Elsevier

Journal of Corporate Finance

Volume 50, June 2018, Pages 349-370
Journal of Corporate Finance

The consequences of shifting the IPO offer pricing power from securities regulators to market participants in weak institutional environments: Evidence from China

https://doi.org/10.1016/j.jcorpfin.2016.10.007Get rights and content

Highlights

  • China experienced shifts in the IPO offer pricing regime between a government-based approach and a market-based approach.

  • IPO offer prices relative to reported earnings are more significantly depressed under the government-based approach.

  • IPO firms' financial reporting quality is higher under the market-based approach.

  • IPO offer prices are not more overstated under the market-based approach.

  • The effect of offer pricing regime on firms' financial reporting quality persists over the long run.

Abstract

We examine the consequences of shifting the IPO offer pricing power from securities regulators to market participants in a representative weak investor protection country, China. We show IPO offer prices relative to reported earnings are less depressed when determined by market participants than by securities regulators. IPO firms are also less likely to select a low quality auditor or inflate the pre-IPO earnings when IPO offer prices are determined by market participants. However, we find no evidence that IPO offerings are more likely to be overpriced when offer prices are determined by market participants. Furthermore, IPO firms' financial reporting choices made at the time of the IPO have a long lasting impact on the firms' subsequent financial reporting quality. Overall, our results contribute to the ongoing debate on the appropriate roles of securities regulators versus market forces in protecting public investors in markets with weak institutional environments.

Introduction

There is a large and growing finance literature on initial public offerings (IPOs) around the world (e.g., Chaney and Lewis, 1998, Chan et al., 2004, Banerjee et al., 2011, Clarke et al., 2016, Nielsson and Wojcik, 2016). Most studies in this literature examine various issues resulting from the strategic interaction between corporate insiders (sellers) and outside investors (buyers). While the conduct of IPOs (including eligibility, timing, offer size, and pricing) is subject to various degrees of government regulation in almost all countries, there is little empirical research on the costs and benefits of such government regulation. This is surprising given the controversies surrounding the government's intervention in the IPO process. The objective of this study is to contribute to this important debate by examining the impact of different IPO offer pricing regimes on the behavior of IPO firm insiders.

Broadly speaking, IPO offer pricing regimes around the world can fall within the following two extremes. At one extreme, referred to as the market-based approach, underwriters and investors, especially institutional investors, play the lead role in determining IPO offer prices and the securities regulator's primary responsibility is to establish the necessary supporting institutions such as the rule of law that facilitate the market's pricing of IPO shares. At the other extreme, referred to as the government-based approach, a country's securities regulator directly sets IPO offer prices based on IPO firms' financial performance indicators.

While it has been widely adopted in the U.S. and many other developed countries, the market-based approach is controversial and often resisted by regulators in many less developed financial markets.1 One frequently cited justification for rejecting the market-based approach is that many important market supporting institutions such as reputable and independent underwriters and institutional investors either do not exist or are very weak in weak investor protection countries and therefore there is a high perceived risk that IPO offerings could be over priced under a market-based approach (Meng et al., 2004, China Securities Regulatory Commission (CSRC), 2009, Sheokand, 2012). Furthermore, even if a market-based approach is preferred, the transition from a government-based approach to a market-based approach may not be a sure success due to the resistance of vested interests and potential unintended negative consequences resulting from the transition. On the other hand, government regulators may not necessarily be as motivated and informed about general market and specific firm conditions as private investors (Jackson and Roe, 2009). Hence, a priori it is not obvious which approach is more effective in protecting the interests of IPO investors in countries with less developed financial markets.

In this study we examine the consequences of a shift in the IPO offer pricing regime from a government-based approach to a market-based approach in China, the largest emerging market economy with weak investor protection (Allen et al., 2005). There has been an ongoing debate since the start of China's modern stock market in the 1990s on whether China should follow a market-based approach or government-based approach to regulating IPO offer prices (Luo, 2013, Deng, 2015).

We examine four specific research questions. First, we examine how IPO offer prices change when the IPO offer pricing approach shifts from a government-based approach to a market-based approach. Consistent with the hypothesis that the Chinese securities regulators suffer from severe agency problems that lead to a strong aversion to the risk of IPO offer overpricing, we find that the IPO offer prices relative to reported earnings are more significantly depressed under the government-based approach than under the market-based approach.

Second, we examine how a shift from the government-based approach to the market-based approach affects IPO firms' financial reporting quality at the time of the IPO. We use two complementary approaches to assess financial reporting quality at the time of the IPO: (a) IPO firms' likelihood of hiring a low quality auditor at the time of the IPO; and (b) the magnitude of upward earnings management in the pre-IPO period. We find that when the IPO offer pricing approach changes from the government-based approach to the market-based approach, IPO firms are less likely to hire low quality auditors and conduct upward earnings management in the years immediately prior to the IPO.

Our third question examines whether IPO offer prices are more likely to be overstated under the market-based approach than under the government-based approach. As noted above, one frequently cited argument against the market-based approach in less developed financial markets is that the market-based approach makes it easier for IPO firms' insiders to sell over-priced shares to less informed and less sophisticated public investors. Since the stock prices of overvalued shares eventually have to reverse with the arrival of new information such as earnings announcements, the above argument implies a greater long-term stock price reversal relative to the IPO offer price for the IPOs under the market-based approach than under the government-based approach. We find no evidence that the long-term abnormal stock price performance relative to the offer price reverses to a greater extent for the IPOs under the market-based approach than the IPOs under the government-based approach.

Our final question examines IPO firms' financial reporting quality over the long run, defined as three-five years after the IPO. Consistent with Stein (1989) and Shivakumar (2000), we conjecture that once a firm's insiders adopt a low (high) quality financial reporting strategy at the IPO time, the insiders will find it in their best interest to continue to do so in subsequent financial reporting periods because of the stock market's rational expectation. Consistent with this conjecture, we find IPO firms' auditor choices made at the time of the IPO are sticky. We find no evidence that IPO firms that hire a low (high) quality auditor at the time of the IPO are more likely than a control sample of non-IPO firms to switch to a high (low) quality auditor three years after the IPO. Furthermore, we find that earnings quality continues to be higher in the three-five year period after the IPO, for the firms that went public under the market-based approach than for the firms that went public under the government-based approach.

Any observed changes in corporate behavior resulting from a shift in IPO offer pricing from the government-based approach to the market-based approach could be due to confounding events (e.g., a general improvement in China's investor protection environment). We perform a variety of robustness checks to rule out such alternative explanations. More importantly, an important strength of our study's research design is that China's IPO offer pricing regimes changed from a government-based approach to a market-based approach and then reversed back to a government-based approach during our sample period. The flip-flop creates a unique opportunity for us to more clearly identify the causal impact of the two contrasting IPO offer price regulatory approaches on our dependent variables of interest.

Overall, we can draw the following conclusions from our empirical analyses. First, our results suggest that even in a less developed financial market like China with the dominance of less sophisticated retail investors, public investors can still price protect by avoiding IPO offer overpricing under the market-based approach, consistent with Ekkayokkaya and Pengniti (2012). Second, our results suggest that due to the CSRC's own agency problems, the government-based IPO offer pricing approach provides IPO firm insiders with a stronger incentive to manage earnings not only at the IPO time but also in the years subsequent to the IPO. Given that financial reporting quality is important to the efficient functioning of financial markets and the fact that earnings management is costly, our results suggest that the government-based IPO offer pricing approach causes greater damages than the market-based approach to the long term health of China's financial markets. For these reasons, we conclude that the market-based approach is more effective than the government-based approach in protecting the interests of public investors in China.

Our study is directly related to the IPO literature (see Ritter, 2003, Ritter, 2011 for reviews of the general IPO literature and Yong, 2007 for a review of the literature on Asian IPOs). Most studies in this literature focus on IPO underpricing and the long term performance of IPOs, but very few studies examine the IPO offer pricing per se. More importantly, while there are significant variations across both countries and time in IPO regulations, there has been little research that compares the costs and benefits of different IPO regulatory regimes. Notable exceptions include Ekkayokkaya and Pengniti (2012) that examine impact of governance reform on IPO underpricing and Cattaneo et al. (2015) that examine how regulatory changes affect IPO firm survival. Our study's contribution is to use the flip-flop of the two IPO offer pricing regimes to demonstrate the consequences of shifting from a government-based to a market-based IPO offer pricing approach in a country with a less developed financial market, China. Our results are important for many emerging market economies because many policy makers and the general public have yet to learn to trust markets (The Economist, 2015).

Our study is also related to the broad earnings management literature in emerging markets. While prior studies have provided evidence of aggressive earnings management by emerging market firms (e.g., Aharony et al., 2000, Chen and Yuan, 2004, Haw et al., 2005), less research is done to identify effective mechanisms to curtail such aggressive earnings management. The evidence from DeFond et al. (2000) shows that many proposed solutions by government regulators are often counterproductive. We contribute to this literature by demonstrating that a market-based approach is more effective than a government-based approach in reducing aggressive earnings management in a weak institutional environment like China.

The rest of the paper is organized as follows. Section 2 describes the sample and data sources. Section 3 explains the institutional details of the three IPO regimes and analyzes the CSRC's incentives. Section 4 discusses the hypothesis development, research design, and regression results on the differences in IPO firms' auditor choice and pre-IPO earnings management across the three IPO regimes. Section 5 examines IPO firms' long term abnormal stock price performance relative to the IPO offer price across the three regimes. Section 6 analyzes the IPO firms' financial reporting quality three-five years after the IPO. Section 7 concludes.

Section snippets

The sample

Many aspects of China's IPOs, including eligibility, timing, offer size, and pricing, are heavily regulated. However, as part of China's economic reforms, China's IPO regulatory environment has experienced several interesting changes over time. In this paper we examine three IPO regulatory regimes over the period January 1, 1997–December 31, 2004. Regime 1 covers January 1, 1997–February 11, 1999; Regime 2 covers February 12, 1999–November 6, 2001; and Regime 3 covers November 7, 2001–December

Institutional background

We first discuss how IPO offer prices are determined under the government-based approach versus the market-based approach during our sample period. During Regime 1 IPO offer prices were largely determined by the CSRC. Specifically, IPO offer prices were determined as the product of an EPS and a relatively fixed PE multiple over the range of 12–15.3

Hypothesis development

In this section we analyze how variations in the IPO pricing mechanisms across Regimes 1–3 affect IPO firms' financial reporting quality in the pre-IPO years. During Regime 1, we expect IPO firms' insiders (i.e., founding shareholders and their appointed managers) to have a strong incentive to inflate reported earnings in the pre-IPO period for two reasons. First, as noted in Section 3, regardless of an IPO firm's growth prospect, the PE multiple imbedded in the offer price prescribed by the

IPO firms' long-term stock price performance

As noted in the Introduction, the debate on the government-based approach versus the market-based approach partially reflects regulators' concern that market forces in weak investor protection countries may not be as effective in pricing IPOs and as a result public investors may end up overpaying for IPOs. In this section we directly test the validity of this concern by examining our sample IPOs' long-term abnormal stock returns relative to the IPO offer prices across the three regimes. To the

Financial reporting quality in the post-IPO period

In this section we examine whether IPO firms' financial reporting quality at the time of the IPO also affects their financial reporting quality long after the IPO, defined as three-five years after the IPO. The conjecture we wish to test is whether a firm has an incentive to maintain the same reporting strategy in the years after the IPO, once the firm has selected a low (high) quality financial reporting strategy at the time of the IPO. We test our conjecture using three complementary

Conclusions

Information asymmetry between corporate insiders and public investors is a constant concern for IPO firms, especially for firms domiciled in weak investor protection countries where corporate insiders have stronger incentives to manipulate the reported information included in IPO prospectuses. To protect public investors from purchasing overpriced IPO shares, securities regulators around the world have adopted different approaches to regulating IPO offer prices, ranging from a government-based

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    We wish to thank an anonymous reviewer, Jeffry Netter (the editor), Sudipta Basu, Francois Brochet, Karthik Ramanna, Siew Hong Teoh, Gwen Yu, Amy Zang, Huai Zhang, and workshop participants at University of California at Irvine, Harvard University, University of International Business and Economics, Shanghai University of Finance and Economics, University of Toronto, Tsinghua University, Xiamen University, China Journal of Accounting Research 2013 Symposium (Zhuhai, China), and the MIT Asia Conference in Accounting for helpful comments. We thank Jaywon Lee for helping us understand the evolution of Korea's IPO regulatory regimes and Douglas Miller for help on the implementation of the wild cluster bootstrap method. Jun Chen acknowledges the financial support from the National Nature Science Foundation of China (approval numbers 71572181 and 71102085).

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