Outcome model or substitute model of D&O insurance on IPO pricing without information asymmetry before issuance

Lanfeng Kao, Anlin Chen and Chandrasekhar Krishnamurti

Pacific-Basin Finance Journal, 2020, vol. 61, issue C

Abstract: Because of information asymmetry and agency costs associated with investment bankers, initial public offerings (IPOs) are severely underpriced in many countries. Furthermore, investors may sue the managers of an IPO firm if the stock trading price decreases after stock issuance. Therefore, to mitigate the litigation risk, IPO firms purchase directors and officers (D&O) liability insurance. This study proposes outcome and substitute models of D&O insurance risk avoidance to examine whether holding D&O insurance influences IPO pricing. The outcome model implies that firms purchase D&O insurance owing to directors' and officers' conservative stance and reluctance to take aggressive decisions. The substitute model implies that directors and officers are aggressive when they have D&O insurance. Our empirical results support the outcome model, which is based on information concerning retail subscription, suggesting that firms purchase D&O insurance because directors and officers are conservative. However, IPO firms under D&O insurance coverage become aggressive when making pricing decisions, as evidenced by the strong retail subscription; thus, the substitute model dominates.

Keywords: D&O insurance; Initial public offerings; Outcome model of risk avoidance; Pre-IPO market; Substitute model of risk avoidance (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:pacfin:v:61:y:2020:i:c:s0927538x1830619x

DOI: 10.1016/j.pacfin.2020.101300

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