Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Monday, January 13, 2014

Billings and Lewis on IPOs

Mary Brooke Billings and Melissa Fay Lewis have posted Investors’ Use of Litigation to Settle the Score in the IPO Setting on SSRN with the following abstract:

Prior research suggests that the fear of litigation precludes most managers from manipulating earnings in the initial public offering (“IPO”) setting. Yet, managers’ restraint is perhaps unwarranted: research has not yet linked instances of aggressive pre-IPO reporting to increased litigation risk. This paper investigates when aggressive IPO reporting triggers legal consequences. Examining 2,037 IPOs, we find that pre-IPO abnormal accruals are not solely opportunistic and, even when ex post evidence indicates the presence of opportunism, litigation is more likely to occur when investors have relied on the suspect earnings during the pricing process. Why might investors rely on some firms’ abnormal accruals when valuing the IPO and yet disregard the abnormal accruals of other firms? Our analyses suggest that IPO investors incorporate abnormal accrual information into IPO prices in situations where accruals are more likely to reflect information and other sources of information to help investors make pricing decisions are lacking or are less reliable. In these situations, we find that abnormal accruals do positively correlate with future performance, validating investors’ use of this information when pricing these offerings. Yet, when ex post performance reveals that the pre-IPO abnormal accruals were in fact inflated, we find that litigation emerges to allow harmed shareholders to recover losses incurred dating back to the pricing process — importantly, investors are only harmed if they used those abnormal accruals in pricing the IPO. Taken collectively, our evidence indicates that litigation does indeed surface in the IPO setting — but only when investors need it to settle the score.

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