Are Strategic Disclosure and Underpricing Decisions Influenced by Liability Risk?

Using word content analysis on IPO prospectuses, we show that the liability risk associated with strategic non-disclosure of information can be mitigated by underpricing. This tradeoff explains a significant fraction of the variation in prospectus revision patterns, the partial adjustment phenomenon, and litigation outcomes. By examining ex-post litigation and involvement by IPO shareholders, we find that both high initial returns and increased disclosure serve as strong hedges against costly outcomes. Underwriters are the primary beneficiaries of underpricing as a hedge against litigation risk because they are subject to penalties beyond monetary damages. Underwriters who fail to adequately hedge litigation risk experience subsequent reductions in market share, and increased failure of their brand name. ∗Federal Reserve Board of Governors and University of Maryland, respectively. We thank Jeff Harris, Wei Li, Jay Ritter, Robert Savickas, Tracy Wang, and seminar participants at George Washington University, the Securities Exchange Commission, University of Delaware, and Washington University. The ideas and opinions expressed in this study are the authors’ and should not be interpreted as reflecting the views of either the Board of Governors of the Federal Reserve System or its staff. Hanley can be reached at [email protected], and Hoberg can be reached at [email protected]. All errors are the authors alone. Copyright c ©2009 by Kathleen Weiss Hanley and Gerard Hoberg. All rights reserved.