Governance reform and IPO underpricing

https://doi.org/10.1016/j.jcorpfin.2011.12.007Get rights and content

Abstract

Underpricing of IPOs in Thailand significantly drops following the country's major governance reform, indicating less price-protection by investors. The lower price-protection is associated with fewer instances of absolute control retention by pre-issue insiders during the post-reform period, not reduction in the expropriation risk. While corporate disclosure does not reveal issuers' true risk type before the reform, it does so after the reform. Yet, insiders make significantly less disclosure when retaining absolute control regardless of the reform. We conclude that governance regulation in an economy with fundamentally weak legal institutions works, but its efficacy is limited when insiders retain absolute control.

Highlights

► We study how a regulatory reform affects investor protection in Thailand. ► Investor price-protection decreases and disclosure quality improves post-reform. ► Despite reform, price-protection remains high when insiders retain absolute control. ► Disclosure also remains poorer post-reform when insiders retain absolute control. ► The reform works, but its efficacy is limited when insiders retain absolute control.

Introduction

Over the past 15 years, significant regulatory reforms aimed at improving investor protection have been instituted in emerging economies. Despite the known institutional differences between emerging and developed economies, the content of the reforms instituted in a number of emerging markets closely resembles the governance rules previously adopted in the United States and United Kingdom. Yet, whether or not regulatory change can be effected to improve investor protection in an economy with fundamentally weak legal institutions still remains a largely unanswered question (also Price et al., 2011). As noted by Leuz and Wysocki (2008), the capital-market regulation literature focuses heavily on developed markets with only little attention paid to the changes that have taken place in emerging economies.

We investigate how a reform of governance regulations affects investor protection in Thailand, an economy with inherently weak legal institutions (e.g., La Porta et al., 1998). The marginal impact of regulatory change, if any, is likely to be relatively easy to detect when using data from a country with a poor legal environment. Moreover, Thai firms are typically family firms with controlling shareholders holding significant cash flow and control rights (Claessens et al., 2000). As large shareholdings in a poor legal environment reflect the agency conflicts between insiders and outside investors (Shleifer and Vishny, 1997), studying Thai data also offers important insights into how regulation curbs the expropriation risk facing outside investors.

Since a reform process is usually very lengthy, an analysis of the impact of regulatory change can be contaminated with confounding events (Mulherin, 2007). When analyzing Thailand's major reform, confounding events are unlikely to be of concern. Its reform process was short and uninterrupted with clear timing: beginning in 1999 and ending in 2002. In response to scandalous corporate collapses due to the 1997 financial crisis, the Thai authorities swiftly instituted a wide-reaching regulatory reform to improve the country's corporate governance. The reform encompassed stepped-up disclosure regulations, institution of mandate on internal control measures, and authoritative recommendations on practices for directors. The reform affects not only all listed firms, but also going-public firms alike.

The quality of a legal environment is pivotal to an initial public sale of firms' equity (e.g., La Porta et al., 1997, Mahoney, 1995). Shleifer and Wolfenzon (2002) argue that, with better legal protection, the risk of wealth expropriation by insiders is lower and investors are more willing to pay higher prices for a firm's equity. Several models of IPO underpricing predict a positive relation between the risk of value loss facing investors and the issue discount (see, e.g., Jenkinson and Ljungqvist, 2001). Thus, the efficacy of a governance reform implies reduction in IPO underpricing following the reform institution. An effective reform should also reduce the extra issue discount demanded as compensation for the expropriation risk inherent in the retention of absolute control by pre-issue insiders (henceforth, insiders). If disclosure quality improves after the reform, moreover, the post-reform corporate disclosure should enable investors to separate high-risk from low-risk issues, and value them accordingly.

We find that IPOs are significantly less underpriced after the reform institution, indicating investors are more willing to pay a higher price for firms' equity. Before the reform, the issue discount is significantly larger when insiders retain absolute control, in line with the view that large shareholdings in a poor legal environment represents expropriation risk facing outside investors. Although significantly fewer issues exhibit controlling ownership retention by insiders after the reform, such a larger discount remains. The post-reform decline in investor price-protection is not associated with expropriation risk reduction, but with fewer instances of insiders' absolute control retention. The inherent cost of large shareholdings persists despite the reform. Also, there is no relation between disclosure of specifics of issuers' intended uses of IPO proceeds and underpricing during the pre-reform period. After the reform, the relation becomes significantly positive. These findings support the view that corporate disclosure improves after the reform and allows investors to distinguish between high- and low-risk issues and to value them accordingly. During the post-reform period, disclosure by issuers characterized by greater ex ante uncertainty (i.e., smaller issuers) is also significantly more detailed. However, insiders' tendency to disclose less information when retaining absolute control persists despite the reform. Overall, we document evidence of limited efficacy of a governance reform in improving investor protection.

Our study contributes to the vast capital-market regulation literature by examining the largely unexplored economic impact of a regulatory reform in an economy with fundamentally weak legal institutions. Price et al. (2011) appear to be the only authors that study a regulatory reform in such an economy. They examine the impact of Mexico's Code of Best Corporate Practices on firm performance, usefulness of reported earnings and dividend payments. We study how a governance reform affects an IPO issue discount, a material part of the cost of going public. Closely related to our work is the study by Chambers and Dimson (2009), which finds that IPO underpricing in the U.K. increased during the time following improvements in investor protection. For an economy with inherently weak legal institutions, our findings hold to the contrary. Our study also offers important policy implications. The internal control mandates and disclosure rules formulated for developed economies can generally reduce material part of the cost of going public in a poor legal environment. Such issuance cost reduction would serve to offset, at least in part, a rise in compliance cost typically associated with regulatory change. However, simply imposing written rules of developed-market law is unlikely to be sufficient to curb the expropriation risk inherent in large shareholdings.

The rest of our study proceeds as follows: Section 2 gives an overview of Thailand's major governance reform and presents our main hypotheses. Section 3 describes our data and methodology. Empirical results are reported and discussed in Section 4. Section 5 concludes our study.

Section snippets

The major governance reform in Thailand: an overview

The scandalous corporate collapses that resulted from the 1997 East Asian financial crisis created an impetus for a major governance reform in Thailand. The reform process was extensive, encompassing not only the considerably more stringent disclosure rules but also the institution of active mandate of actual internal corporate control measures: all of which are also applicable to going-public firms.1

Data and sample

We draw our sample from the population of initial public offerings of equity in Thailand with the last subscription date falling between January 1990 and December 2007. Our prospectus data (including, subscription period, offer price, numbers of listed and offered shares, firm age, issue managers, pricing techniques, uses of proceeds) come from two sources. We first identify IPOs during our sample period and collect the prospectus data from the Thomson Financial Securities Data Company (SDC)

Governance reform, controlling ownership and underpricing

Over the entire sample period (1990–2007), as shown in Panel A of Table 3, the average (median) initial return on the full sample of 463 IPOs is 30.4% (14.3%).25 Seventy-three percent of them have positive initial return. Improvement in investor protection predicts that the issue discount generally declines, and particularly, the underpricing effect of

Conclusion

In this study, we investigate how a reform of governance regulation affects investor protection in a market with fundamentally weak legal institutions. If the reform improves investor protection, the extent to which IPO investors price-protect themselves against the risk of value loss and demand an issue discount should become smaller following the reform institution. We document significant reduction in an issue discount for IPOs in Thailand following the country's major governance reform,

References (47)

  • A.E. Sherman et al.

    Building the IPO order book: underpricing and participation limits with costly information

    J. Finan. Econ.

    (2002)
  • A. Shleifer et al.

    Investor protection and equity markets

    J. Finan. Econ.

    (2002)
  • R.M. Stulz et al.

    Culture, openness, and finance

    J. Finan. Econ.

    (2003)
  • C.B. Barry

    Initial public offering underpricing: the issuer's view—a comment

    J. Finance

    (1989)
  • D.J. Bradley et al.

    Partial adjustment to public information and IPO underpricing

    J. Finan. Quant. Anal.

    (2002)
  • D. Chambers et al.

    IPO underpricing over the very long run

    J. Finance

    (2009)
  • V. Chhaochharia et al.

    Corporate governance and firm value: the impact of the 2002 governance rules

    J. Finance

    (2007)
  • S. Claessens et al.

    Disentangling the incentive and entrenchment effects of large shareholdings

    J. Finance

    (2002)
  • S.A. Corwin

    The determinants of underpricing for seasoned equity offerings

    J. Finance

    (2003)
  • F. Derrien et al.

    Auctions vs. bookbuilding and the control of underpricing in hot IPO markets

    Rev. Finan. Stud.

    (2003)
  • M. Greenstone et al.

    Mandated disclosure, stock returns, and the 1964 Securities Acts Amendments

    Q. J. Econ.

    (2006)
  • M. Grinblatt et al.

    Signalling and the pricing of new issues

    J. Finance

    (1989)
  • C.G. Holderness

    The myth of diffuse ownership in the United States

    Rev. Finan. Stud.

    (2009)
  • Cited by (47)

    • Pre-and-aftermarket IPO underpricing: Does use of proceeds disclosure matter?

      2023, Journal of Contemporary Accounting and Economics
    • Does a reduction of state control affect IPO underpricing? Evidence from the Chinese A-share market

      2021, Journal of International Money and Finance
      Citation Excerpt :

      Chambers and Dimson (2009) examine how the underpricing of UK IPOs changed along with the improvements in regulation, disclosure and underwriting (broadly speaking, an improvement in the regulatory environment of investor protection) over a century. Ekkayokkaya and Pengniti (2012) document that the average underpricing level of Thai IPOs significantly declined following the country’s governance reform of investor protection. In the US market, Johnston and Madura (2009) suggest the passage of the Sarbanes-Oxley Act (SOX)4 has a positive impact on pricing efficiency in the IPO market, where they find the average underpricing level of US IPOs within the post-SOX period is lower than the IPOs during the pre-SOX period.

    • Simultaneous effects of clustering and endogeneity on the underpricing difference of IPO firms: A global evidence

      2020, Research in International Business and Finance
      Citation Excerpt :

      Thus, a positive association between underpricing and pre-IPO market volatility is expected. Secondly, Lee et al. (1996) and Ekkayokkaya and Pengniti (2012) argue that the longer the elapsed time between the first trading day and the IPO announcement day where offer price is set, the less demand informed investors will have for the issue. This implies that when informed investors indicate low demand for an IPO firm, then the IPO requires more time to be fully subscribed to avoid failure of subscription.

    • Strategic participation in IPOs by affiliated mutual funds: Thai evidence

      2020, Pacific Basin Finance Journal
      Citation Excerpt :

      Based on the descriptive statistics in Table 1 where initial returns of stocks listed in mai tend to be higher, we include a dummy variable for listings in mai (MAI). Results from Ekkayokkaya and Pengniti (2012) and Komenkul and Siriwattanakul (2016) suggest that time-specific factors such as market hotness and regulation can influence underpricing, so we include listing year fixed effects (δt) as additional control variables. In all specifications, we use White robust standard errors to account for heteroskedasticity.

    View all citing articles on Scopus

    We are grateful for valuable comments and suggestions from an anonymous referee, David Denis (the editor), participants at the Chulalongkorn Business School (CBS) workshop, Chulalongkorn Accounting and Finance Symposium (CAFS), Singapore Management University Finance Summer Camp, and especially the discussants (CBS workshop—Jay Ritter; CAFS—Jarrad Harford; Summer Camp—Jeremy Goh), Paul Malatesta, Krishna Paudyal, Kee Chung, Hank Bessembinder, Tom Connelly, Shiva Shivakumar, David Hillier, Anant Chiarawongse, Sunti Tirapat, Thaisiri Watewai, Joseph Fan, and Nuttawat Visaltanachoti. Assistance from Jatupoom Prachyangprecha and Anon Aunsinmun in searching for details of the Thai securities regulations and bylaws is acknowledged. Manapol Ekkayokkaya acknowledges research grant from the Chulalongkorn University Centenary Academic Development Project. All errors are ours.

    View full text