entrepreneur, the entrepreneur may undertake a number of strategic responses to attempt to minimize her exposure to the firm's idiosyncratic risk. These actions could involve initial underpricing of the IPO, managerial entrenchment, choosing lower value (but safer) business projects, investing in insurance or hedging transactions, partitioning of assets, refraining from disclosing positive information about the firm in the IPO prospectus, or firm-level diversification ("empire building"). Most of these activities have the potential to destroy value and lead to outcomes that are inefficient compared to allowing the entrepreneur and shareholder to allocate risk between them as they choose.

1. A NOTE ON THIS ARTICLE'S CONTRIBUTION TO THE LITERATURE

   The chief aim of this Article is to describe the effect that securities liability has on the incentives of the entrepreneur and the firm from an ex ante perspective, providing a linkage between the public capital-raising process and the nature and structure of the public firms that result. This is something on which relatively little has been written. While some have argued in very general terms that overly harsh liability or an overly litigious environment may keep issuers from the public markets in favor of, inter alia, private or offshore deals, (6) those authors do not consider the entrepreneur's broad range of dynamic responses to the threat of litigation. This Article fills that gap, and concludes that these responses are themselves potentially quite harmful.

   More broadly, this Article bears upon the merits of the Securities Act itself and, in doing so, weighs in on a question the legal literature has widely discussed: whether mandatory disclosure laws are justified. (7) While this Article does not discuss the potential costs and benefits (8) of a private-ordering system of disclosure, instead taking the mandatory disclosure regime as given, it does elaborate upon the costs that a one-size-fits-all system of mandatory disclosure and risk shifting can impose upon issuing firms and shareholders. A description of these costs, including the strategic maneuvers by the entrepreneur to affect the firm's structure or capitalization, forms the bulk of this Article, to be found in Parts III and IV.

   This Article also considers the issue of how, exactly, current liability rules function. This inquiry bears on a major question the literature has addressed: whether the litigation mechanism for imposing securities liability is "broken." This literature, which developed around Janet Cooper Alexander's seminal 1991 article, argues positively that the underlying existence of fraud or material inaccuracy appears uncorrelated with settlement outcomes. (9) The so-called "strike suit," where a decline in share price, by itself, leads to significant settlement amounts, is ostensibly evidence of brokenness. (10) I argue, in contrast, that, from a Bayesian point of view, a decline in share price should be a major factor in deciding whether inaccurate disclosure occurred, and in some cases could be the only factor...