Initial public offerings (IPOs) of equity are typically underpriced on the day of the offering. A frequently mentioned explanation for this puzzling phenomenon relies on issuers' desire to avoid legal liabilities under federal securities laws for misstatements in the offering prospectus or registration statement. According to this ''lawsuit avoidance hypothesis,'' large positive returns from offer price to early aftermarket trading reduce (i) the probability of a lawsuit, (ii) the conditional probability of an adverse judgment if a lawsuit is filed, and (iii) the amount of damages in the event of an adverse judgment. This paper explores the validity of this hypothesis and studies the nature of litigation risk in IPOs. We examine 93 IPOs by issuers who were subsequently sued under provisions of the 1933 and/or 1934 Securities Acts in the period 1969 to 1990. In contrast to the views of a number of previous researchers. our evidence suggests that the lawsuit avoidance hypothesis cannot easily explain why IPOs are underpriced. First, the data show that our 93 sample IPOs are just as underpriced as other IPOs of similar size. Thus, IPO underpricing is not a sufficient condition to avoid lawsuits. Furthermore, an analysis of the settlement data for our sample firms shows that IPO underpricing is an expensive form of insurance against future lawsuits. Conditional upon being sued, the average settlement in our sample represents about 15% of the offering value. Prior studies have documented that the underpricing of the typical IPO is also roughly 15%. Therefore, even if only part of the underpricing is an attempt at insurance against lawsuits, the prior probability of being sued would have to be unrealistically high for underpricing to be an efficient form of insurance. Second, the nature of the litigation process itself casts serious doubts on the lawsuit avoidance hypothesis. Typically, our sample firms are sued several months or even years after their IPO. The lawsuits follow large aftermarket price declines often triggered by unfavorable news about the deteriorating financial position of the company. The unfavorable news and the resulting large aftermarket price drop lead shareholders to file suit, claiming that corporate insiders knew about the unfavorable developments prior to the IPO, but failed to disclose this information in the prospectus or registration statement. Thus, litigation results from some unfavorable company-specific news in the aftermarket, not because the IPO is overpriced on the first trading day. Furthermore, IPO-related litigation typically takes the form of class-action lawsuits. In our sample, class-action plaintiffs entitled to damages include investors who bought stock in the aftermarket for up to 14.7 months, on average, after the IPO. Underpricing the IPO at the offer date is irrelevant to such aftermarket investors' incentive to sue and has little effect on the issuer's potential damage payments. In summary, our study has shown that the litigation risk arising from accessing public capital markets appears not to be related to whether the issue was initially underpriced or not. Minimizing legal liabilities by ''leaving money on the table'' through underpricing appears to be a very expensive form of insurance against IPO-related litigation.
