UNDERWRITERS AND THE BROKEN CHINESE WALL: INSTITUTIONAL HOLDINGS AND POST‐IPO SECURITIES LITIGATION
| Author | Sergey S. Barabanov,Kuntara Pukthuanthong,Thomas J. Walker,Onem Ozocak |
| Published date | 01 December 2013 |
| DOI | http://doi.org/10.1111/jfir.12023 |
| Date | 01 December 2013 |
UNDERWRITERS AND THE BROKEN CHINESE WALL: INSTITUTIONAL
HOLDINGS AND POST‐IPO SECURITIES LITIGATION
Sergey S. Barabanov
University of St. Thomas
Onem Ozocak
Brock University
Kuntara Pukthuanthong
San Diego State University
Thomas J. Walker
Concordia University
Abstract
We examine whether underwriters have an information advantage over other institutional
investors in new public companies. Focusing on firms targeted by IPO‐related class
action litigation and a matched sample of nonsued firms, we find evidence suggesting that
lead underwriters retain an information advantage in the firms they take public and that
they capitalize on this information by closing out or reducing their holdings in sued firms
prior to the eventual litigation date. An examination of analyst opinions suggests that
analysts affiliated with lead underwriters are reluctant to reduce their earnings forecasts or
downgrade sued firms before the litigation date.
JEL Classification: G11, G12, G14, G18, K22
I. Introduction
The primary goal of this study is to examine whether underwriters retain an information
advantage in firms they take public and whether they capitalize on their superior
knowledge better than other institutions. We distinguish between money managers
affiliated with lead underwriters, managers affiliated with other members of the
underwriting syndicate, and unaffiliated institutional investors, and examine their relative
abilities to anticipate negative developments in new public companies at an early stage
and whether and to what extent they decrease positions in such firms over time.
To answer our research questions we investigate initial levels as well as changes
in lead underwriter, syndicate member, and unaffiliated institutional ownership around
We are thankful to colleagues at Concordia University, the University of St. Thomas, the University of
Mannheim, UCLA, Rutgers University, and Washington State University for helpful comments. Sergey Barabanov
gratefully acknowledges support from the Opus College of Business, University of St. Thomas. Thomas Walker
gratefully acknowledges the financial assistance provided by the Canadian Social Sciences and Humanities
Research Council (SSHRC) and Germany’s Alexander von Humboldt Foundation.
The Journal of Financial Research Vol. 36, No. 4 Pages 543–577 Winter 2013
543
© 2013 The Southern Finance Association and the Southwestern Finance Association
IPO‐related lawsuits. In these lawsuits, investors and their law firms typically accuse
the IPO firm of having omitted from or misrepresented material negative information in its
IPO prospectus that would have affected the investors’decision to invest in the company.
We choose litigation announcements because we hypothesize that they are not entirely
unexpected for the firm itself and those parties that have an information advantage about
the firm.
Institutional investors have long been considered as being more sophisticated
than individuals and there is abundant empirical evidence that supports this “smart
money”view of the industry. For example, there are several studies that document a
positive correlation between changes in institutional ownership and returns in secondary
markets (e.g., Nofsinger and Sias 1999; Barabanov and McNamara 2013; Sias, Starks,
and Titman 2006). One implication of the “smart money”theory is that professional
money managers are more sophisticated than individuals and are therefore more
successful at avoiding poorly performing firms or at selecting winning stocks than the
average individual investor. In addition to examining differences in the trading behavior
of institutional and individual (retail) investors, a large body of research has investigated
differences in trading patterns among different types of institutions, that is, banks,
mutual funds, and so on. Yet, unlike for seasoned firms, there are few studies that
examine institutional ownership trends for new public companies. Specifically, we are not
aware of any studies that compare the trading of lead underwriters, syndicate
members, and nonunderwriting institutions in young IPO firms. Our study attempts to
close this gap.
If lead underwriters rely on the same information and employ the same analytical
methods as syndicate members and other (unaffiliated) institutions, we would not expect
them to be more successful than syndicate members and other institutions in the post‐IPO
market. However, unlike syndicate members and other institutions, lead underwriters are
often personally familiar with the managers of the firms they take public and are more
likely to be aware of material developments within IPO firms at the time of the IPO and
thereafter. Moreover, they should be in a good position to judge management’s abilities
because they have personally dealt with the firm’s managers over an extended period. This
implies that even if all material information is properly disclosed in a firm’s IPO
prospectus, lead underwriters remain better positioned to understand the company’s
business and to correctly interpret management’s ability to react to any post‐IPO
developments that may affect the firm. Furthermore, it is likely that during their roadshow
underwriters will gain valuable insights into the concerns that other institutions have
about the issuing firm and its industry, which, once aggregated, will provide them with a
clearer overall picture about the investing industry’s opinion about the firm. Taken
together, lead underwriters are not only likely to have better access to hard information
about the firms they take public but are also in a position to build up a considerable “soft
information”advantage relative to other institutional investors.
1
Consequently, lead
underwriting firms may be able to better understand company prospects at the time of the
1
The use of soft information by underwriters has been examined previously, albeit not in an IPO context. For
instance, Butler (2008) finds that investment banks with a local presence are better able to assess soft information
about local borrowers and place difficult municipal bond issues.
544 The Journal of Financial Research
IPO, better interpret firm‐and industry‐specific developments that affect the company
after its IPO, and further enhance their information advantage by collecting and analyzing
information about similar firms and sectors by underwriting IPOs or secondary offerings
for other firms in the same industry. We hypothesize that these factors allow lead
underwriters to not only enter the IPO aftermarket with a static information advantage that
allows them to identify “at‐risk”companies early on but that they also dynamically
enhance their information advantage over time. Based on this premise, our first hypothesis
(Hypothesis 1a) proposes that lead underwriters decrease their holdings in sued IPOs
(with which they are associated) during quarters T2 and T1, where quarter Tincludes
the lawsuit announcement date. Similarly, we hypothesize that nonlead members of
the underwriting syndicate and other (unaffiliated) institutions do not significantly
decrease their holdings in sued IPOs during quarters T2 and T1, where quarter T
includes the lawsuit announcement date (Hypothesis 1b).
We find support for prior anecdotal evidence about net institutional selling in
recent IPOs as first empirically documented by Field and Lowry (2004). Furthermore,
our findings reveal that institutional owners sell their positions sooner and to a greater
extent in IPOs that are subject to subsequent class action litigation than in nonsued IPOs.
Most important, we document that lead underwriters are more proactive than
unaffiliated institutions in selling shares of IPO firms that are later sued. Nonlead
members of the syndicate do not exhibit any significant abilities in identifying potential
litigation targets and in avoiding ownership in these firms. Unlike institutions that were
not part of the underwriting syndicate, lead underwriters appear to capitalize on their
information advantage at least one more time when they start acquiring back positions in
recent IPOs shortly after the litigation is announced. All of our findings are consistent
with institutions in general and lead underwriters in particular being well‐informed
investors, who are actively trading on their information advantage. In addition, we
hypothesize that the trading behavior of lead underwriters before the litigation
announcement is positively related to the abnormal returns of sued firms, particularly if
they are able to predict lawsuits that hit the market by surprise. Thus, our second
hypothesis (Hypothesis 2a) proposes that lead underwriters have superior information
and are able to reduce their stock holdings during the period T4toT1infirms that are
sued by surprise, that is, in firms that experience significant negative cumulative
abnormal returns (CARs) around the lawsuit announcement date. In the same vein, we
argue that nonlead members of the underwriting syndicate and unaffiliated institutions
do not have superior information and are not able to reduce their holdings before
unexpected lawsuits (Hypothesis 2b).
Our results show that lead underwriters’stock holding changes from T4toT1
are positively related to the CARs of sued firms during a (1,1) event window around the
announcement date, suggesting they are able to identify potential litigation targets better
than other market participants.
Furthermore, we explore whether an institution’s trading decisions conform to
the earnings forecasts provided by its analysts. In our final hypothesis (Hypothesis 3) we
argue that lead underwriter‐affiliated analysts adjust their earnings forecasts downward
before the lawsuit announcement to a lesser extent than analysts affiliated with nonlead
members of the underwriting syndicate and other (unaffiliated) institutions.
Underwriters and the Broken Chinese Wall 545
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