The effect of the trading system on the underpricing of

initial public offerings

Financial Management (Financial Management Association),
Spring, 1993 by John Affleck-Graves, Shantaram P. Hegde,
Robert E. Miller, Frank K. Reilly
Two major trading systems in common stocks in the United
States are (i) the exchange auction markets of the New York
Stock Exchange (NYSE) and the American Stock Exchange
(AMEX), and (ii) the negotiated dealer markets of the National
Association of Securities Dealers' Automated Quotations
(NASDAQ), National Market System (NMS) and non-NMS. These
trading systems are further distinguished by their initial and
continued standards for stock trading (i.e., listing).(1) The
objective of this study is twofold. First, we examine whether the
underpricing previously documented for initial public offerings
(IPOs) on NASDAQ also applies to IPOs on the AMEX and NYSE.
Second, we examine the effects of these trading systems on the
pricing of IPOs.
A firm that is going public is surrounded by substantial
informational asymmetry and the extant theoretical and
empirical literature suggests this leads to the underpricing of
IPOs (Baron |5~, Beatty and Ritter |6~, Grinblatt and Hwang |
12~, Rock |25~, Smith |26~, Tinic |27~, and Welch |31~). We
advance a trading system certification proposition which posits
that the initial and continued listing standards imposed by a
trading system provide investors with reliable information about
the quality of new issues, reduce uncertainty about their
prospects, and thereby lower the expected underpricing of IPOs.
Using a sample of IPOs which went public on the various systems
over the period 1983-1987, we show that IPOs on all four trading
systems display significant underpricing, on average. We also
provide support for the certification proposition. After controlling
for other factors previously shown to be associated with the
underpricing of IPOs, namely, offer size, ownership retention, age
of the firm, standard deviation of returns in the aftermarket,
prestige of the underwriter, and auditor reputation, we show that
NYSE, AMEX and NASDAQ/NMS IPOs are associated with
significantly lower underpricing than NASDAQ/non-NMS IPOs.
Further analysis indicates that no significant differences in
underpricing exist between the NYSE, AMEX and NASDAQ/NMS
trading systems, after controlling for other ex ante uncertainty
proxies.
The rest of the paper is organized as follows. In Section I, we
examine the role of initial and continued listing standards in
certifying the quality of new issues and develop our certification
proposition. We present the empirical results in Section II, while
Section III contains several robustness checks on our main
results. Section IV sets forth a summary of our findings and
conclusions.
I. Trading Systems and the Underpricing of IPOs
In this section, we develop a certification proposition regarding
the impact of trading systems on the underpricing of IPOs. We
begin by summarizing the listing standards of the four market
systems and then discuss how these standards mitigate
uncertainty about the quality of new issues through certification.
A. Listing Standards
An important distinguishing characteristic of a trading system is
its listing standards. There are two types of listing standards:
quantitative and qualitative. Also, there are initial as well as
continued listing standards. Exhibit 1 summarizes the minimum
quantitative initial and continued listing standards for the NYSE,
AMEX, NASDAQ/NMS, and NASDAQ/non-NMS markets. Clearly,
there is wide variation in the requirements related to income,
public ownership, firm size, and stockholder equity across the
trading systems. Notably, size, distribution of ownership and
earnings standards are substantially higher for the NYSE,
somewhat comparable for the AMEX and NASDAQ/NMS, and least
stringent for the NASDAQ/non-NMS.
In addition, the listing agreement includes numerous qualitative
standards designed to protect shareholders from agency
problems ensuing from the separation of ownership and
management of a firm. These standards are meant to (i) ensure
timely disclosure of information that may affect security value or
influence investment decisions, (ii) encourage and enforce
certain business practices aimed at maintaining sound standards
of corporate responsibility, integrity and accountability to
shareholders, and (iii) provide the trading system with timely
information to facilitate the maintenance of a fair and orderly
market in the firm's securities.
Major issues covered by the qualitative standards of the NYSE
are: the number of outside directors, the representation of
independent directors on the audit committee, the review of
related party transactions, the quorum required for shareholder
meetings to ensure a representative vote, and the shareholder
approval policy for securities issued to directors, officers, or key
employees (see New York Stock Exchange |21~). These
qualitative standards are also representative of the corporate
governance rules adopted by the AMEX.(2) In early 1985, the
NASD board of governors developed similar rules for the NMS
securities. These rules were approved by the SEC in June 1987
and implemented in February 1989. The NASD corporate
advisory board observed that most NMS companies already
complied with the new corporate governance standards.(3)

Clearly there is some duplication between these qualitative

standards and the Securities Act of 1933 and Securities
Exchange Act of 1934, which apply to all publicly traded
companies. Several provisions of the corporate governance
standards, however, go beyond the SEC rules. Partly as a result
of these extended provisions, securities listed on the NYSE and
AMEX are automatically exempt from blue-sky regulations in
most states. Obtaining a similar exemption was a major objective
of the new NASDAQ/NMS rules. Further, to avoid these high
standards, many firms that are quantitatively eligible for listing
on the NYSE and AMEX may elect to continue trading on
NASDAQ. A 1985 study by Wall |29~ relative to this possibility
indicated that more than 600 NASDAQ companies are eligible for
listing on the NYSE and 1,600 are eligible for listing on the AMEX,
although of course, there are other reasons, such as direct costs
or the existence of an active market in their stock on NASDAQ,
which may impact the trading system decision.
TABULAR DATA OMITTED
B. Certification of Firm Quality
A trading system(4) seeks to maintain high listing standards not
only to maintain an orderly market for securities, but also to
develop a reputation as a leading marketplace for securities
trading. In fact, the NYSE states,
A listing on the NYSE is internationally recognized as signifying
that a publicly owned corporation has achieved maturity and
front-rank status in its industry -- in terms of assets, earnings,
and shareholder interest and acceptance. Indeed, the Exchange's
listing standards are designed to assure that every domestic or
non-U.S. company whose shares are admitted to trading in the
exchange market merits that recognition. |21, p. 11~
Commenting on its listing requirements, the NYSE observes,
In determining eligibility for listing, particular attention is given
to such qualifications as: (1) the degree of national interest in the
company; (2) its relative position and stability in the industry;
and (3) whether it is engaged in an expanding industry, with
prospects of at least maintaining its relative position. |22, p. 22~.
A privately held firm intending to go public is characterized by a
great deal of informational asymmetry about its prospects
between insiders (the firm) and outside investors. By seeking to
list a new public offering, the management of the firm asserts
that it meets the initial listing standards, that it expects to satisfy
the continued quantitative listing standards, and that it is
committed to honoring the trading system's corporate
governance standards.(5) This managerial signal derives
credibility from several factors. First, the firm expends resources
on preparing the initial listing forms and payment of the initial
listing fees and subjects itself to recurring annual listing fees.
Second, by agreeing to abide by the system's corporate
governance standards, the firm incurs higher shareholder
servicing costs and potential managerial inconveniences and
inflexibilities. Third, the firm exposes itself to the risk of being
delisted if it fails to maintain the continued listing standards.
More importantly, listing carries with it the approval and
reputation of the trading system because the trading system
effectively certifies that the new issue meets its initial
quantitative and qualitative admission standards.(6) The latter
mitigates the agency problems confronting investors. The
importance trading systems attach to this certification is
illustrated by the AMEX which states,
Since new issues may pose investment and trading risks not
normally encountered in securities of a company which is already
publicly traded, the Exchange has followed the practice of
accepting an IPO for trading only when it is demonstrated that
the issue will exceed all the numerical guidelines for original
listing. (emphasis added) |3, p. 11~
A trading system has incentive to carefully monitor these initial
and continued listing standards because (i) the listing standards
are public information, (ii) there is keen competition for listing
securities among the NYSE, AMEX, and NASDAQ/NMS as
evidenced by the promotional literature distributed by the
trading systems, and (iii) the trading system has nonsalvageable
reputation capital at stake.
C. Informational Asymmetry and Underpricing of IPOs
An important consequence of informational asymmetry is the
equilibrium underpricing of IPOs. Rock |25~ views this situation
as a winner's curse problem. In his model, there exist two groups
of investors: the informed investors who possess superior
information, and uninformed investors (including the firm as well
as other investors). To ensure continued liquidity of the IPO
market, new issues must be underpriced to compensate
uninformed investors for this adverse selection risk.
We use Beatty and Ritter's |6~ framework to test the impact of
listing on IPO underpricing in the Rock framework.(7) They show
that as ex ante uncertainty about the value of a new issue
increases so does the expected underpricing. We have argued
that, through their listing standards, trading systems certify the
quality of a new issue which partially resolves the informational
asymmetry between insiders and outside investors. Therefore,
given a choice between two new issues scheduled to be listed on
two alternative trading systems with differential listing
standards, we argue that investors will demand less underpricing
from the issue associated with the trading system with higher
listing standards.(8) This leads to our certification proposition:
Proposition: Higher listing standards reduce the expected
underpricing of an IPO by reducing ex ante uncertainty about its
value.
It is important to note that certification could exist at several
levels. For example, there could be a strict rank ordering from
NYSE to AMEX to NASDAQ/NMS to NASDAQ/non-NMS.
Alternatively, there could be relatively little difference between
the NYSE and AMEX, but considerable difference between the
exchanges and NASDAQ. Finally, the major certification
difference could be between the exchanges and NASDAQ/NMS on
the one hand and the NASDAQ/non-NMS IPOs on the other.

These three issues will be examined empirically in the following

section. Our prior analysis suggests that many of the qualitative
standards are comparable across the NYSE, AMEX, and
NASDAQ/NMS,(9) because of NASDAQ's attempts to raise
standards in order to gain blue-sky exemption for NMS-listed
securities. If this is true, the largest difference may lie between
the group comprising the exchanges plus the NASDAQ/NMS IPOs
and the NASDAQ/non-NMS IPOs.
II. Empirical Analysis
A. Data
The NYSE developed special procedures in 1983 to enable firms
to list concurrently with their initial public offering of common
stock. Accordingly, our study begins with January 1983 and
covers IPOs on the NYSE, AMEX and NASDAQ markets through
December 1987. The sample includes all firm commitment IPOs
on the NYSE and AMEX for which a closing price on the first day
of trading was available. This resulted in a sample of 95 IPOs that
were listed on the NYSE and 50 IPOs on the AMEX. Over the same
five-year period, we found 158 NMS and 824 non-NMS firm
commitment IPOs that were listed on the NASDAQ system,(10)
with a first quoted bid of at least a dollar.(11) All price and return
data were obtained from the CRSP NYSE/AMEX and NASDAQ
tapes. Offer prices on the IPOs were obtained from Going Public:
The IPO Reporter and Investment Dealers Diges
Several of the IPOs in the exchange samples were closed-end
funds, real estate investment trusts, master limited partnerships,
or reorganizations (i.e., spinoffs or restructurings). Because IPOs
such as these may have particular characteristics different from
IPOs in general (e.g., Weiss |30~ has shown little underpricing in
closed-end fund IPOs), the presence of these in the exchange
sample may bias our results. Accordingly, we remove all IPOs in
the above four classes from our samples of NYSE and AMEX IPOs.
(12)
B. Underpricing
Exhibit 2 presents summary statistics on the underpricing of our
sample of IPOs. We use initial return, IR, as a measure of
underpricing, where IR is defined as the excess (in percent) of
the first day's closing price over the offer price (not adjusted for
market movements). The average first day returns (IR) for the
NYSE, AMEX, NASDAQ/NMS, and NASDAQ/non-NMS IPOs are
4.82%, 2.16%, 5.56%, and 10.41%, respectively. Each of these
average first day returns is significantly different from zero (t-
values of 3.91, 2.24, 7.04, and 17.39, respectively) indicating
that significant underpricing, on average, exists in each of the
trading systems examined. Our results for the NYSE and AMEX
IPOs are consistent with those of Ibbotson |15~ and confirm that
IPOs on the exchanges TABULAR DATA OMITTED display an
underpricing phenomenon similar to that documented, for
example, by Ritter |23~ for NASDAQ stocks. In addition, the
mean initial returns from NYSE and AMEX IPOs are smaller than
those from the NASDAQ/NMS and NASDAQ/non-NMS IPOs, which
is consistent with our expectation, although it does not validate
our first proposition, since factors such as risk and size are not
controlled for in these initial tests.
Our proposition makes a stronger claim because it asserts that
the lower underpricing of the NYSE, AMEX and NASDAQ/NMS IPOs
is attributable to their listing standards which reduce the ex ante
uncertainty about the value of a new issue. To test this
proposition, we control for six accepted proxies for ex ante
uncertainty: (i) OR, ownership retention (Grinblatt and Hwang |
12~ and Leland and Pyle |16~); (ii) AGE, the age of the firm on
the date of the initial public offering (Carter and Manaster |8~);
(iii) RGP, the reciprocal of gross proceeds (Beatty and Ritter |6~);
(iv) IB, the prestige of the investment banker (Carter and
Manaster |8~); (v) AUD, the reputation of the auditor (Balvers,
McDonald and Miller |4~); and (vi) |Sigma~, the standard
deviation of daily aftermarket returns estimated over the first 20
days in the aftermarket (Ritter |23~).(13)
Our test procedure is to fit the following cross-sectional
regression model:
|IR.sub.i~ = ||Alpha~.sub.0~ + ||Alpha~.sub.1~|OR.sub.i~ + ||
Alpha~.sub.2~|AGE.sub.i~ + ||Alpha~.sub.3~|RGP.sub.i~ + ||
Alpha~.sub.4~|IB.sub.i~ + ||Alpha~.sub.5~|AUD.sub.i~ + ||
Alpha~.sub.6~||Sigma~.sub.i~ + ||Alpha~.sub.7~(|IB.sub.i~ |
center dot~ |AUD.sub.i~) + ||Alpha~.sub.8~|E.sub.1i~ + ||
Alpha~.sub.9~|E.sub.2i~ + ||Alpha~.sub.10~|E.sub.3i~ + |
e.sub.i~. (1)

where |OR.sub.i~, ownership retention, is the percentage of

shares retained by the original owner (i.e., not offered in the
initial public offering); |AGE.sub.i~ is the number of years the
firm was incorporated prior to the initial public offering (obtained
from Moody's Manuals and Ward Business Directory); |
RGP.sub.i~ is the reciprocal of gross proceeds from the offering,
defined as the number of shares offered times the offering price;
|IB.sub.i~ equals one if the investment banker was in the bulge
bracket as defined by Hayes |13~, i.e., the top five investment
banking firms in the United States, and zero otherwise; |
AUD.sub.i~ equals one if the auditor was a big-8 (now big-6)
auditor, and zero otherwise; ||Sigma~.sub.i~ is the standard
deviation of the first 20 daily returns (as calculated from the
average of the closing bid and ask quotes each day)(14) in the
aftermarket; and |E.sub.1~, |E.sub.2~ and |E.sub.3~ are binary
variables which assume a value of one for the NYSE, AMEX and
NASDAQ/NMS IPOs, respectively, and are zero otherwise. The
interaction between investment banker and auditor is included
following Balvers, McDonald, and Miller |4~. Previous research
suggests ||Alpha~.sub.1~ |is less than~ 0, ||Alpha~.sub.2~ |is
less than~ 0, ||Alpha~.sub.3~ |is greater than~ 0, ||
Alpha~.sub.4~ |is less than~ 0, ||Alpha~.sub.5~ |is less than~ 0,
||Alpha~.sub.6~ |is greater than~ 0 and ||Alpha~.sub.7~ |is
greater than~ 0. Our proposition implies negative coefficients
associated with |E.sub.1~, |E.sub.2~ and |E.sub.3~, indicating
that underpricing is lower on these market centers after
controlling for other accepted measures of ex ante uncertainty.
Before reporting our regression results, we provide summary
statistics for each of the six proxies in Exhibit 3. The summary
statistics for the proxies show some differences across the
trading systems. For example, gross proceeds is largest by far for
the NYSE IPOs, followed by AMEX, NASDAQ/NMS and
NASDAQ/non-NMS in decreasing order of magnitude. Similar
comments apply to the firm value variable. About 47% of IPOs on
the NYSE are taken public by an investment banker in the "bulge
bracket" -- i.e., one of the five largest investment banks.
TABULAR DATA OMITTED The proportion declines to
approximately 12% and 24% for AMEX and NASDAQ/NMS IPOs,
respectively, while less than 10% of IPOs on NASDAQ/non-NMS
are associated with a bulge bracket investment banker. Finally,
over 80% of IPOs on all four trading systems are associated with
a big-8 auditor.

We report the ordinary least squares regression estimates of

Equation (1) in the first column of Exhibit 4. The overall
regression is significant at the one percent level. In addition, the
signs for all seven variables included to capture ex ante
uncertainty have the predicted signs, and all, except for
ownership retention, are statistically significant at the five
percent level.
Coefficients ||Alpha~.sub.8~ through ||Alpha~.sub.10~ show the
extent to which the initial NYSE, AMEX and NASDAQ/NMS IPO
returns differ from their NASDAQ/non-NMS counterparts after
controlling for the six proxies for ex ante uncertainty. If the
proposition that listing standards serve as a signal of investment
and managerial quality of IPOs has any merit, we should expect
that, at the minimum, the NYSE, AMEX and NASDAQ/NMS IPOs
have initial returns that are lower than those of the NASDAQ/non-
NMS IPOs. This is reflected in the following joint null (|H.sub.0~)
and alternative (|H.sub.A~) hypotheses:
|H.sub.01~: ||Alpha~.sub.8~ = ||Alpha~.sub.9~ = ||
Alpha~.sub.10~ = 0,
|H.sub.A~: not all ||Alpha~.sub.k~ equal 0, k = 8, 9 and 10.
The F-statistic for the joint hypothesis is 3.98 (with 3 and 1,067
degrees of freedom) and is statistically significant at the one
percent level. Further, the t-statistics for the individual
coefficients indicate that the estimates |Mathematical Expression
Omitted~ and |Mathematical Expression Omitted~ are
significantly negative, while |Mathematical Expression Omitted~
is negative but not statistically significant.(15Having identified
that initial IPO returns are significantly lower on the NYSE, AMEX,
and NASDAQ/NMS relative to NASDAQ/non-NMS stocks, we next
examine whether the degree of underpricing varies across the
NYSE, AMEX and NASDAQ/NMS IPOs. This is reflected in the
following joint null hypothesis:
|H.sub.02~: ||Alpha~.sub.8~ = ||Alpha~.sub.9~ = ||
Alpha~.sub.10~.
The F-statistic for this joint hypothesis is 1.06, which is not
significant at conventional levels. Consequently, we conclude
that there is no significant difference in the underpricing of IPOs
listed on the NYSE, AMEX, and NASDAQ/NMS after controlling for
ex ante uncertainty and hence that the major certification role is
played by the exchanges or NMS for NASDAQ stocks versus non-
NMS TABULAR DATA OMITTED stocks. Although our data do not
allow us to determine why certification only differs across the
exchanges and NMS versus non-NMS dimension and not between
the exchanges and NASDAQ/NMS IPOs, we suggest it may be
because the NASDAQ/NMS is the prestige segment of the
NASDAQ market (which itself is the upper echelon of the total
OTC market). Put another way, there are three segments of the
OTC market: (i) NASDAQ/NMS, (ii) NASDAQ/non-NMS, and (iii)
non-NASDAQ. As a result, listing on the NMS segment of NASDAQ
is certification for OTC stocks and makes these stocks similar to
NYSE stocks in the eyes of IPO investors. There is support for this
higher status based on the differential listing requirements for
the two NASDAQ groups as shown in Exhibit 1 (especially net
income, shares publicly held, and market value of shares). There
is also empirical evidence of the prestige of NASDAQ/NMS from
the sample in Exhibit 3. Specifically, only about 16% of the IPOs
that were traded on the total NASDAQ system were admitted to
the NMS segment of NASDAQ (158 of 982). Also, 24% of the NMS
stocks had prestigious investment bankers which was a larger
percentage than for the AMEX sample (12%), and a much higher
percentage than for the non-NMS sample (10%).
III. Robustness Checks
In this section, we present several checks to demonstrate that
our results are not sensitive to model specification. These checks
include a weighted least squares to control for possible
heteroskedasticity, inclusion of price in the regression to control
for transaction costs (Chalk and Peavy |9~), and alternative
proxies to the reciprocal of gross proceeds (namely log (gross
proceeds) and log (market value)). The results of all robustness
checks are summarized in columns 2 to 6 of Exhibit 4. An
ordinary least squares regression of initial returns on the ex ante
proxy explanatory variables may be characterized by
heteroskedasticity. Since firm value and ex ante uncertainty tend
to vary inversely, we multiplied all variables by the log of market
value (market capitalization at the close of the first day of
trading). This weighting procedure is expected to produce
homoskedastic disturbances and is in the spirit of Beatty and
Ritter |6~. The results are presented in the second column of
Exhibit 4 and are qualitatively identical to those in the first
column in terms of the signs and significance of the coefficients.
Chalk and Peavy |9~ suggest inclusion of price in the regression
model to control for the effects of transaction costs. In particular,
Chalk and Peavy find a negative relationship between price and
the level of underpricing. Inclusion of price in Equation (1) results
in the OLS estimates reported in column 3 of Exhibit 4. Once
again, the coefficients are very similar in terms of both signs and
significance to those in the first column. The coefficient of price is
significant but positive, possibly as a result of the partial
adjustment phenomenon (Hanley |14~). Nevertheless, our major
result, namely the significant difference between the
NASDAQ/non-NMS IPOs and the other IPOs, is not altered.
In Equation (1), we used the reciprocal of gross proceeds as
a proxy for the size of the offering. To test the robustness of the
results to this specification we repeat the analysis using two
alternative size proxies, the log of gross proceeds and the log of
market value (FS, defined as number of shares outstanding times
price at the close of the first day of trading). Once again, the
results (columns 4 and 5 of Exhibit 4), which indicate a significant
difference between NASDAQ/non-NMS IPOs and the other IPOs,
are essentially unaltered.
Finally, we examine the distribution of offerings by trading
systems over the calendar years 1983 to 1987. The results are
presented in Exhibit 5, which also gives the mean underpricing in
each year for each system. Clearly, the majority of the offerings
on the exchanges occurred in 1986 and 1987. Similarly, all but
one of the NASDAQ/NMS offerings occurred in these two years.
We, therefore, reestimated the regression model using only data
for 1986 and 1987. The results are presented in the final column
of Exhibit 4 and are qualitatively unchanged from those in
column 1.
The use of nominal gross proceeds in the regressions may
introduce measurement error as the level of the market was
much higher in August 1987 than in January 1983. The results in
the final column of Exhibit 4, which are based on only 1986 and
1987 data, provide some evidence that our results are not being
driven by the measurement error problem. The above results
suggest that the evidence in favor of our certification hypotheses
is not sensitive to model specification. Indeed, the results show
considerable consistency, with the coefficients of most variables
being similar across alternative specifications. While some
differences emerge, these are probably due to multicollinearity in
the data and do not affect our major conclusion, namely that
initial returns differ significantly between NASDAQ/non-NMS IPOs
and those on the other trading systems (i.e., the exchanges and
NASDAQ/NMS).
IV. Summary and Conclusion
We present results showing that the previously documented
average underpricing of IPOs on the NASDAQ system extends to
both NYSE and AMEX IPOs. More specifically, we find that our
sample of NYSE IPOs are, on average, underpriced by 4.82%,
while our sample of AMEX IPOs have an average underpricing of
2.16%. This contrasts with the 5.56% and 10.41%, respectively,
for NASDAQ/NMS and NASDAQ/non-NMS IPOs, on average, over
the same time period.
We also advance the proposition that, through their quantitative
and qualitative initial and continued listing standards, trading
systems certify the quality of IPOs, including managerial quality
narrowly defined along its agency dimension. The higher listing
standards of the NYSE, AMEX and NASDAQ/NMS relative to the
NASDAQ/non-NMS reduce the ex ante uncertainty about the
value of an IPO and thus reduce its expected underpricing.
Our empirical results support this proposition with the NYSE,
AMEX, and NASDAQ/NMS IPOs having significantly lower
underpricing than non-NMS IPOs after controlling for several
other proxies for ex ante uncertainty. However, while the
average underpricing for NYSE and AMEX IPOs was less than that
of NASDAQ/NMS IPOs, these differences in underpricing were not
statistically significant once other sources of ex ante uncertainty
were controlled.
1 We use the phrase "listing standards" in a broad sense to refer
to admission standards for trading not only on the exchanges but
also on the NASDAQ. For a discussion of listing standards, see
American Stock Exchange |1~, National Association of Securities
Dealers |19~ and |20~, and New York Stock Exchange |22~.
2 For a discussion on the difference in corporate governance
standards between the NYSE and AMEX, see American Stock
Exchange |2~ and |3~. Also note that the listing standards are
only guidelines, as evidenced by some listed firms having
negative book values of shareholder equity.
3 See National Association of Securities Dealers |19, p. 35~.
4 We use the term "trading system" throughout the paper
because we wish to compare both the specialist-based
exchanges and the competitive dealer NASDAQ system.
5 Arguments along these lines are advanced in the context of
listing of seasoned offerings by Ying, Lewellen, Schlarbaum, and
Lease |32~.
6 On the application of reputational signaling to financial
markets, see Beatty and Ritter |6~, Booth and Smith |7~,
DeAngelo |10~, Easterbrook |11~, Mayers and Smith |17~, and
Wakeman |28~.
7 In Rock's model, the firm is uninformed. In our setting, we
assume the firm fully conveys its private information through
information releases (for example, the prospectus) and its choice
of the trading system. Thereafter, the firm is assumed to be in
the same position as other uninformed investors.
8 The predicted effects of trading systems are also consistent
with other theories of underpricing of IPOs. In the models of
Grinblatt and Hwang |12~ and Welch |31~, underpricing serves
as a signal of inside information about firm quality. Since
certification through listing standards also signals firm quality
both in its economic and agency dimensions, it serves as an
alternative signal to underpricing. This implies that firms listing
on trading systems with higher standards need to underprice
less. In Tinic's |27~ interpretation, our argument suggests that
higher listing standards reduce underpricing by mitigating the
expected adverse legal consequences and damages to the
reputation of investment bankers. Finally, Merton |18~ predicts
that a larger investor base leads to wider recognition of the firm.
Assuming higher listing standards make a security more
attractive to both individual and institutional investors, these
standards promote broader ownership of the firm, which reduces
the severity of informational asymmetry and thus reduces the
expected level of underpricing of IPOs.
9 Recall that although the NASDAQ/NMS implemented the
qualitative standards in early 1989, many NMS firms already had
business practices in place that were consistent with the new
standards.
10 Best efforts IPOs were excluded because none of our sample
of NYSE or AMEX IPOs were best efforts offerings. Ritter |24~ has
documented that best efforts IPOs on NASDAQ have different
initial return behavior than firm commitment offerings. To make
our samples of NASDAQ IPOs as similar as possible to our NYSE
and AMEX samples and to avoid a bias which may be introduced
by including best efforts offerings in some groups and not others,
it was decided to limit the study to firm commitment offerings.
Similarly, all unit offerings (i.e., offerings with warrants attached)
were excluded.
11 We discarded IPOs with a first quoted bid of less than a dollar
in order to mitigate the bias in returns induced by discrete price
quotes.
12 Although the impact on the size of the NYSE sample was
substantial (reduction from 95 to 55 IPOs), the results are
essentially unaltered when all IPOs are included.
13 Within the literature, numerous other proxies have been used.
However, there is no consensus as to which is most appropriate
and hence we employ six widely used and readily available
proxies. We do not claim that these are either the best or the
only possible proxies but believe that they adequately capture ex
ante uncertainty.
14 Closing bid and ask quotes for AMEX and NYSE stocks were
provided by the American Stock Exchange.
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15 The lack of significance on ||Alpha~.sub.8~ may be
caused by lack of statistical power due to the small sample size.