Underwriter Compensation Structure: Can It Really Bond Underwriters?

• Published date: 01 February 2014
• DOI: http://doi.org/10.1111/fire.12024
• Date: 01 February 2014

The Financial Review 49 (2014) 21–48

Underwriter Compensation Structure: Can

It Really Bond Underwriters?

Jacqueline L. Garner∗

Mississippi State University

Beverly B. Marshall

Auburn University

Abstract

Underwriter compensation can be structured as all cash or a combination of cash and

warrants. Using a sample of small initial public offerings (IPOs), we find that underwriter

compensation contracts that include warrants in exchange for cash can serve as certification

for IPO firms by substituting for reputation capital. When underwriters accept warrants when

they could have received more cash compensation, the IPOs avoidthe well documented long-

run underperformance. However, when underwriters receive warrants after maximizing cash

compensation, the IPO experiences higher underpricing and poorer long-run performance.

The findings are consistent with a motivation by the underwriters to circumvent regulatory

constraints.

Keywords: initial public offerings, underwriting compensation, underpricing, regulatory

guidelines

JEL Classifications: G18, G24

∗Corresponding author: Department of Finance and Economics, Mississippi State University, 312

McCool Hall, Mississippi State, MS 39762; Phone: (662) 325 6716; Fax: (662) 325-1977; E-mail:

jacqueline.garner@msstate.edu.

Wethank the editors (Robert and Bonnie VanNess) and two anonymous referees for their helpful comments

and suggestions. We also thank participants at the 2010 Financial Management Association meeting.

C2014 The Eastern Finance Association 21

22 J. L. Garner and B. B. Marshall/The Financial Review 49 (2014) 21–48

1. Introduction

Underwriter compensation in initial public offerings (IPOs) is regulated by

Financial Industry Regulatory Authority (FINRA) Rule 5110, which imposes limits

on both the types and the amount of compensation. In general, cash compensation is

limited to 13%, composed of a 10% limit on the spread and a 3% limit on the expense

allowance. Noncash compensation, including warrants, is also subject to regulations,

which include policies on the lock-up period, warrant term, quantity of warrants

issued, and the warrant valuation method. Further, FINRA Notice to Members 92–53

provides guidelines on total compensation, which vary with the size of the offering

and are suggested to represent “the maximum amount of compensation ‘underwriters

and related persons’ may receive in a public offering” (NASD Manual and Notice to

Members, www.nasd.com).

For larger offerings, Chen and Ritter (2000) show that total compensation al-

lowed by the regulations is approximately 7% and results in the clustering of spreads

for offers over $20 million.1However, for offers below $20 million, the regulatory

guidelines cap total compensation at levels between 7.52% and 15.80% of proceeds

resulting in significant variation in the actual level and types of compensation for

small offerings. For example, for offerings below$12 million, the guidelines suggest

total compensation at levels over 13% of offer proceeds, which exceeds the limit

on cash compensation. Therefore, it is not surprising that warrants are accepted as

compensation among small offerings where the dollars generated as a percentage of

the offer size could be insufficient to cover expenses and the risk of underwriting the

offering. For these underwriters, once cash compensation is maximized, warrants are

simply included by default.

However, warrantsare not always included in compensation by default. Among

our sample of underwriters receiving warrant compensation, cash compensation is

not at the maximum allowable level about 40% of the time. This suggests that the un-

derwriters either trade off cash compensation for warrant compensation or are forced

by the issuing firm to take contingent compensation. The presence of significant

regulations on compensation implies that less reputable underwriters would extract

excessive compensation in their absence. This suggests that significant monopsony

power over the issuing firm could be present despite what appears to be a relatively

crowded market of underwriters. Lesser knownunderwriters could signal their quality

to investors in the compensation contract by setting a low levelof cash compensation

and accepting contingent compensation in the form of warrants as conjectured by

Bae and Jo (2007). On the other hand, the issuing firm could force less proven un-

derwriters to take contingent compensation as a bonding mechanism, in an effort to

encourage effective performance of responsibilities surrounding the offering. Either

1The compensation guidelines for offers of $50 million or more is 6.89%, whereas the compensation

guideline for offers of $20 million is 7.52%.