Secondary Market Price Stabilization of Initial Public Offerings
William J. Wilhelm, Jr.
Wallace E. Carroll School of Management, Chestnut Hill, MA 02167
(617) 552-3990; William.Wilhelm@bc.edu
January 1999
For many investors, a double-digit first-day return is the defining characteristic of the
initial public offering (IPO). Historically, U.S. IPOs have exhibited average first-day
returns of about 10-15%.1 Substantial in its own right, this average masks extraordinary
episodes like the recent series of internet-related IPOs involving eBay, EarthWeb, and
Broadcast.com that culminated on November 13, 1998 with a 605% first-day return on
TheGlobe.com’s IPO. Of course, not all IPOs exhibit large price runups, but because
underwriting syndicates routinely “stabilize” the secondary market price for poorly
received offerings, few suffer sharp price declines during the first day of trading.
Price stabilization practices have drawn considerable interest in recent months following
a series of articles by Michael Siconolfi and Patrick McGeehan of the Wall Street Journal
questioning the use of “penalty bids” that discourage immediate resale or “flipping” of
IPO shares, particularly by retail investors.2 Although the apparent discriminatory
application of penalty bids has triggered litigation and attracted the attention of the
regulatory community, in a 1997 article in this journal, Lawrence Benveniste and I
argued that there may be a sound economic rationale for such discriminatory practices. 3
In an effort to shed further light on this debate, the Wallace E. Carroll School of
Management at Boston College recently sponsored a roundtable discussion of price
stabilization practices moderated by former Securities and Exchange Commisioner
Steven Wallman.4 In this article I will describe the various practices that fall under the
rubric of price stabilization and outline several economic rationales for what is by
definition a manipulative but legal practice. I will also summarize recently published
evidence characterizing the winners and losers when IPOs are stabilized and outline some
conclusions from the roundtable discussion that might serve as a guide to policymakers.
See Roger Ibbotson, Jodie Sindelar, and Jay Ritter, 1994, “The Market’s Problem with the Pricing of
Initial Public Offerings,” Journal of Applied Corporate Finance 6, 66-74.
2
See, for example, “Big Institutions Can Cash Out Quickly; the Little Guy Can't Without Penalties”
(6/26/98) and “SEC Launches Probe Into IPO Flipping; State Regulators Fire 1st Volley in Matter”
(8/20/98).
3
Lawrence M. Benveniste and William J. Wilhelm, Jr., 1997, Intial Public Offerings: Going by the Book,
Journal of Applied Corporate Finance 10, 98-108.
4
In addition to Mr. Wallman, both the discussion and this article benefitted from the input of Robert
Henderson (General Partner, Greylock Management), Andrew Klein (Founder and Chief Strategist, Wit
Capital), William Schnoor (Partner, Testa, Hurwitz, and Thibeault), Dean Furbush (Chief Economist,
NASD), Erik Sirri (Chief Economist, Securities and Exchange Commission), Deborah Bortner (Department
of Financial Institutions, State of Washington and the North American Securities Administrators
Association), Matthew Nestor (Chief of Enforcement, Securities Division of the Massachusetts Secretary of
State), Jay Ritter (University of Florida), Bharat Anand (Harvard Business School), Joseph Downing
(Boston College). The conference was sponsored in part through the generosity of the State Street Financial
Markets Group.
1
Price Stabilization: An Overview
The Securities and Exchange Commission (SEC) defines price stabilization as
“…transactions for the purpose of preventing or retarding a decline in the market price of
a security to facilitate an offering [italics added].”5 Such practices are permitted because:
Although stabilization is a price-influencing activity intended to induce
others to purchase the offered security, when appropriately regulated it is
an effective mechanism for fostering an orderly distribution of securities
and promotes the interests of shareholders, underwriters, and issuers. (SEC
release No. 34-38067, p.81)
To gain some appreciation for the potential impact of price stabilization, consider the
price and volume behavior following Landstar Systems’ March 5, 1993 IPO illustrated in
Figure 1. The lower panel shows the difference between seller-initiated and buyerinitiated volume during the first 40 days of trading. Daily net selling pressure is almost
uniformly positive and substantial during the first 22 days of trading and yet Landstar’s
price remained at or above the offer price of $13.00 per share. Over the next several days,
presumably with the conclusion of the price stabilization effort, Landstar’s price fell
sharply despite relatively balanced buying and selling activity.
FIGURE 1
LANDSTAR SYSTEMS (3/5/93)
Offer Price: $13.00
Closing Stock Price for the First 40 Days of Trading
$13.75
$13.50
Stock Price
$13.25
$13.00
$12.75
$12.50
$12.25
$12.00
Trade Day:
5
1
251
1
1
501
2
751
1001
1251
6
15
24
Transaction Count
See page 81 of SEC release No. 34-38067, Dec. 20, 1996 (the document is available on line at
www.sec.gov/cgi-bin/txt-srch-sec?regulation+M). This release announces the adoption of Regulation M to
replace Exchange Act rules 10b-6, 10b-6A, 10b-7, 10b-8, and 10b-21 (the trading practice rules). Rule 104,
which governs stabilization and other syndicate activities, is discussed on pages 80-94 of the release.
Footnote 116 draws attention to the Commission’s distinction between facilitating an offering and
facilitating distribution of securities, with the former allowing for broader scope.
40
Net Seller-Initiated Volume during the First 40 Days of Trading
1000000
Net Sell Volume
(number of shares)
800000
600000
400000
200000
0
-200000
1
6
11
16
21
26
31
36
Trade Day
From Lawrence M. Benveniste, Sina M. Erdal, and William J. Wilhelm, Jr., 1998, “Who Benefits from Secondary
Market Price Stabilization of IPOs?” Journal of Banking and Finance 22, 741-767.
Stabilization of an IPO’s secondary market price usually involves one or more of the
following practices: stabilizing bids, penalty bids, syndicate short positions. In the
following sections I will describe each practice and summarize recent evidence of their
relative importance
Stabilizing Bids
An underwriter can post a stabilizing bid in the secondary market whereby it agrees to
repurchase shares (typically) at the offer price. This approach to price stabilization is
essentially a reaction to selling pressure created by immediate resale or “flipping” of
share purchased in the offering. Rule 104, requires that those placing stabilizing bids
“…disclose the purpose of such bid to the person to whom the bid is entered (e.g., the
specialist or executing broker-dealer).”6 For shares traded on Nasdaq, stabilizing bids are
identified by a symbol on the quotation display. Consequently, price stabilization efforts
implemented by way of a stabilizing bid are transparent to market makers and, in
principle, can be made so to investors at large.
Penalty Bids
In contrast to stabilizing bids, penalty bids are designed to prevent selling pressure by
providing an incentive for syndicate members to place shares with investors who will not
immediately flip their allocations. Regulation M, Rule 100 defines a penalty bid as:
…an arrangement that permits the managing underwriter to reclaim a
selling concession otherwise accruing to a syndicate member (or to a
selected dealer or selling group member) in connection with an offering
6
SEC release No. 34-38067, p.90.
when the securities originally sold by the syndicate member are purchased
in syndicate covering transactions.7
Managing underwriters are required to disclose the presence of penalty bids, so defined,
to the regulatory body of the market in which the stock will trade and to maintain records
of their scope, duration, and enforcement. However, public disclosure of penalty bids is
not currently required. Moreover, Regulation M does not contemplate the possibility that
managing underwriters can use both explicit penalties unrelated to the selling concession
and implicit penalties, such as the threat of exclusion from the manager’s future
transactions, to create similar incentives within the syndicate membership.8
Syndicate Short Positions
Finally, a syndicate manager can create buying power to offset selling pressure by
overselling or taking a syndicate short position during the allocation of the offering. This
practice is best illustrated with a simple example. Suppose the issuing firm desires to sell
1,000,000 million shares in its offering. The managing underwriter might make
commitments to investors for an additional 20% thereby committing the syndicate to
deliver a total of 1,200,000 shares to investors. If the first 200,000 shares delivered to
investors are immediately flipped, the syndicate can cover the remainder of its
commitment by simply repurchasing shares at the offer price and then placing them (at
the offer price) with investors to whom shares have yet to be distributed. In the event that
significant selling pressure does not arise, the syndicate manager generally exercises an
overallotment option that permits the syndicate to sell up to 15% more shares than issuing
firm originally desired. The difference between the 20% overcommitment and the 15%
overallotment option is referred to as the syndicate’s naked short position. The risk in
establishing the naked short position is the possibility that the syndicate manager will be
forced to repurchase shares at prices in excess of the offer price to satisfy its original
commitments to investors (at the offer price).
Regulation M defines this type of share repurchase as a syndicate covering transaction
and imposes the same disclosure requirements as those imposed on penalty bids.
Consequently, investors need not be informed that an offering is or will be stabilized by
way of a syndicate short position. Rather, investors need only be exposed to language
indicating that “the underwriter may effect stabilizing transactions in connection with an
offering of securities” and a characterization of possible stabilization practices in the
“plan of distribution” section of the prospectus.
Figure 2 summarizes Reena Aggarwal’s recent review of price stabilization practices
from the first quarter of reporting under Regulation M (May-July, 1997).9 Aggarwal
reports that about 50% of the syndicate contracts (54 out of 112 IPOs) contained explicit
7
SEC release No. 34-38067, footnote 129.
See IDD Magazine, April 25, 1994, for a description of an arrangement used by Prudential Securities to
explicitly condition future allocations on points awarded for purchase and retention of shares by a selling
member’s clients in past transactions.
9
Reena Aggarwal, 1998, “Stabilization Activities by Underwriters after new Offerings,” Georgetown
University Working Paper.
8
penalty bid provisions. However, penalty bids were actually assessed in only 28 cases.
The fact that syndicate short positions are covered both in the presence and absence of
penalty bids suggests that these stabilization practices are used both independently and in
a complementary fashion. Perhaps most striking is Aggarwal’s failure to find even a
single instance of price stabilization being implemented via the posting of a stabilizing
bid. As a consequence, the early returns suggest that price stabilization efforts generally
may not be highly transparent to secondary market investors.
Figure 2: Penalty Bid and Short Covering Frequency [Aggarwal (1998)]
No Penalty Bid
58
25
Penalty Bid
54
35
Penalty Bid Assessed
19
0
10
20
28
30
Short Covered
40
50
60
70
Total
It may be useful to recognize that the SEC effectively presents underwriting syndicates
with a tradeoff. By posting a stabilizing bid, the syndicate does not put significant capital
at risk because it can always withdraw the bid. The “price” imposed on the syndicate,
however, is that it must make its intentions transparent. On the other hand, a syndicate
short position puts capital at risk because the syndicate may be forced to cover its
position at a loss if the deal is well received. In “exchange” for bearing this risk, the
syndicate is not required to make its intentions transparent. It is obvious from Aggarwal’s
findings how syndicates rate these alternatives.
The Economic Consequences of Price Stabilization
Risk Transfer
Cast in the most negative light, price stabilization might be seen as a means of
transferring risk to a relatively naïve segment of the investor population. Returning to
Figure 1, we see that during the first three weeks of trading Landstar Systems shares
traded almost exclusively at 13-131/8. Consequently, any secondary market investor
unaware of price stabilization or expecting stabilization to be a short-term phenomenon
might reasonably assume that Landstar’s IPO had been fairly priced at $13.00 per share.
Unfortunately, buying shares under this assumption would have been costly as the price
declined sharply during the fifth week of trading and remained at its apparent equilibrium
level of 121/4-121/2.
Risk Reduction
In the sense that price stabilization postpones the market’s search for an equilibrium price
level, it is similar to secondary market trading halts, or “circuit breakers,” introduced in
the aftermath of the 1987 market crash. Economists generally see little benefit in
interventions that essentially throw sand in the gears of the market’s price discovery
mechanism. However, Jeremy Stein and Bruce Greenwald provide a compelling
argument for doing so when markets are subject to large volume shocks. 10 The basic idea
is that under ordinary circumstances “value buyers” respond to price declines and thereby
prevent prices from falling “too far.” However, when selling volume is large and
concentrated, value buyers may hesitate to express their demands because the
“transactional risk” arising from uncertainty surrounding the price at which an order will
executed may be too great. Although a circuit breaker sacrifices timeliness, it might
facilitate price discovery under such circumstances by reducing transactional risk and
thereby encouraging a more complete expression of demand among value buyers when
trading resumes.
Initial public offerings might be subject to volume shocks of the type imagined by
Greenwald and Stein by virtue of the fact that there is no price and volume history against
which to judge the early stages of secondary market trading. To make the idea concrete,
consider two possible inferences secondary market participants might draw from an
institutional investor selling a 50,000 share allocation of Landstar Systems at the offer
price of $13.00. If such a trade involved the liquidation of the investor’s entire allocation,
one might reasonably infer that the investor did not view the IPO favorably at the offer
price, but for some reason was willing to accept an allocation from the syndicate. 11 If, on
the other hand, the sale of 50,000 shares at the offer price represented a partial liquidation
of a much larger allocation for diversification purposes, a less negative inference might
be in order. The problem facing both potential secondary market investors and those
receiving allocations in the offering is that it is impossible to distinguish between these
two motives for the sale of an initial allocation.
In the absence of a commitment to price stabilization, investors have an incentive to
respond rapidly to the noisy signal associated with the sale of a large initial allocation by
liquidating their own positions. Unfortunately, when the liquidation of a large initial
allocation occurs simply for the purpose of improved risk sharing, this may not be the
optimal response ex post. A commitment to price stabilization weakens this incentive by
temporarily shifting the risk of the deal being fundamentally overpriced to the syndicate.
Presumably this provides both initial investors and secondary market investors an
opportunity to develop a more measured perspective on volume shocks during the early
stages of trading. If this in turn reduces the chance that investors will mistake a
Jeremy Stein, 1987, “Informational Externalities and Welfare-Reducing Speculation,” Journal of
Political Economy 95, 1123-1145, Bruce Greenwald and Jeremy Stein, 1991, “Transactional Risk, Market
Crashes, and the role of Circuit Breakers,” Journal of Business 64, 443-462.
11
In my 1997 article with Lawrence Benveniste, we suggested that relatively indiscriminate participation
might be a reasonable price of admission to an IPO investor pool.
10
liquidation motivated by risk sharing considerations for an informationally motivated
liquidation, price discovery might be facilitated by a more complete expression of
aggregate demand conditions.
Price Stabilization and Bookbuilding
Even if it does not diminish the transactional risk described by Greenwald and Stein, I
have suggested in a recent article with Lawrence Benveniste and Walid Busaba that price
stabilization might be an important element of the bookbuilding effort that precedes the
pricing and distribution of an IPO.12 The basic idea, which is outlined in my 1997 article
in this journal with Lawrence Benveniste, stems from the notion that the indications of
interest collected from institutional investors during the lead manager’s bookbuilding
effort provide information about market demand conditions and thereby promote more
efficient pricing. In the same article we outlined the evidence supporting this theory and
have since provided additional evidence in a recently published article with Sina Erdal.13
Coupled with the fact that the bookbuilding approach is rapidly gaining popularity
outside the U.S., the evidence suggests that this practice contributes to the relative
vibrancy of the U.S. IPO market.
The banker’s challenge in a bookbuilding effort is to gain the trust of the investor
community. A central tenet of this practice is that if after canvassing the investor
community the lead manager finds that demand is stronger than expected, it will be in a
position to set the offer price in excess of the price estimate suggested in the preliminary
prospectus. However, because the syndicate’s compensation is a fraction of gross
proceeds, it is in the lead manager’s interest to price aggressively regardless of what it
learns from investors. If the investor community perceives this incentive distortion as
being severe, it may be unwilling to cooperate in the bookbuilding effort in the first
place. We argue that a commitment to price stabilization bonds the lead manager against
overly aggressive pricing. The idea follows directly from the fact that a commitment to
repurchase shares at the offer price is equivalent to providing initial investors with a put
option. Any attempt on the part of the lead manager to mislead investors about the
outcome of the bookbuilding effort will backfire on the syndicate. Thus a commitment to
price stabilization promotes cooperation by lending credibility to the lead manager’s
dealings with investors.
The theory makes an important prediction given recent concerns. If price stabilization is
conducted for the purpose of promoting information sharing in the bookbuilding process,
Lawrence M. Benveniste, Walid Y. Busaba, and William J. Wilhelm, Jr., 1996, “Price Stabilization as a
Bonding Mechanism in New Equity Issues,” Journal of Financial Economics 42, 223-255.
13
Lawrence M. Benveniste, Sina M. Erdal, and William J. Wilhelm, Jr., 1998, “Who Benefits from
Secondary Market Price Stabilization of IPOs?” Journal of Banking and Finance 22, 741-767. See also the
1998 working papers by Francesca Cornelli and David Goldreich, “Bookbuilding and Strategic
Allocation,” (London Business School) and Dennis Logue, Richard Rogalski, James Seward, and Lynn
Foster-Johnson, “Underwriter Book-building Methods, Investment Bank Reputation, and the Return
Performance of Firms Conducting Initial Public Offerings,” (Amos Tuck School of Business
Administration, Dartmouth College).
12
banks would prefer not to make blanket commitments. Rather, efficiency considerations
call for allocation of the put options implicit in a price stabilization effort only among
those investors who contribute to the bookbuilding effort. Since institutional investors are
the primary source of information, the theory predicts that banks would have little interest
in committing to repurchase shares from retail investors. I will explore this point further
in the following section.
Who Benefits from Price Stabilization?
The preceding discussion can be summarized as follows:

price stabilization retards the price discovery process in the secondary market for an
IPO;

its effects might plausibly comprise some combination of risk transfer, risk reduction,
and enhancement of the efficiency of a bookbuilding effort;

the available evidence suggests that price stabilization is implemented by way of
relatively opaque mechanisms.
Legitimate concern about current practices rests on price stabilization being a relatively
opaque mechanism for risk transfer. If this characterization of price stabilization is
accurate, some (presumably retail) investors might be losers in a game that permits the
issuing firm to transfer the burden of price uncertainty to a relatively naïve segment of
the investor population.
In our 1998 article with Sina Erdal, Lawrence Benveniste and I attempt to shed light on
who benefits from secondary market price stabilization of IPOs. To do so, we distinguish
between large-quantity and small-quantity traders and between investors purchasing
shares in the offering and secondary market investors. Figure 3 provides a snapshot of
some of our findings.
Figure 3 suggests that large-quantity, presumably institutional, investors are indeed the
primary beneficiaries of price stabilization efforts. Specifically, large-quantity traders are
more active sellers of stabilized IPOs than of non-stabilized IPOs. In contrast, selling of
stabilized IPOs by small-quantity traders is light relative to both their own selling of nonstabilized IPOs and the selling of stabilized IPOs by large-quantity traders. This pattern is
most pronounced during the first day of trading but persists beyond the second week of
trading. These findings are consistent with the common perception that penalty bids work
to suppress secondary market selling pressure within the retail segment of the investor
population.
Figure 3. Relative Intensity of Small-Quantity and Large-Quantity Seller-Initiated
Trades during the First Ten Days of Secondary Market Trading
Trades of 1,000 Shares or Less
Percentage of Offer Size
5.0
Stabilized IPOs
Non-stabilized IPOs
4.0
3.0
2.0
1.0
0.0
1
2
3
4
5
6
7
8
9
10
Day
Trades of 45,000 Shares or More
Percentage of Offer Size
6.0
Stabilized IPOs
Non-stabilized IPOs
5.0
4.0
3.0
2.0
1.0
0.0
1
2
3
4
5
6
7
8
9
10
Day
Presumably, the suppression of small-quantity sell orders by penalty bids, particularly
during the first few days of trading, bears most heavily on retail investors receiving
allocations in the offering. Although it is possible that such investors are unaware of the
threat of penalty bids, this risk is probably attenuated by members of the distribution
team concentrating allocations among a relatively narrow set of regular retail investors.
Moreover, in some cases, the penalty bid is made explicit to retail investors receiving
allocations in an offering. For example, Wit Capital, the leading e-syndicate manager,
includes the following statement in communications with its network of retail investors:14
Flippers will lose priority. Members who have track records for buying
public offering shares and holding them for at least 60 days will have
priority over Members who do not have such records. Thus, Wit Capital
shall attempt to penalize "flippers" by reducing their likelihood of
obtaining shares in subsequent public offerings.
To enforce this anti-flipping policy, Wit Capital will maintain for each
Member a rating score that tracks their record for buying and holding
public offering shares. Members will score positive points based on the
number of Initial Public Offering shares purchased and held. If you sell
these shares, or transfer them out of your account, within 60 days, then
you will score negative points.
Consistent with the view that penalty bids complement bookbuilding efforts, Robert
Lessin, Wit Capital's chairman, observes that "The penalty is Draconian, but … there's a
quid pro quo" for individuals receiving IPO allocations. "We will get you what you can't
get, but life's not perfect."15
Although retail investors willingly accept these terms as the price of admission to IPO
pools, state regulators initially took the position that "we don't believe that small
investors should be treated in a disparate fashion from big investors."16 But among their
concerns, perhaps the most serious was expressed by Matthew Nestor, chief of
enforcement for the Massachusetts Securities Division: "If the penalty bid is not
adequately disclosed to the investors, and the broker makes improper statements to the
customer, then we certainly may have some instances where customers have been
defrauded."17 A simple disclaimer like that provided by Wit Capital should be sufficient
to mitigate this threat to retail investors receiving IPO allocations.
I would argue that the more serious and difficult question is how to address the
possibility that secondary market retail investors are systematically fooled by price
stabilization efforts, particularly when penalty bids are in place. Investors accepting
allocations on the condition that they be held for a minimum period of time are in a
position to weigh the costs and benefits of doing so. By contrast, investors buying shares
in the secondary market may not be in a position to make well-informed decisions if
prices are artificially inflated through relatively opaque practices.
14
See www.witcapital.com/stok/home.html.
Michael Siconolfi and Patrick McGeehan, “Wall Street Boosts Penalty On IPO Flips,” The Wall Street
Journal, July 31, 1998.
16
Denise Voigt Crawford, president of North American Securities Administrators Association, as quoted in
Siconolfi and McGeehan, “Wall Street Boosts Penalty On IPO Flips.”
17
Michael Siconolfi and Patrick McGeehan, “Penalty Bids By Big Firms: Brokers Are Punished If Clients
Flip IPOs,” The Wall Street Journal, July 10, 1998.
15
If this were a serious problem, we might expect to find a preponderance of secondary
market purchase orders for stabilized IPOs being initiated retail investors. In my work
with Lawrence Benveniste and Sina Erdal, we find precisely the opposite to be the case:
small-quantity purchase orders for stabilized IPOs are infrequent relative to both largequantity orders for stabilized offerings and small-quantity orders for non-stabilized
offerings. Thus, the evidence to date does not suggest cause for alarm.
On the other hand, the evidence reported by Reena Aggarwal that I summarized in figure
2 suggests that price stabilization practices have become increasingly opaque with the
apparent wholesale shift from stabilizing bids to penalty bids and syndicate short
positions. At minimum, continued analysis of the data now being collected under
Regulation M is warranted. If we learn that secondary market investors are systematically
misled by relatively opaque price stabilization practices, the SEC might then consider
weighing the costs and benefits of more comprehensive real-time reporting of price
stabilization activities.