Lawyer Experience and IPO Pricing *

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1 Lawyer Experience and IPO Pricing * Royce de R. Barondes Assistant Professor Department of Finance E.J. Ourso College of Business Administration 2165 CEBA Louisiana State University Baton Rouge, LA (225) and Gary C. Sanger Professor and Associate Dean E.J. Ourso College of Business Administration 3304 CEBA Louisiana State University Baton Rouge, LA (225) May 4, 2000 * We wish to thank Alex Butler and, especially, Kelley Pace for comments and suggestions and David Beard for research assistance.

2 1 Lawyer Experience and IPO Pricing ABSTRACT We examine the level of experience of law firms participating in IPOs and the impact of law firm experience on IPO pricing. We find a statistically significant, negative relationship between market share of the law firm representing the investment banks and IPO price. In general, the relationship between legal counsel to the issuer and IPO price is of the same sign but not statistically significant, at customary levels, in all model specifications. We also find regional variations; there is a statistically significant, negative relationship between price and the participation of New York City underwriters lawyers. This evidence is consistent with more practiced legal counsel requiring more negative disclosure in prospectuses.

3 Lawyer Experience and IPO Pricing 2 1. Introduction Numerous pieces have examined a curious aspect of the IPO process an average, significant abnormal short-term return available to those who purchase stock sold in an IPO at the IPO price, called underpricing in the literature. Various theoretical explanations for this phenomenon have been proposed (e.g., Benveniste and Spindt, 1989; Booth and Smith, 1986; Rock, 1986; Tinic, 1988). Empirical literature examines the relationship between underpricing and measures of reputation of the managing underwriters. The literature generally finds greater managing underwriter reputation is associated with decreased underpricing (Carter and Manaster, 1990; Megginson and Weiss, 1991; Carter et al., 1998). However, Beatty and Welch (1996) find the opposite relationship in a more recent period, particularly in offerings of smaller firms, in results that are consistent with those of Cooney et al. (1999). The literature also examines the relationship between measures of auditor reputation and various aspects of IPO stock price. Beatty (1989) finds support for the hypothesis that hiring a nationally known auditor is related to less underpricing. Beatty (1993) also investigates the relationship between auditor compensation and underpricing, finding a negative relationship. Stock sold in an IPO typically is not priced until the day before the offering begins, although Securities and Exchange Commission (SEC) rules discussed below require a preliminary prospectus used before the offering is priced disclose a bona fide estimate of the price expected to be charged. The difference between the estimated price and the realized price has received only modest attention. Consistent with the theory of Benveniste and Spindt

4 Lawyer Experience and IPO Pricing 3 (1989), Hanley (1993, p. 242) finds the percentage change in price from the estimate to the actual price is positively associated with underpricing. Cooney et al. (1999, p. 18) find a statistically significant greater percent change in offerings managed by investment banks they classify as high reputation, relative to offerings managed by banks they classify as low reputation. Logue et al. (1999, p. 18) find IPO underpricing is more pronounced in IPOs that are priced above the estimated price range. We examine the relationship between changes in IPO price from the original estimates to the final offer prices for purposes of investigating the role in an IPO of legal counsel and, in particular, whether more skillful lawyers produce more complete, i.e., more negative, disclosure and, as a consequence, are associated with a decrease in the price realized by the issuer. Prior empirical literature has examined selected legal aspects of IPOs. Tinic (1988) argues IPOs are typically underpriced as insurance against future legal liability, and finds support from increased underpricing after the passage of the Securities Act of Beatty et al. (1998) show a negative relationship exists between investment bank IPO market share and the public announcement of an investigation by the SEC of the investment bank. Most comparable to this study is Beatty and Welch (1996). Those authors, examining IPOs over the period , find no general statistically significant relationship between lawyer market share and underpricing, although they find some support for a positive relationship in IPOs of old, large firms. They also find the compensation of the issuer s counsel is associated with a statistically significant decrease in underpricing in IPOs of young, small firms. They analyze this relationship as indicating [e]ither law services help

5 Lawyer Experience and IPO Pricing 4 the issuer in negotiations, or they provide quality assurance to the underwriter (Beatty and Welch, 1996, p. 596). Beatty and Welch (1996, p. 590) further hypothesize, [C]ompetent lawyers, themselves insulated from legal liability, might allow an issuer to be more aggressive in the prospectus. 1 We investigate whether more practiced counsel are more aggressive in requiring adverse disclosure and, consequently, their participation is associated with a decrease in price realized. The advantages of our formulation of the test addressing the change in price realized, as opposed to aftermarket performance are as follows: A review of underpricing for purposes of our investigation would at least in part depend on a potential second-order effect on the extent to which lawyers perform their jobs. The estimated price formed at the beginning of the IPO process in an offering should reflect the amount of underpricing necessary to sell that stock given the level of risk evident to the participants before diligence has been done. Lawyers can require adverse disclosure in an IPO prospectus that indicates the issuer is worth less without implying an investment in the firm s stock has more risk. Disclosure merely implying a decreased value of the firm would not directly affect 1 The legal conclusion that lawyers are insulated from liability under Federal securities laws is suspect. A panel of the U.S. Court of Appeals for the Third Circuit, in a controversial opinion, recently held lawyers who are authors or co-authors of disclosure actionable under Rule 10b-5 (Securities and Exchange Commission, 1999, sec b-5) will be treated as primary violators of Rule 10b-5 and therefore can be held liable under that rule, even where those lawyers are not named in the disclosure, as long as the other elements of the cause of action are met. Klein v. Boyd, Nos and (3d Cir. Feb. 12, 1998), vacated on grant of reh g, 1998 U.S. App. LEXIS 4121 (Mar. 9, 1998). Beatty and Welch s assertion was even more suspect during three quarters of the period included in their data set, which was prior to the Supreme Court s holding in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), that a private plaintiff may not maintain an action under section 10(b) against one who merely aided or abetted a violation of that section. There was some authority, prior to Central Bank, directly holding lawyers who recklessly draft misleading disclosure in a securities offering can be held liable under Rule 10b-5 for aiding and abetting a violation of that Rule (Andreo v. Friedlander, Gaines, Cohen, Rosenthal & Rosenberg, 660 F. Supp (D. Conn. 1987)).

6 Lawyer Experience and IPO Pricing 5 the required underpricing, although there could be a second-order effect arising from the partial adjustment phenomenon, examined by Hanley (1993). Our investigation also expands on the current literature in more technical ways. First, previous studies have evidently examined only the issuer s counsel. 2 The underwriters are also represented by counsel, who also perform extensive due diligence prior to an IPO. This omission is significant for two reasons. Market share data for law firms based solely on those who represent the issuers is misleading; it devalues those firms that have institutional relationships with investment banks and therefore frequently participate in IPO representation but do so on behalf of the underwriters. For example, the average annual market shares of Cravath, Swaine & Moore; Davis, Polk & Wardwell; and Sullivan & Cromwell three of the most prestigious securities firms as issuer s counsel in our sample are 1.52%, 1.60% and 1.19%, respectively, compared to 6.75%, 6.07% and 8.96% respective average annual market shares as underwriters counsel. Moreover, underwriters counsel may be less inhibited by its client relationship in requiring negative disclosure be included in the prospectus. Thus, sole reference to issuer s counsel may miss significant relationships. Second, we control for the geographic location of counsel, as anecdotal evidence suggests norms of legal practice vary across communities. 3 We find a statistically significant, negative relationship between market share of the law firm representing the lead manager and the offering price. Consistent with the notion 2 Beatty and Welch (1996) do not explicitly mention the underwriters counsel. Moreover, certain data they use, legal fees, is not available for underwriters counsel it is not required to be disclosed publicly. 3 Hazard (1981, p. 193) describes differing levels of vigor in negotiation as follows: At one extreme lies the rural God-fearing standard, so exacting and tedious that it often excludes the use of lawyers. At the other extreme stands New York hardball, now played in most larger cities using the wall-to-wall indenture for a playing surface.

7 Lawyer Experience and IPO Pricing 28 Table 2 Factors Associated with a Change in IPO Price from Estimated Price Results of OLS regressions. Panel A: Sample of 4,367 IPOs in 1985 to 1998, inclusive. Panel B: Alternative model specifications addressing robustness of results for IPOs in 1985 to 1998, inclusive. Panel C: Subsample of 2,936 IPOs in , inclusive. In all panels, below parameter estimates, in parentheses, are t-statistics (computed using White (1980) heteroskedasticity-corrected standard errors). Dependent variable for each regression is offer price per share. Omitted from reproduced results are parameter estimates and t-statistics for dummy variables, which were included in each regression, reflecting year of issuance and various SIC code ranges. Share prices used to compute estimated coefficients and t-statistics are deflated with the GDP implicit price deflator (1997=100). Significance at 1%, 5% and 10% levels (two-tailed) identified by ***, ** and *, respectively. Panel A: 4,367 IPOs from 1985 through 1998 Independent Variable Model 1 Model 2 Model 3 Model 4 Intercept ( )*** ( )*** ( )*** ( )*** Estimated Offer Price ( )*** ( )*** ( )*** ( )*** Log Size (U.S.) ( )*** ( )*** ( )*** ( )*** Gross Spread (%) ( )*** ( )*** ( )*** ( )*** Retain (%) (9.9522)*** (9.9734)*** (9.4566)*** ( )*** Log (Secondary (%) + 1) (7.5922)*** Log (Underwriter Rank (%) + 1) ( ) ( ) ( ) ( ) Log (Issuer Lawyer Rank (%) + 1) ( ) ( ) ( )*** ( )* Log (Underwriter Lawyer Rank (%) + 1) ( )*** ( )*** ( )*** ( )*** General Counsel Dummy ( ) ( ) ( ) Sonsini Dummy (6.1154)*** (5.5530)*** Adjusted R

8 Lawyer Experience and IPO Pricing 29 Panel B: IPOs from 1985 through 1998 Alternative Model Formulations Alternative models confirming robustness of results for the period , inclusive. The first model incorporates percentage market share independent variables (as opposed to natural log of percentage market share). The second model is limited to IPOs in the sample in which the estimated price first listed in a preliminary prospectus is a range (i.e., not a single value). The third model is limited to IPOs in which the offer price, in nominal dollars, is at least $1.00. Independent Variable All 4,367 IPOs 3,769 IPOs Where Estimated Price Expressed as a Range 4,344 IPOs with Offer Price at Least $1 (nominal dollars) Intercept ( )*** ( )*** ( )*** Estimated Offer Price ( )*** ( )*** ( )*** Log Size (U.S.) ( )*** ( )*** ( )*** Gross Spread (%) ( )*** ( )*** ( )*** Retain (%) ( )*** ( )*** ( )*** Log (Secondary (%) + 1) (7.6029)*** (7.4568)*** (7.6179)*** Log (Underwriter Rank (%) + 1) ( ) ( ) Log (Issuer Lawyer Rank (%) + 1) ( )** ( )* Log (Underwriter Lawyer Rank (%) + 1) ( )*** ( )*** Underwriter Rank (%) (1.3792) Issuer Lawyer Rank (%) ( )** Underwriter Lawyer Rank (%) ( )*** General Counsel Dummy ( ) ( ) ( ) Sonsini Dummy (5.5210)*** (5.2312)*** (5.5506)*** Adjusted R

9 Lawyer Experience and IPO Pricing 30 Panel C: 2,936 IPOs in Regressions incorporating variables reflecting the locations of the lawyers. Independent Variable Intercept ( )*** ( )*** Estimated Offer Price ( )*** ( )*** Log Size (U.S.) ( )*** ( )*** Gross Spread (%) ( )*** ( )*** Retain (%) ( )*** ( )*** Log (Secondary (%) + 1) (5.2142)*** (5.1582)*** Log (Underwriter Rank (%) + 1) ( ) ( ) Log (Issuer Lawyer Rank (%) + 1) ( ) ( )** Log (Underwriter Lawyer Rank (%) + 1) ( )** ( )** Issuer Lawyer Boston (2.0147)** (2.1728)** Issuer Lawyer Chicago (0.0173) (0.0606) Issuer Lawyer Los Angeles (0.1487) (0.1972) Issuer Lawyer New York City ( )* ( ) Issuer Lawyer San Francisco Area (3.0741)*** (1.9436)* Underwriter Lawyer Boston (0.7403) (0.8083) Underwriter Lawyer Chicago ( ) ( ) Underwriter Lawyer Los Angeles ( ) ( ) Underwriter Lawyer New York City ( )*** ( )*** Underwriter Lawyer San Francisco Area (1.4446) (0.5274) General Counsel (0.1234) Sonsini (3.0702)*** Adjusted R

10 Lawyer Experience and IPO Pricing 31 Table 3 Determinants of the Filing of a Lawsuit Alleging Violation of Securities Laws IPOs Probit model estimates of likelihood of the filing of a lawsuit alleging violation of securities laws, where the dependent variable is equal to one if a lawsuit was filed and zero otherwise. Below each estimate, in parentheses, is the p-value (1%, 5% and 10% levels identified by ***, ** and *, respectively). Results are presented for IPOs in the period 1992 through 1998, inclusive. Ninety-five of the IPOs were subjects of securities lawsuits. Not reproduced are estimated coefficients and p-values for dummy variables reflecting the year of the IPO and various two-digit primary SIC codes. Independent Variable Intercept (0.0001)*** Offer Price (per share) (0.3586) Estimated Offer Price (per share) (0.8124) Log Size (U.S.) (0.0942)* Gross Spread (%) (0.0036)*** Retain (%) (0.8775) Log (Secondary (%) + 1) (0.2606) Log (Underwriter Rank (%) + 1) (0.7392) Log (Issuer Lawyer Rank (%) + 1) (0.9100) Log (Underwriter Lawyer Rank (%) + 1) (0.6264) Issuer Lawyer Boston (0.4101) Issuer Lawyer Chicago (0.6419) Issuer Lawyer Los Angeles (0.1431) Issuer Lawyer New York City (0.4336) Issuer Lawyer San Francisco Area (0.1027) Underwriter Lawyer Boston (0.5656) Underwriter Lawyer Chicago (0.7211) Underwriter Lawyer Los Angeles (0.9820)

11 Underwriter Lawyer New York City (0.0435)** Underwriter Lawyer San Francisco Area (0.5117) Log (Risk Proxy) (0.0001)*** General Counsel (0.9997) Sonsini (0.5014) Likelihood Ratio Statistic (0.0000) Pseudo-R Lawyer Experience and IPO Pricing 32

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