The relation between IPO underpricing and litigation risk revisited: changes between 1990 and 2002

The litigation risk hypothesis of IPO underpricing posits that issuers underprice IPOs in an effort to avoid costly litigation and that underpricing should be greater for issuers with ex-ante higher levels of litigation risk. This paper reexamines this hypothesis for IPO samples in the different legal and economic environments before and after 1995, the year a law designed to reduce the litigation risk - the Private Securities Litigation Reform Act - was passed. When litigation risk is reduced in three years after 1995, we find firms' litigation risk plays a less significant role in IPO pricing strategy, and underpricing does deter traditional IPO cases more compared to that effect in the pre-1995 period. In the period after that, however, there is another structural change in which firms do again use IPO underpricing as insurance against IPO lawsuits, but more underpricing may actually have led to greater litigation relating to IPO allocation irregularities. We conclude that the evidence of the LRH is very sensitive to the legal and economic environment. Issuers probably have other ways of handling litigation risk in IPOs, more so today than before, rendering a broad and blunt instrument such as underpricing less necessary.