Abstract

One potential explanation for the underpricing of initial public offerings is the lawsuit avoidance hypothesis of Tiniç (1998). In this study, we empirically test the insurance effect of the lawsuit avoidance hypothesis which states that firms that are subject to higher litigation risk underprice their issues more to reduce the likelihood of being sued in connection with their IPO. In addition, by underpricing their issues, firms can limit the amount of damages plaintiffs can claim in a lawsuit. We examine the relationship between IPO underpricing and litigation risk in an international setting using a sample of 6,326 firms that went public across 34 countries between January 1995 and December 2002. We control for known determinants of IPO underpricing and test whether IPOs in countries with higher levels of litigation risk are more underpriced. While the majority of single-country studies do not find support for the lawsuit avoidance hypothesis, we find a significant positive relationship between litigation risk and underpricing in a cross-country framework. Contrary to all single-country legal liability studies outside the US and consistent with the US studies of Tiniç (1988) and Lowry and Shu (2002), our empirical results support the insurance effect of the lawsuit avoidance hypothesis in an international context. Our findings imply that the degree of litigation risk in a given country affects the level of underpricing for firms that go public in that country. We conclude that differences in legal risk factors can partially explain differences in underpricing across countries.