Underwriter Manipulation in Initial Public Offerings

We provide a new explanation for the extremely high level of initial public offering (IPO) underpricing during the Internet bubble years of the late 1990s based on the allocation practices of underwriters. By requiring their customers to buy the stock in the aftermarket in return for IPO allocations (a tie-in agreement), the underwriters created artificial excess demand for the IPOs, leading to distorted (manipulated) price levels in the immediate aftermarket. Empirically, we show that IPOs with tie-in agreements exhibit a distinctly different pattern for the first-day and long-term returns than do IPOs without tie-in agreements during the 1998 to 2000 period, consistent with the model. IPOs with tie-in agreements have seven times higher first-day returns and considerably higher first-day trading volume. However, these stocks begin to underperform significantly starting from the sixth month after the IPO, and the lower returns persist for up to three years after the IPO. We also find that the tie-in IPOs experience significantly lower returns around the lock-up expiration period. Even after controlling for hot market conditions and issuer characteristics such as issue size, underwriter quality, and whether the IPO is a technology stock, we find that manipulation explains much of the unusually high level of underpricing during the late 1990s. * We thank Sudheer Chava, Thomas Chemmanur, Grace Hao, Alexander Ljungqvist, Jay Ritter, Bhaskaran Swaminathan, Bill Wilhelm, Jaime Zender and seminar participants at China International Finance Conference, University of Michigan, University of Minnesota, and Western Finance Association 2005 meetings for helpful discussions and comments. We are responsible for all remaining errors. † Carlson School of Management, University of Minnesota, 321 19 Avenue S., Minneapolis, MN 55455, E-mail: [email protected] ‡ Ross School of Business, University of Michigan, 701 Tappan Street, Ann Arbor, MI 48109, Phone: (734) 7646886, E-mail: [email protected] § Bauer College of Business, University of Houston, 334 Melcher Hall, Houston, TX 77204, Phone: (713) 7434813, E-mail: [email protected]