Local corporate misconduct and local initial public offerings

• DOI: http://doi.org/10.1111/fire.12199
• Author: Darshana D. Palkar,Emre Kuvvet
• Date: 01 February 2020
• Published date: 01 February 2020

DOI: 10.1111/fire.12199

ORIGINAL ARTICLE

Local corporate misconduct and local initial public

offerings

Emre Kuvvet Darshana D. Palkar

H. WayneHuizenga College of Business &

Entrepreneurship, Nova Southeastern

University, Ft. Lauderdale, Florida

Correspondence

DarshanaD. Palkar,H . WayneHuizenga College

ofBusiness & Entrepreneurship, Nova South-

easternUniversity, 3301 College Avenue,Ft.

Lauderdale,FL 33314-7796.

Email:dp788@nova.edu

Abstract

This paper investigates the cost of going public through initial pub-

lic offerings (IPOs) for firms located in regions with significant fraud

density.We find that companies in regions with a high proportion of

nearby firms that have committed corporate misconduct havemore

pronounced underpricing, experience higher post-IPO stock return

volatility,and are more likely to withdraw their offerings. Overall,our

results show that local corporate misconduct is associated with the

pricing of IPOs, and the breach of trust is related to costly IPOs for

newcomers.

KEYWORDS

contagion, local fraud density, local initial public offerings, trust,

underpricing

JEL CLASSIFICATIONS

G11, G32, G41, K22

1INTRODUCTION

In the majority of financial transactions, trust plays an important role. According to Arrow (1969, p. 14), “It is useful

for individuals to have some trust in each other's word. In the absence of trust, it would become very costly to arrange

for alternative sanctions and guarantees,and many opportunities for mutually beneficial cooperation would have to be

foregone.”Without trust betweenthe counterparties, financial transactionsare either too costly for both sides, leading

one or both parties to withdraw from the transaction,or the transaction will ultimately fail.

Surprisingly, relatively few empirical studies have researched the role of trust in financial transactions, perhaps

because trust is difficult to observe and to measure directly and accurately.However, when examining the role of trust

in certain financial transactions, recent studies use corporate misconduct at local companies as a proxyfor the break-

down of trust in other nonfraudulent local firms. Forinstance, Giannetti and Wang (2016) find that after the revelation

of corporatemisconduct in a state, that state's household stock market participation decreases. Theyshow that house-

holds decrease holdings in both fraudulent and nonfraudulent firms even if some of these households do not own any

stocks in the fraudulent firms. The authors attribute this situation to a loss of trust in the stock market as awhole, not

necessarilyas a loss of trust in an individual company. Likewise, Parsons, Sulaeman, and Titman (2018a) find that when a

Financial Review.2020;55:169–192. wileyonlinelibrary.com/journal/fire c

2019 The Eastern Finance Association 169

170 KUVVET ANDPA LKAR

region in the United States experiences a series of corporatemisconduct events, bank credit for nearby nonfraudulent

firms becomes temporarily more expensiveand more difficult to obtain.

In this study,we look at the association between trust and capital formation through initial public offerings (IPOs).

Capital raised through U.S. IPOs reached $691.45 billion1from 1996 to 2017; however,many firms are still reluctant

to use IPOs as a source of financing. For example, only 1.62% of the 28.8 million U.S. small businesses use IPOs as a

source of financing.2This is a concern, given that these businesses account for 64% of net new private sector jobs and

produce 16 times more patents per employee than larger companies.3In this study,we show that the breach of trust

is associated with costly IPOs for newcomers. We want to emphasize that our goal is not to document the causal link

between local corporatemisconduct and local IPOs but rather to provide important evidence regarding the association

between local fraud density and local IPOs.

We find that firms in regions with a high proportion of nearby companies that have committed corporate miscon-

duct have more pronounced underpricing and experience higher post-IPO stock return volatility.Our results are also

economically significant; a one-standard-deviation increase in our local fraud measure is associated with an increase

in the underpricing of local IPOs by 1.14% (or 4.09% compared to the sample average).For an average issuer with pro-

ceeds of $138.10, this increase in underpricing translates into an increase of $1.58 million in the money left on the

table.4In addition, we find that IPOs headquartered near more severe fraudsexperience higher underpricing. We also

show that IPOs that are headquartered close to a large volume of fraud misconduct cases are more likelyto withdraw

their offerings.

The paper proceeds as follows. Section 2 discusses the related literature. Section 3 developsthe research hypothe-

ses. Section 4 explains the sources, variables, and model specifications. Section 5 discusses the empirical results.

Section 6 presents our conclusions.

2LITERATURE REVIEW

Arrow (1972, p. 357) emphasizes the importance of trust in economic transactions and suggests that “virtually every

commercial transaction has within itself an element of trust, certainly anytransaction conducted over a period of time.

It can be plausibly argued that much of the economic backwardness in the world can be explainedby the lack of mutual

confidence.”

Our research is related to two branches of existing literature: the growing number of studies related to the role of

trust in financial transactions and the economic importance of geography.Most studies in the existing literature deal-

ing with trust are international. For example, using cross-country data, Guiso, Sapienza, and Zingales (2008) find that

trust has a positive and significant effect on stock marketparticipation and a negative effect on the dispersion of own-

ership. Guiso et al. (2008) also show that reduced bilateral trust between countries leads to less portfolio investment.

Bottazzi, Da Rin, and Hellmann (2016) find that trust among nations has a positive effect on venture capital (VC)firms’

investmentdecisions. Ahern, Daminelli, and Fracassi (2015) also show that trust has significant effects on international

mergers. By using a large international sample of both publicly traded and privately held companies across 41 coun-

tries, Xie, Zhang, and Zhang (2018) find that trust alleviates incomplete contracting and increases innovationby acting

as an informal contracting mechanism. Other studies haveexamined the effects of trust on stock market participation

(Giannetti & Wang,2016), bank credit (Parsons et al., 2018a), and the investment advisory industry (Gurun, Stoffman,

& Yonker, 2017) by exploiting trust differences within the United States. Forexample, Gurun et al. (2017) examine the

1https://site.warrington.ufl.edu/ritter/files/2018/01/IPOs2017Statistics_January17_2018.pdf

2https://www.sba.gov/sites/default/files/advocacy/SB-FAQ-2016_WEB.pdf

3https://www.thoughtco.com/how-small-business-drives-economy-3321945

4Money left on the table is defined as the difference between the first aftermarket price and the offer price, multiplied by the number of shares sold (see

Loughran& Ritter, 2002). This amount represents the wealth transfer from pre-issue shareholders to investors who are allocated shares at the offer price. In

robustness tests, we find that a one-standard-deviation increase in alternative local fraudmeasures is associated with a $2.01–$5.27 million increase in the

moneyleft on the table for an average IPO firm.