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Rev Fin 1992; 5:709-742
© 1992 the Society for Financial Studies

Article

Litigation risk, intermediation, and the underpricing of initial public offerings

PJ Hughes1 and AV Thakor2,z
1 University of Southern California, USA
2 Indiana University, School of Business, 10th and Free Lane, Room 356, Bloomington, IN 47405, USA
z Corresponding author

Abstract

We formally examine the role of litigation risk in initial public offering (IPO) pricing. The underwriter's pricing decision trades off current revenue against expected future litigation costs, both of which are increasing in the IPO price. Given a time-consistency constraint and rational expectations on the part of investors, however, the 'standard' litigation risk argument does not lead to equilibrium underpricing. We develop a richer model that provides sufficient conditions under which there is equilibrium underpricing. The issuer's choice of employing an underwriter versus floating the IPO on its own is examined, and various testable implications of the model are developed.


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