การประชม ทางว ชาการ ศาสตราจารย ส งเว ยน อ นทรว ช ย ด านตลาดการเง นไทย คร งท 22 ประจ าป 2557

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1 การประชม ทางว ชาการ ศาสตราจารย ส งเว ยน อ นทรว ช ย ด านตลาดการเง นไทย คร งท 22 ประจ าป 2557 การน าเสนอผลงานว จ ยเร อง IPO Underpricing and Conflict of Interest inside the Intermediation Structure โดย คณฉ ตรช ย ท ศาดลด ลก ว นพฤห สบด ท 13 พฤศจ กายน 2557 เวลา น. ห อง 201 คณะพาณ ชยศาสตร และการบ ญช มหาว ทยาล ยธรรมศาสตร ท าพระจ นทร

2 IPO Underpricing and Conflict of Interest inside Intermediation Structure presented at Thammasat Business School Nov 2014 The views expressed herein are the author s and not those of the Securities and Exchange Commission, Thailand. This draft is submitted for a conference held at Thammasat Business School, in November, Please send comments to chatchat@sec.or.th. Chatchai Thisadoldilok Chatchai Thisadoldilok May 2011 Introduction Initial Public Offerings Issuer: fund raising. Market: new investment opportunities Underpricing (initial returns): leaving money on the table Ritter (1984) : 18.8% in the US. Su and Fleisher (1999): 948.6% in China. Allen et al. (1999): 63.49% in Thailand IPO Intermediation: investment banking business Transaction advisory, underwriting and distribution. This paper: Look inside the bank: conflict of interest as a cause of IPO underpricing Average initial returns is 17% for 331 IPOs in Thailand, lower for the deals completed by independent financial advisors.

3 Literature Review IPO underpricing Ljungqvist (2007) : Underpricing in Europe from 1990 to 2003 Literature Review IPO Underpricing Ljungqvist (2007) : Underpricing in Emerging markets from 1990 to 2001

4 Progress in literature: towards the conflict of interest Information-based Risk premium and uncertainties of IPOs Compensation for price revelation Conflict of interest Quid pro quo: IPO allocations for kickback or profit sharing (from flipping) Spinning: IPO allocations to corporate executives for future corporate business (corporate bribes) Laddering: tying IPO allocations to after-listing purchases in IPO shares (also high brokerage commissions) Others Firm quality signaling, market sentiment, shaping ownership structure, price support, litigation avoidance, tax benefits, behavioral explanations, and etc. 5 Qui Pro Quo: IPO allocation in return for profit sharing (soft-dollar) from share flipping Litigation Release (Jan 2002) SEC sues Credit Suisse First Boston Corporation for IPO violations; CSFB will pay $100 million. Summary of allegation In exchange for shares in "hot" IPOs, CSFB wrongfully extracted from certain customers a large portion of the profits that those customers made by immediately selling ("flipping") their IPO stock. The profits were channeled to CSFB in the form of excessive brokerage commissions generated by the customers in unrelated securities trades that the customers effected solely to share the IPO profits with CSFB. During , CSFB employees allocated shares of IPOs to over 100 customers who were willing to funnel between 33 and 65 percent of their IPO profits to CSFB. Employees of CSFB's ECM, PCS, and Tech PCS divisions informed the relevant customers, both implicitly and explicitly, that they were expected to pay a portion of profits earned on their IPO flipping to CSFB in order to continue to receive allocations in "hot" IPOs. For example, on December 9, 1999, an Institutional Customer that had received a 13,500 share allocation of Linux and a 20,000 share allocation of El Sitio from CSFB paid CSFB $1 million by placing a commission of $.50 per share on 2 million shares of Compaq. to generate commissions for CSFB. Customers frequently executed one side of the trade with CSFB (e.g., a purchase at a commission as high as $3.15 per share) and then virtually simultaneously executed the off-setting side of the trade through another broker-dealer (e.g., a sale of the same quantity of the same stock) at the standard commission of $.06 per share. NASD Conduct Rule 2110 requires members to observe high standards of commercial honor and just and equitable principles of trade. NASD Conduct Rule 2330(f) prohibits a member or any person associated with a member from sharing directly or indirectly in the profits or losses of a customer, unless certain conditions not applicable here are met. 6

5 Laddering: IPO allocation upon indication of aftermarket interest Litigation Release (Jan 2005) SEC sues Goldman Sachs & Co. for IPO violations; Goldman Sachs will pay $40 million. Summary of allegation During , Goldman unlawfully attempted to induce, or induced, certain customers to purchase stock in the aftermarket of certain IPOs underwritten by Goldman, in violation of Rule 101 of Regulation M (prohibiting underwriters, during a restricted period prior to the completion of their participation in the distribution of shares, from directly or indirectly bidding for, purchasing, or attempting to induce any person to bid for or purchase any offered security in the aftermarket.) The rule is designed to prevent activities that could artificially influence the market. For example, by creating a perception of scarcity of IPO or aftermarket demand for stock. Communicated to certain customers that Goldman considered purchases in the immediate aftermarket to be significant in the determination of IPO allocations. verified whether customers placed orders for stock in the immediate aftermarket. asked customers at what prices and in what quantities, they intended to place orders to purchase in the immediate aftermarket. Sample of communication: From Goldman to customers: Goldman... has told me that for now, all their small techy deals will be subject to close scrutiny with regard to flippers. AMO's [aftermarket orders] will be watched for follow-thru on indicated intentions.... From Sales to ECM in CoSine IPO: The customer.will buy between 2-3x their allocation in the after market." 7 Spinning: IPO allocation in return for future IB deals. Research Analyst COI: buy recommendation in return for IB deals. Summary of allegation Litigation Release (Apr 2003) SEC sues Citigroup Global Markets (f.k.a. Salomon Smith Barney) for research analyst conflict of interest and IPO spinning. SSB has agreed to pay $150 million as disgorgement and an additional $150 million in penalties: settled with authorities, distributed to for customers benefits, provided independent research, and funded investor education. Firm engaged in "spinning" of hot initial public offering ("IPO") shares to executives of investment banking clients, and failed to maintain appropriate supervision over its research and investment banking operations. SSB, in a practice known as "spinning," provided preferential access to hot IPO shares to officers of existing or potential investment banking clients who were in a position to direct their companies' investment banking business to SSB. The officers sold the shares provided to them for substantial profit. Subsequently, the companies for which the officers worked provided SSB with investment banking business. Executives of five telecom companies made approximately $40 million in profits from approximately 3.4 million IPO shares allocated from , and SSB earned over $404 million in investment banking fees from those companies during the same period. Research analysts were promoting IB deals: deal pitching, promoting to clients, and giving favorable coverage. Their performance and compensation were tied to IB business. During , research analysts at SSB - including Grubman (one of the most prominent telecom analyst) - were subject to inappropriate influence by investment banking at the firm: false or misleading research reports and published research reports that were exaggerated, unwarranted, or lacked a reasonable basis. For example, SSB and Grubman published certain fraudulent research reports on two of the firm's telecom investment banking clients; These reports were contrary to the true views that Grubman and another analyst on his team privately expressed. SSB did not maintain written policies and procedures reasonably designed to prevent the sharing and misuse of material, non-public information between a person affiliated with SSB who served as a director of another company and a SSB research analyst covering that company. 8

6 "Global Settlement" COI is common among top investment banks. Joint Press Release (Apr 2003) Ten of Nation's Top Investment Firms Settle Enforcement Actions Involving Conflicts of Interest Between Research and Investment Banking Historic Settlement Requires Payments of Penalties of $487.5 Million, Disgorgement of $387.5 Million, Payments of $432.5 Million to Fund Independent Research, and Payments of $80 Million to Fund Investor Education and Mandates Sweeping Structural Reforms. Joint investigations by the regulators into alleged conflicts of interest between investment banking and securities research at brokerage firms: 1. Bear, Stearns & Co. Inc. (Bear Stearns) 2. Credit Suisse First Boston LLC (CSFB) 3. Goldman, Sachs & Co. (Goldman) 4. Lehman Brothers Inc. (Lehman) 5. J.P. Morgan Securities Inc. (J.P. Morgan) 6. Merrill Lynch, Pierce, Fenner & Smith, Incorporated (Merrill Lynch) 7. Morgan Stanley & Co. Incorporated (Morgan Stanley) 8. Citigroup Global Markets Inc. f/k/a Salomon Smith Barney Inc. (SSB) 9. UBS Warburg LLC (UBS Warburg) 10.U.S. Bancorp Piper Jaffray Inc. (Piper Jaffray) From 1999 to 2001 or later, all of the firms engaged in acts and practices that created or maintained inappropriate influence by investment banking over research analysts, thereby imposing conflicts of interest on research analysts that the firms failed to manage in an adequate or appropriate manner. For example, fraudulent research reports; not based on principles of fair dealing and good faith ; not provide a sound basis for evaluating facts, contained exaggerated or unwarranted claims; and undisclosed payments for research. Reform their future practices, including separating the research and investment banking departments at the firms, how research is reviewed and supervised, and making independent research available to investors. For example, prohibiting analysts from receiving compensation for investment banking activities, and prohibiting analysts' involvement in investment banking "pitches" and "roadshows. The ten firms have collectively entered into a voluntary agreement restricting allocations of securities in hot IPOs - offerings that begin trading in the aftermarket at a premium - to certain company executive officers and directors, a practice known as "spinning." This will promote fairness in the allocation of IPO shares and prevent firms from using these shares to attract investment banking business. 9 Investment banks represent interests of both issuers and investors: probably subject to conflict of interests. Challenge: to balance between the interests of issuers and investors (advisory vs. market) Advisory Market Ritter & Welch (2002): given several percent of observed underpricing, information-based explanation is rejected. Underpricing for lawsuit avoidance or advertisement is cost ineffective. Rather, explanation based on share allocation (esp. related to UW compensation) is very appealing. Loughran and Ritter (2002) argue that underpricing encourages rent-seeking in IPO allocation. Underwriters can receive benefit in the form of overpaying commission from potential IPO investors who are trying to get allotment of hot IPOs. Loughran and Ritter (2004) find that more prestigious underwriters are associated with higher underpricing. This is because allocations of hot IPOs to the personal brokerage accounts of issuing firms executives create an incentive to seek rather avoid underwriters with a reputation for severe underpricing. 10

7 Selected papers: IB conflict of interest and securities offering Reuter (2006) find a positive relationship between underpriced IPO holdings of mutual fund families and the level of commission paid to the lead underwriters. The kickback gives underwriters incentive to lower offering prices and leads to principal-agent conflict with the issuers. Hoberg (2007) construct a model and provide empirical evidence of quid pro quo arrangement between the investment bank and investors where the initial returns are the favor given to IPO investors. In addition, past records of initial returns are provided as an important measure of reputation of an investment bank. Liu and Ritter (2012) document that spinning IPOs has 23% initial returns higher than similar IPOs. Also, issuing firms with spinning IPOs are less likely to switch the investment banks in post-ipo transactions. Fjesme (2012) finds an evidence of IPO laddering in Oslo Stock Exchange. The relationship between IPO allocations and aftermarket purchases is even stronger when investors sell the shares shortly after listing and when IPOs give positive initial returns. Laddering investors make profit and receive more IPO allocations by paying high brokerage commissions to lead underwriters. Cliff and Denis (2004) examine analyst lust hypothesis, which post-ipo analyst coverage is bundled with IPO underwriting service. IPO issuers eagerly pay for the analyst coverage by IPO underpricing, incurred benefit to underwriters via soft dollar commission from IPO investors. Furthermore, they find that IPO firms are more likely to switch underwriters in subsequent offerings if underwriters do not deliver the expected analyst coverage. 11 Selected papers: other explanations Lawsuit avoidance: Hughes and Thakor (1992). Liquidity increase: Boehmer and Fishe (2001). Ownership structure: Stoughton and Zechner (1998). Tax benefit: Rydqvist (1997). Price-stabilization: Ruud (1993). Information cascades: Welch (1992).

8 To create payment currency for funding growth opportunities and valuing the shares. Less relevant to optimal capital structure. Why go public? Source: Brau and Fawcett (2006), Journal of Applied Corporate Finance (Morgan Stanley), Evidence on what CFOs think about IPO process ( survey on 336 CFOs of private and public companies during ) When to IPO? When the overall market is well performing, rather than the industry conditions and the company stage. 13 Trust in intermediary certification (reputation, expert, research quality, and trading & liquidity) is the most relevant. Which Why investment go public? bank? Fee and pricing are less important. Source: Brau and Fawcett (2006), Journal of Applied Corporate Finance (Morgan Stanley), Evidence on what CFOs think about IPO process ( survey on 336 CFOs of private and public companies during ) Expected median of 10%. Underpriced for risk-taking and market uncertainties. Why underpriced IPOs? Least aware of flipping and spinning. (trust in banks) 14

9 Good quality: strong earnings and top banks and auditors. How to signal? Also, the first day price jump, though inefficient ads (just 23%: underpricing for publicity). Source: Brau and Fawcett (2006), Journal of Applied Corporate Finance (Morgan Stanley), Evidence on what CFOs think about IPO process ( survey on 336 CFOs of private and public companies during ) Bad quality: sales by insiders Control and timing is the most Why stay private? important. Capital structure, fee/cost, and pricing are less relevant. 15 Gap in the Literature Ritter and Welch (2002): we believe future progress in the literature will come from non-rational and agency conflict explanations. This paper: Conflict of interest inside investment banks. Direct test for the effect of different IPO intermediation structure, i.e. independent financial advisors. Allen and Dudney (2010): studied FA quality in municipal issues; newly issued muni-bonds pay higher yields under advisor-turned-underwriter scenario.

10 Estimation & Data Controls: higher risk, higher returns Issues: PROC, OVERHANG, DTT Issuing Companies: AGE, ASSET, LEV, STD Market Conditions: PRIOR10, MKTSD Others: UWPREM, MAI Intermedition: IFA = 1 if independence between advisor and underwriter Data Hand-collected information from IPO prospectuses, formally the form 69-2, available in the library of Securities and Exchange Commission, Thailand. SETSMART, an electronic database provided by the Stock Exchange of Thailand. 331 IPOs from 1993 to 2010 where 53 IPOs completed by independent financial advisors. IPOs in Thailand Number of firms

11 Descriptive Statistics Correlations

12 Intermediation Structure Estimation Results

13 Robustness Check - Specifications Robustness Check - Endogeneity Endogeneity : TSLS with the floatation (direct) cost as the IV. Variable definitions: 30, 60, 90 days for SD and MKTSD, 5 and 10 recent IPOs for PriorIR and UWPrem.

14 Conclusion Conflict of interest in the IPO intermediation, investment banks. Doubt on IB s governance structure. Test of different intermediation structure. Underpricing is 17% for 331 IPOs from 1993 to 2010 in Thailand. Independence of the advisory unit from sale force reduces the amount of underpricing by 8.7% - 10%. Robustness checks: OK Underwriter persistence found. Reputation =/= Attention.