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Penny Stock IPOs Daniel J. Bradley, John W. Cooney, Jr., Steven D. Dolvin, Bradford D. Jordan* We examine underpricing, long-run returns, lockup periods, and gross spreads for penny stock IPOs over the 1990-1998 period. We find that penny stock IPOs have higher initial returns than ordinary IPOs, but significantly worse long-run underperformance. We also find that penny stock IPOs have longer lockup periods and larger gross spreads. To explore the effect of potential market manipulation, we examine IPOs led by a group of underwriters that were the subject of SEC enforcement actions and/or other penalties. Penny stock issues led by these banks are particularly underpriced and underperform ordinary IPOs led by other underwriters. Forthcoming: Financial Management July 15, 2005 The authors thank Ken Cyree, Tim McCormick, Jay Ritter, Ajai Singh, Lemma Senbet and James Seward (the editors), an anonymous referee, and seminar participants at Texas Tech University and the 2002 Financial Management Association meetings in San Antonio, TX. Dan Bradley gratefully acknowledges the financial support of the Spiro Center for Entrepreneurial Leadership at Clemson University. * Daniel J. Bradley is an assistant professor at Clemson University. John W. Cooney, Jr. is an assistant professor at Texas Tech University. Steven D. Dolvin is an assistant professor at Butler University. Bradford D. Jordan is the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. Penny Stock IPOs Introduction Standard research on initial public offerings (IPOs) focuses primarily on “ordinary” IPOs and routinely uses filters to eliminate various types of offerings. Examples of groups that are almost always purged include real estate investment trusts, unit offerings, closed-end investment funds, and American depositary receipts. Other groups that are often dropped include spin-offs, reverse leveraged buyouts, financial firms, mutual-to-stock conversions, and stocks with offer prices below some minimum value. Most of these excluded subgroups have been examined independently; however, there appears to be very little research on IPOs with low offer prices, or so-called “penny stock” IPOs. This lack of research on low-priced IPOs is surprising, given the prominent fraud and manipulation that existed in the 1980s that eventually led to the adoption of the Penny Stock Reform Act of 1990 (PSRA). We explore the similarities and differences between penny stock IPOs and ordinary IPOs in relation to the major findings of IPO research. In keeping with both legal standards and common research practice, we define a penny stock IPO as an IPO that (1) is not issued by an investment advisor (e.g., not a closed-end fund), (2) has an offer price of $5 or less, and (3) is not listed on a national exchange or market. Thus, we classify IPOs listed on the NYSE, AMEX, or Nasdaq National Market as ordinary IPOs regardless of the offer price. Conversely, we classify IPOs listed on other markets (e.g., the Nasdaq SmallCap Market) as penny stock IPOs if the offering is not issued by an investment advisor and the offer price is $5 or less. Given their scandal-plagued past, penny stock IPOs appear to be particularly well suited for examining issues involving market manipulation and informational asymmetries. The firms involved are generally small and often face limited disclosure and reporting requirements, and they are usually underwritten by low prestige investment banks. In addition, penny stock IPOs are much less likely to be backed by venture capital (VC), and there is likely to be little or no institutional buying or analysis of these issues. Based on the 1990-1998 post-PSRA period, we find that penny stock issues show significantly higher initial returns than do ordinary IPOs. To explore the effect of potential market manipulation, we segregate IPOs based on whether the lead underwriter is among a group of 39 banks that were the subject of SEC enforcement actions and/or other penalties. Penny stock issues led by one of these 39 banks have significantly higher underpricing than do ordinary issues led by banks not in this group. We next examine long-run returns. We analyze three- and five-year market-adjusted buy- and-hold returns and find that penny stock IPOs have lower market-adjusted returns than do ordinary IPOs. We reach the same conclusion when we examine the frequency of delistings due to poor performance, as well as monthly abnormal performance using the Fama and French (1993) time-series approach. We show that long-run performance for penny stock IPOs underwritten by the 39 sanctioned banks is significantly worse than that of ordinary IPOs with nonsanctioned underwriters and conclude that the pattern of larger initial returns and subsequent lower long-run returns is consistent with price manipulation in the aftermarket for penny stocks brought to the market by these sanctioned underwriters. In other analyses, we attempt to isolate whether the pattern of higher initial returns and poorer long-run performance for penny stock IPOs is driven by their low offer price or by the market or exchange on which the IPO is initially listed. Our results suggest that initial returns are primarily related to offer price, but that both factors are related to long-run performance. We show that penny stock IPOs typically have much longer stated lockup periods than do ordinary IPOs. These longer periods are consistent with the view that lockup restrictions are a commitment mechanism to help alleviate moral hazard problems. However, we note that the lead 2 underwriter can selectively allow inside shareholders of locked-up shares to sell whenever they wish, and consequently, longer stated lockup periods might be a device to mislead investors rather than to alleviate moral hazard problems. We also find that reported gross spreads for penny stock IPOs are clustered at 10% compared to 7% for ordinary IPOs. Once we factor in additional nonaccountable expense allowances, we find that the actual gross spreads (as opposed to the reported spreads) for penny stock IPOs are typically 13%. Ordinary IPOs rarely have this extra component of underwriter compensation. The paper proceeds as follows. Section I provides background on the penny stock market. Section II presents the data. Section III reports descriptive statistics and empirical results, and section IV concludes. I. Background The market for penny stocks has changed dramatically over the last few decades. Prior to the development of the Nasdaq market in 1971, these stocks were typically traded over the counter or on regional exchanges, often with very limited disclosure requirements. Particularly before the PSRA, the penny stock market was plagued by unscrupulous broker-dealers and underwriters. “Boiler room” tactics were common, with unregistered “brokers” cold-calling primarily unsophisticated investors and using high pressure sales techniques to induce investment. In theory, a firm can undergo a reverse stock split prior to the IPO and increase its offer price, thereby avoiding penny stock status. For example, a $10 million IPO could be packaged as two million shares at $5 per share, or 0.2 million shares at $50 per share. However, a stockbroker might have found it easier to convince an unsophisticated investor that it was more likely that a stock at $5 might hit $20 than a $50 stock would go to $200. Another possible reason for maintaining a lower offer price was that penny stocks tended to be “house stocks” with high 3 percentage bid-ask spreads. A $0.50 bid-ask spread on a $5 stock might be less attention- grabbing than a $5 bid-ask spread on a $50 stock.1 The term “penny stock,” as it is used in the financial press and IPO research, has no precise meaning. The definition may be based on listing requirements. For example, starting in August 1991, the Nasdaq National Market required that stocks have a minimum bid price of $5, and the Nasdaq SmallCap Market required a minimum bid price of $3. In 1997, the minimum bid price was changed to $4 for the Nasdaq SmallCap Market. Alternative listing criteria and discretionary exceptions allow some firms to be listed with lower prices. In screening out low-priced issues, IPO researchers have used different filters. Bradley, Jordan, and Ritter (2003) and Loughran and Ritter (2002) remove all issues that have a midpoint of the original filing range below $8. Ljungqvist and Wilhelm (2003) and Ritter and Welch (2002) exclude stocks with offer prices below $5, and Ritter (1991) eliminates issues with offer prices less than $1. In their study of long-run price performance and mortality for Nasdaq-listed issues over the period 1974-1988, Seguin and Smoller (1997) classify an issue as a penny stock if the first listed price (as opposed to the IPO’s offer price) is less than $3. Also, many studies drop issues that are not in the Center for Research in Security Prices (CRSP) database, which is effectively a screen on nonlisted, lower-priced stocks. Although there are differences across studies, the filters commonly used in recent IPO research closely correspond to the legal definition of a penny stock established by the PSRA. We draw on guidelines provided by the PSRA and Section 17 (§240.3a51-1) of the Code of Federal Regulations (CFR) and define a penny stock IPO as an issue that meets the following three criteria: (1) it is not issued by an investment advisor (e.g., it is not a closed-end fund), (2) its offer price is $5 or less, and (3) it is not listed on a national exchange or market. The PSRA and 1 We thank the referee for suggesting both of these explanations. 4 Section 17 of the CFR identify $5 (net of fees and commissions) as the price cutoff for classification as a penny stock. In addition, the PSRA and Section 17 of the CFR categorize the NYSE, AMEX, and Nasdaq National Market as a “national exchange or market.” Thus, we classify IPOs listed on the NYSE, AMEX, or Nasdaq National Market as “ordinary” without regard to their offer prices. IPOs listed on other markets (such as the Nasdaq SmallCap Market, OTC Bulletin Board, pink sheets, or regional exchanges) are classified as penny stocks if the offering is not issued by an investment advisor and the offer price is $5 or less. In practice, there are complications with our definition. For example, according to the CFR, firms with sufficient net tangible assets are not penny stocks even if their offer price is less than $5. However, lack of accounting data prevents us from considering the issuing firm’s net tangible assets. Blind pools (blank check/shell offerings) may be classified as penny stock issues even with offer prices above $5. Additionally, unit offerings are IPOs that include a package of a share (or shares) of stock and warrants. Thus, a unit offering with an offer price above $5 might also be legally classified as a penny stock if the warrant value is large enough or if multiple shares are issued in the unit. Although many unit offerings are penny stocks, we exclude them from our analyses because of limited data availability and accuracy. In particular, we note substantial data errors in Thomson Financial’s SDC database with regard to units. Further complicating matters, units frequently become unbundled once they start trading, thereby introducing additional opportunity for data errors. II. Data Our primary sample covers 1990-1998, which is the period from the implementation of the PSRA to the beginning of the IPO “bubble” period. There are only three penny stock IPOs during 1999-2000. Such a small sample prevents meaningful analysis, and, as we illustrate later, 5 inclusion of this period distorts the comparison between ordinary and penny stock IPOs, particularly as it relates to underpricing. Thomson Financial’s SDC database lists a total of 5,066 firm-commitment (ordinary and penny stock) IPOs from 1990-1998.2 We eliminate 280 IPOs not identified on CRSP, as well as limited partnerships (21 observations), real estate investment trusts (150 observations), closed- end investment funds (304 observations), spin-offs (547 observations), reverse LBOs (171 observations), mutual-to-stock conversions (15 observations), American/global depositary receipts (106 observations), units and unit trusts (361 observations), shares of beneficial interests (one observation), and firms incorporated outside the U.S. (152 observations), leaving a sample of 2,958 IPOs. Since CRSP only includes stocks traded on the NYSE, AMEX, Nasdaq National Market, and Nasdaq SmallCap Market, we do not include IPOs that initially start trading on the OTCBB, pink sheets, or regional exchanges in our dataset. Following our definition, we classify all offerings that initially start trading on the Nasdaq SmallCap Market and have an offer price less than or equal to $5 as penny stock IPOs. (We do not need to screen further for closed-end funds, since we have already eliminated these IPOs from our sample). We define all other IPOs (i.e., those initially listed on the NYSE, AMEX, and Nasdaq National Market regardless of offer price, and those that initially start trading on the Nasdaq SmallCap Market with an offer price greater than $5) as ordinary IPOs. This process results in a sample of 251 penny stock IPOs and 2,707 ordinary IPOs. III. Descriptive Statistics and Empirical Results In this section, we provide descriptive statistics for our sample and the results of our empirical analyses of penny stock and ordinary IPOs. 2 A number of corrections were made to the SDC database, many of which were provided by Jay Ritter (see http://bear.cba.ufl.edu/ritter/SDC%20corrections.pdf) and Alexander Ljungqvist (see Ljungqvist and Wilhelm, 2003). 6 A. Descriptive Statistics Table I provides basic descriptive statistics on firm and offering characteristics for penny stock and ordinary IPOs for the 1990-1998 period. We obtain the p-values from a t-test for equality of means and assume equal or unequal variances, depending on a test of equality of variances. The first line gives the average offer price for penny stock and ordinary IPOs. As indicated, the average offer price for penny stock IPOs ($4.42) is much smaller than that of ordinary IPOs ($11.83). Offer Size (i.e., shares issued times offer price, not inflation adjusted) is smaller for penny stock issues. In fact, 242 of the 251 penny stock IPOs have an offer size of $10 million or less, and the maximum offer size for a penny stock IPO is $22.4 million. Insert Table I about here HT is a dummy variable that takes the value of one for high-tech firms, and zero otherwise. We obtain the underlying high-tech classification codes from SDC and supplement this information with a list of internet IPOs provided by Jay Ritter (see http://bear.cba.ufl.edu/ ritter/ipodata.htm). In our sample, approximately 32% of penny stock IPOs are high-tech firms, compared to 42% of ordinary IPOs, which is significantly different at the 0.26% level. The variable VC is also a dummy variable, indicating the presence of venture capital (VC) backing. Only 16% of penny stock IPOs are VC-backed, compared to 44% for ordinary IPOs. These percentages are statistically different at the 0.01% level. The variable CM rank represents the Carter and Manaster (1990) underwriter prestige variable as updated by Loughran and Ritter (2004). In our sample, this ranking ranges from one (lowest prestige) to nine (highest prestige). With a mean underwriter prestige ranking of 2.6 compared to 7.1, it is clear that penny stock IPOs are primarily led by lower-ranked underwriters, while ordinary IPOs are led by higher-ranked underwriters. We find that approximately 60% of 7 underwriters that participate in the penny stock IPO market also lead ordinary IPOs. Thus, the penny stock and ordinary IPO markets are not completely segmented. In Figure 1, we look more closely at the Carter and Manaster (1990) ranks. The figure shows the percentages of ordinary and penny stock IPOs led by underwriters of each rank. Because the underwriter ranks are ordinal, the t-test in Table 1 may not be well specified; however, Figure 1 clearly shows that there are two distinct clusters, one in the highest ranks for ordinary IPOs and one in the lowest ranks for penny stock IPOs. Insert Figure 1 about here Loughran and Ritter’s (2004) ranked underwriters include a group of 39 that were subject to enforcement actions by the SEC and/or other penalties, suspensions, and sanctions during the 1990s and early 2000s.3 For example, in 1997, the U.S. Attorney for the Southern District of New York issued an indictment that outlined the infiltration of organized crime families into the brokerage firm of Meyers, Pollock, & Robbins for the purpose of artificially inflating the stock price of HealthTech International. In 2000, the Manhattan District Attorney indicted D.H. Blair & Co., Inc., and various firm members on 173 counts for participating in the “D.H. Blair Criminal Enterprise” during the period 1989-1998. Specific charges included stock price manipulation and the use of illegal sales practices to generate excessive commissions. Sterling Foster & Company, Inc., was charged in 1997 with using boiler room sales tactics to illegally obtain $75 million from investors in connection with the IPOs of six companies. We create a dummy variable, Enforce, that is equal to one if the lead underwriter is in this group of 39. Table I shows that potentially manipulative activity is more prevalent in penny stock IPOs. 3 We thank Jay Ritter for supplying us with an initial list of 32 underwriters. The original source for this information on enforcement actions was the Chicago office of the SEC’s Division of Enforcement for 1995-1999. Additional searching produced the names of another seven underwriters. 8 Approximately 26% of these IPOs are led by this set of underwriters compared to only 4% for ordinary IPOs. The remaining variables in Table I are those that have been most closely examined in the IPO literature: initial return, lockup length, gross underwriting spread, and long-run return. As the table shows, penny stocks have higher initial returns (22.4% compared to 15.4%), longer lockup periods (452 days compared to 208 days), and larger reported gross spreads (9.7% compared to 7.2%). In each case, the difference is statistically significant and economically meaningful. To examine long-run performance, we compute the total dividend- and split-adjusted buy- and-hold percentage return beginning at the end of the first trading day. By doing so, we exclude the initial return. The ending date is either 756 trading days (i.e., three years) after the first day of trading or the delisting return date, whichever is earlier. We use the CRSP delisting return whenever available. When it is not available, we assume that the delisting return for performance-related delists is -30% for NYSE/AMEX stocks, -55% for Nasdaq stocks, and zero for non-performance delists (Shumway, 1997; Shumway and Warther, 1999). We label this variable 3YrRet. Penny stock IPOs have a lower mean 3YrRet than do ordinary IPOs, -21.7% compared to 44.4%. The difference in means between the two groups is statistically significant at the 0.01% level. We then adjust 3YrRet by subtracting the contemporaneous compounded return on the CRSP Nasdaq value-weighted market index and label this variable 3YrMARet. Both penny stock IPOs and ordinary IPOs have negative market adjusted returns (-101.8% compared to - 39.9%), which is consistent with results reported in previous studies (e.g., Ritter, 1991). The difference is statistically significant at the 0.01% level. B. Initial Returns Figure 2 plots the average initial returns by year for penny stock and ordinary IPOs. From 1990 to 1998, penny stock IPOs are more underpriced in every year except 1998. The 1998 result 9 may be due in part to the beginning of the IPO “bubble” period, during which there were very few penny stock IPOs and, at the same time, extraordinarily large initial returns for ordinary IPOs. Of the 252 offerings in 1998, only 14 (or 5.6%) were penny stock IPOs, the lowest percentage across the eight years of our study. In fact, if we include the 1999-2000 period in our sample, ordinary IPOs are more underpriced, on average, than penny stock IPOs (26.2% compared to 22.2%). However, this result is misleading, because, as noted earlier, there are only three penny stock IPOs during the 1999-2000 period. Insert Figure 2 about here The significant difference in initial returns between ordinary and penny stock IPOs may be due to factors commonly discussed in the IPO literature, such as adverse selection and informational asymmetry. These factors may be particularly pronounced in penny stock offerings. However, since sanctioned underwriters lead a substantial percentage of the penny stock offerings in our sample, it is also possible that manipulation drives up first-day market prices beyond their equilibrium levels, leading to higher initial returns. As a first look at this issue, we segment both penny stock IPOs and ordinary IPOs based on the variable Enforce. Table II reports the results of this analysis. Insert Table II about here The results in Table II show that penny stock IPOs led by the sanctioned investment banks have a mean initial return of 31.6% compared to 19.2% for issues not led by this group. These means are significantly different at the 5% level. For ordinary IPOs, there is no statistical difference between the mean initial return for issues led by the 39 sanctioned underwriters (13.3%) and other issues (15.5%). However, the mean initial return for the sample of penny stock IPOs with sanctioned underwriters (31.6%) is significantly higher at the 1% level than is 10 the mean for ordinary IPOs with other underwriters (15.5%). These results suggest that a large portion of the difference in initial returns between the two types of IPOs could be due to manipulation. To examine the underpricing for penny stock and ordinary IPOs in more detail, we estimate the following regression, which controls for important determinants of underpricing identified by previous studies: Initial return = α + β1PS + β2Enforce + β3PS × Enforce + β4VC + β5VC × Enforce + β6Over + β7HT + β8MedRank + β9HighRank + β10Secondary + β11LnSize + β12Integer + β13IPOLag+ β14NasLag + β15Multiple + β16PartU + β17PartD + β18-25Year Dummies + ε (1) where Initial return = percentage return from the offer price to the closing price on the first day of trading PS = dummy variable equal to one if the issue is a penny stock, zero otherwise Enforce = dummy variable equal to one if the lead underwriter is one of a group of 39 that were the subject of SEC enforcement actions and/or other penalties during the 1990s or early 2000s, zero otherwise PS × Enforce = interaction of PS and Enforce VC = dummy variable equal to one if the issue is VC-backed, zero otherwise VC × Enforce = interaction of VC and Enforce Over = “overhang,” measured as pre-IPO shares retained divided by total shares offered HT = dummy variable equal to one if the issuing firm is high-tech, zero otherwise MedRank = dummy variable equal to one if the lead underwriter has a Carter and Manaster (1990) rank greater than or equal to six and less than eight, zero otherwise HighRank = dummy variable equal to one if the lead underwriter has a Carter and Manaster (1990) rank greater than or equal to eight, zero otherwise Secondary = percentage of shares offered that are secondary shares LnSize = natural logarithm of the CPI-adjusted (1982-1984=100) offer size in millions of dollars Integer = dummy variable equal to one if the offer price is an integer, zero otherwise IPOLag = an underpricing index defined as the average initial return, in percent, for all IPOs in the sample for the month before the issue date NasLag = compounded return, in percent, for the CRSP Nasdaq value-weighted market index for the 21 trading days (i.e., one month) prior to the issue date 11 Multiple = dummy variable equal to one if the firm has more than one class of common shares, zero otherwise PartU = percentage difference between the offer price and the original mid-file price if the adjustment is positive, zero otherwise PartD = percentage difference between the offer price and the original mid-file price if the adjustment is negative, zero otherwise, and, Year Dummies = eight dummy variables equal to one if the offering is in year 1991, … , 1998, zero otherwise The first two variables, PS and Enforce, are dummy variables for penny stock status and SEC enforcement actions and/or other penalties, respectively. We include a dummy variable indicating venture capital backing (VC), which we also interact with Enforce (VC × Enforce). The remaining variables are among those widely used in various recent studies of IPO underpricing (e.g., Bradley and Jordan, 2002; Cai, Ramchand, and Warga, 2004; Houge, Loughran, Suchanek, and Yan, 2001; Loughran and Ritter, 2004). Issues with greater overhang (Over) are typically more underpriced over our sample period, as are firms in high-tech industries (HT). Contrary to earlier findings (e.g., Carter and Manaster, 1990), numerous recent studies find that firms associated with prestigious lead underwriters are more underpriced in the 1990s (e.g., Beatty and Welch, 1996; Cooney, Singh, Carter, and Dark, 2001; Dolvin, 2005). Therefore, we include dummy variables for high-prestige banks (ranks eight and higher, HighRank) and medium-prestige banks (ranks greater than or equal to six, but less than eight, MedRank). The omitted category of low-prestige banks includes all of the sanctioned underwriters, most of which are ranked two or lower. Following Habib and Ljungqvist (2001), we include the percentage of secondary shares sold in the IPO (Secondary). Habib and Ljungqvist (2001) find a negative relation between initial returns and this variable. The natural log of the CPI-adjusted size of the deal (LnSize) is a common conditioning variable, but it also controls for the possibility that the relation between penny stock status and initial returns is simply a size effect. A recent study by Bradley, Cooney, Jordan, and Singh (2004) finds that IPOs priced on an integer (Integer) exhibit greater 12 underpricing. The lag variables, IPOLag and NasLag, proxy for the existence of a hot IPO market and investor sentiment. We include Multiple to follow Smart and Zutter (2003), who find that IPOs with multiple share classes are less underpriced. The listing of firms with multiple classes of stock comes from Smart and Zutter (2003), as tracked by Jay Ritter. Because this listing of firms does not include low-priced issues, there may be some penny stock IPOs that have more than one class of common stock, but are not identified as such in our sample. To avoid potential bias associated with this variable, we drop Multiple and repeat the analysis in columns (5) through (8) in Table III, finding results similar to those reported. Finally, PartU and PartD control for the well-known partial adjustment phenomenon documented by Hanley (1993). Following Bradley and Jordan (2002), we include separate variables for upward and downward adjustments because recent studies find evidence of an asymmetric effect (upward adjustments have a much greater impact). Our results are presented in Table III. Throughout this study, p-values from ordinary OLS t-statistics are reported. Insert Table III about here Regressions (1) through (5) in Table III examine all IPOs in our sample. In regression (1), the only independent variable is the dummy PS. Consistent with Table I, the results show that penny stock IPOs are more underpriced than ordinary IPOs by 7%, which is significant at any conventional level. Regression (2) adds the variable Enforce. The penny stock dummy, PS, remains economically and statistically significant, but Enforce is nonsignificant. Our previous results in Table II suggest that penny stock IPOs led by sanctioned underwriters are particularly underpriced; therefore, in regression (3) we include an interaction between PS and Enforce. Consistent with our earlier findings, PS remains significant (p = 0.0549) and Enforce remains nonsignificant. However, the interaction between PS and Enforce is relatively 13 large (14.6%) and highly significant (p = 0.0009). Thus, the evidence so far indicates that penny stocks are more underpriced than are ordinary IPOs, with particularly severe underpricing for penny stock issues led by underwriters that were the subject of SEC enforcement actions and/or other penalties. To examine the effect of VC participation, we include two additional variables in regression (4), the dummy VC and the interaction between VC and Enforce. VC backing is positively related to underpricing, but subsequent analysis shows that this result may be due to industry proxy effects. Of greater interest here is that the coefficient on the interaction term, -19.5%, is economically and statistically significant. This finding indicates that the presence of a venture capitalist substantially reduces the underpricing associated with the group of sanctioned underwriters. A plausible explanation is that the presence of a venture capitalist, who has reputational capital at stake, reduces the likelihood of manipulation, and so plays a valuable certification role in offers underwritten by these particularly low-prestige banks.4 Regression (5) adds the other variables listed in Equation (1) above. The coefficient on PS is 6 and is highly significant. The interaction between PS and Enforce also remains relatively large at 10.7 and significant. The VC dummy is no longer significant, but the interaction between VC and Enforce remains negative and significant with a coefficient of -11. The remaining variables in regression (5) have signs and significance levels that are generally consistent with previous studies. In comparing regressions (4) and (5), the VC dummy moves from positive and highly significant to nonsignificant. As discussed in Bradley and Jordan (2002), the reason VC-backed issues appear to be more underpriced is probably due to industry focus—VCs tend to concentrate 4 An interesting issue arises on the interrelation between VC backing and the group of sanctioned underwriters. The referee points out that VC firms listed in a manipulated offering might not be genuine. To explore this possibility, we examined prospectuses from EDGAR on a small sample of penny stock IPOs with sanctioned underwriters and VC backing (as reported by SDC). In each case, the VC firm listed in the IPO prospectus appeared to be a legitimate VC firm based on industry sources and web sites. 14 in industries with higher underpricing. In our case, for example, adding only the high tech dummy variable, HT, to regression (4) eliminates any significant effect from the VC dummy. In unreported results, we repeat regression (5) of Table III after dropping all IPOs with initial mid-file prices at or above $10.5 Our motivation for this analysis is the possibility that lower- priced IPOs are simply more underpriced than are higher priced IPOs, and that penny stock status per se is not important. Higher initial returns for penny stock IPOs are consistent with Fernando, Krishnamurthy, and Spindt (2004), who find a large degree of underpricing for IPOs with low offer prices. However, Fernando et al. do not specifically examine penny stock status. We find that PS drops in level (3.5) and significance (p = 0.1256), and the coefficient on Enforce remains nonsignificant. However, the coefficient on the interaction of PS and Enforce becomes larger (13.1) and more significant (p = 0.0013). An interesting result from the lower-priced sample is that the coefficient on VC is negative (-4.6) and significant (p = 0.0191), which suggests that VC certification is more important for lower-priced issues. Also, the coefficient on the VC × Enforce interaction remains significantly negative (coefficient = -8.1, p = 0.0977). An important aspect of our analysis of the lower-priced sample is our use of the original mid- file price as the cutoff. If we were to use the offer price, we would create a potentially serious bias because of the partial adjustment phenomenon. Firms with offer prices originally below (above) $10, but subsequently adjusted to more (less) than $10, would be excluded (included). The resulting sample would have a downward bias to its measured underpricing because firms with downward adjustments would be overrepresented relative to firms with upward adjustments. The $5 offer price cutoff we use for defining penny stock status creates a similar, 5 When a firm files its preliminary prospectus with the SEC, an initial file range is given that represents a range of possible offer prices for the issuing firm’s stock. During the registration process, the IPO firm and its underwriters will typically go on a road show pitching the IPO to institutional investors. Using the information gleaned from the road show, and other sources, the offer price is set, which may be within, above, or below the initial file range. For penny stock IPOs, however, it is unlikely that a road show will be undertaken because institutional investors would not be interested in such small offerings (or might be prohibited from purchasing them). Thus, the underwriter may need to set the offer price for penny stock IPOs without the benefit of institutional input. 15 but unavoidable, problem. However, in this case, the effect is that we are biased against finding greater underpricing for penny stock IPOs. That is, our estimates of the difference in underpricing for penny stock IPOs may be downward biased. In fact, during the 1990-1998 period, there are 25 penny stock IPOs (less than 1% of our total IPO sample) that meet this criterion (i.e., have an original mid-file price above $5, but a final offer price of $5 or less), and the average initial return for these 25 IPOs is only 11.7%. As noted earlier, the average initial return for our entire sample of penny stock IPOs is 22.4%. We note that because of changes in issue characteristics and other aspects of the IPO market, there may be some confounding of time-series and cross-sectional effects in our regressions. Thus, we split the sample into three subperiods, IPOs offered during 1990-1992, 1993-1995, and 1996-1998, and repeat regression (5) in Table III for each subperiod. Our main variable, PS, remains positive in all three subperiods, with p-values of 0.0005, 0.1574, and 0.2255, respectively. The two other variables of interest, PS×Enforce and VC×Enforce, are both nonsignificant in the 1990-1992 period, but there are very few IPOs led by sanctioned underwriters during this period. Similar to the results in regression (5) of Table III, PS×Enforce is positive and significant in the later two periods with p-values of 0.0635 and 0.0172, respectively. The interaction of VC and Enforce is negative and significant (p-value = 0.0109) in the 1993-1995 period. For 1996-1998, VC×Enforce is also negative, but with a p-value of 0.1949. It is possible that the control variables used in our Table III regressions affect ordinary IPOs and penny stock IPOs differently. Therefore, we estimate regression (5) from Table III separately for ordinary and penny stock IPOs. We note that in these analyses, we must drop the dummy variable PS (and the interaction of PS and Enforce). The results from these analyses are presented in regressions (6) and (7), respectively, of Table III. Column (8) of Table III reports 16 the p-value for difference tests between the marginal effects (i.e., the estimated coefficients) in each of these regressions. The findings of the ordinary IPO analysis in regression (6) are generally consistent with those from the entire sample. One result of particular interest is that the interaction of VC and Enforce remains negative even with the penny stocks excluded, but the coefficient is significant at only the 16% level. For the penny stock IPOs, only the variables Enforce, the interaction of VC and Enforce, Over, and IPOLag are significant (at the 10% level) in predicting initial returns. The lack of significance for other variables may be due to the relatively small sample size. In many cases, the coefficients in the regressions (6) and (7) are numerically similar. In fact, as column (8) shows, the hypothesis that the coefficients are identical can be rejected at the 10% significance level for only six variables: Enforce, Over, IPOLag, Multiple, PartU, and the 1998 year dummy (not reported). Lee and Wahal (2004) conclude that VC backing is an endogenous variable. Thus, as a final robustness check, we repeat columns (4) through (8) in Table III, using a two-stage least squares framework. The results for PS, Enforce, and PS×Enforce, are similar to those presented in Table III. For Predicted VC, the results are similar to Table III for regression (4) through (6), but the coefficient is now negative and significant in regression (7). Predicted VC×Enforce, however, is nonsignificant in all regressions. Consistent with this last result, we find that none of the predicted venture-backed penny stock IPOs from the first stage regression are brought to the market by a sanctioned underwriter. C. Long-Run Returns We next compare long-run returns for ordinary and penny stock IPOs. If the greater underpricing for penny stock IPOs is driven primarily by economic forces such as informational asymmetry, then the pricing effects should be incorporated into the initial offer and market 17 prices. Therefore, we would expect similar long-run performance for penny stock and ordinary IPOs. However, if price manipulation drives higher penny stock underpricing, then we would expect penny stock IPOs to show lower long-run performance as the post-IPO prices of manipulated issues revert to fundamental levels. As noted in Table I, the sample of penny stock IPOs has a significantly lower mean three- year market-adjusted buy-and-hold return than the sample of ordinary IPOs. We also calculate the market-adjusted buy-and-hold return for the five years following the IPO date for penny stock and ordinary IPOs, 5YrMARet, and present these results in the second row of Table IV. Similar to the three-year results, the mean market-adjusted return calculated over a five-year period for penny stock IPOs is significantly lower than the mean for ordinary IPOs, -126.4% and -55.2%, respectively. Insert Table IV about here In Table IV, we further explore long-term performance. We first examine the percentage of IPOs delisted by the NYSE, AMEX, or Nasdaq because of liquidation or poor performance within three years (and five years) of the IPO date (rows three and four). We identify liquidations as firms with CRSP delist codes of 400-490; performance-related delists are codes 500 and 520- 591. Over the three-year period following the IPO, penny stock IPOs have a significantly higher percentage of firms that delist for liquidation or performance reasons (31.5%) than do ordinary IPOs (6.4%). The most frequent reasons given for delisting are insufficient float, capital, or assets, low stock price, delinquencies in filing, or nonpayment of fees. Analysis over a five-year period shows similar results. In a related study, Beatty and Kadiyala (2003) also find that penny stock IPOs underperform relative to ordinary IPOs and are more likely to delist for performance-related reasons. They investigate whether the PSRA curtailed fraudulent securities issues by comparing IPOs issued 18 during the pre-PSRA period to those issued during the post-PSRA period. Their results indicate that it did not. In particular, they find that measures of issuer quality for non-penny stock IPOs declined significantly between the two periods, suggesting that issuers dodged the new rules by simply issuing securities at higher prices. We next evaluate long-run performance using the Fama and French (1993) time-series approach. To do so, we form monthly value-weighted portfolios for each calendar month. These portfolios comprise all IPOs issued during the previous 60 calendar months (not including the month of issue) that are still CRSP-listed. If the firm delists before the end of the five-year period, we include the delisting return as the final month of the return series. We then regress the monthly value-weighted portfolio returns less the risk-free rate (i.e., NetReturn) on the returns from the three Fama and French (1993) factor portfolios Mkt, SMB, and HML. Mkt is the excess value-weighted total market return, SMB is the return from a portfolio of small capitalization less big capitalization stocks, and HML is the return from a portfolio of high minus low book-to- market firms.6 To reduce the influence of an individual stock on the results, we eliminate a particular month’s observation if there are fewer than ten stocks in the portfolio. We find similar results when cutoffs of five or 15 stocks are used.7 Equation (2), estimated over the period from January 1990 to December 2003, or 168 calendar months, is as follows: NetReturn = α + β1Mkt + β2SMB + β3HML + ε (2) In Equation (2), the intercept (alpha) represents the monthly abnormal return. We use only 139 of the 168 calendar months in the penny stock regressions and 164 of 168 months for the ordinary IPO regressions. The excluded months do not have at least ten stocks with return data. 6 The factor portfolio returns are from Ken French’s website (mba.tuck.dartmouth.edu/pages/faculty/ken.french), where greater detail about their construction is available. 7 As an alternative, we include all months, but use t-statistics constructed with White’s (1980) heteroskedasticity- consistent standard errors. Results are similar to those presented in Table IV. 19 Consistent with our earlier results, we find that penny stock IPOs have an alpha equal to -1.69%, significant at the 1% level, but the alpha for ordinary IPOs is close to zero. To test for differences in abnormal returns, we form a zero-cost portfolio that is long in ordinary IPOs and short in penny stocks IPOs and re-estimate Equation (2), so that the intercept is the difference in abnormal returns. To be included in the difference regressions, the calendar month must include at least ten ordinary IPO stock returns and ten penny stock IPO stock returns. For penny stock and ordinary IPOs, the difference in abnormal performance of 1.71% per month is statistically significant with a p-value of 0.0136 (N = 139 calendar months). To further evaluate the effects of potential manipulation, we again split the sample into two groups based on the variable Enforce, and compare penny stock IPOs led by sanctioned underwriters to ordinary IPOs led by other underwriters. Rows 6-20 of Table IV present our results. Consistent with the presence of market manipulation, according to all three long-run performance measures, the sample of penny stock IPOs with sanctioned underwriters underperforms the sample of ordinary IPOs with nonsanctioned underwriters. The differences in performance measures are quite large. For example, the mean three-year, market-adjusted, buy- and-hold return is -131.8% for penny stock/sanctioned IPOs compared to -37.3% for ordinary/nonsanctioned IPOs. The frequency of performance delists over the three years following the IPO is more than four times larger for penny stock/sanctioned IPOs as compared to ordinary/nonsanctioned offerings. The Fama and French (1993) alpha for penny stock/sanctioned IPOs indicates abnormal performance of -2.73% per month, and the alpha for ordinary/nonsanctioned issues is 0.02%. Further examination of Table IV shows that long-run underperformance is primarily a result of penny stock status. Compared to penny stock IPOs led by a sanctioned underwriter, penny stock IPOs led by nonsanctioned underwriters have higher three- and five-year market-adjusted 20 buy-and-hold returns. However, the frequency of performance delists and Fama and French (1993) alphas are statistically similar for these two groups. It is interesting to note that for ordinary IPOs, the evidence that being led by a sanctioned underwriter results in poorer long- term performance is much stronger. The analysis of long-run returns for sanctioned compared to nonsanctioned underwriters presents a potential endogeneity problem. That is, it is unlikely that an underwriter would have been sanctioned unless at least one of their IPOs had significantly declined in price. Thus, the differential performance between these two groups may be overstated. D. Offer Price Compared to Exchange/Market All 251 penny stock IPOs in our study are listed on the Nasdaq SmallCap Market. However, our sample of ordinary IPOs includes both high-priced offerings that start trading on the Nasdaq SmallCap Market and low-priced offerings that start trading on the AMEX or Nasdaq National Market. To explore the differential impact of high compared to low offer prices and the particular exchange or market on which the IPO starts trading, Table V provides mean initial returns, three- and five-year market-adjusted returns, and three- and five-year delisting frequencies classified by whether the IPO has a high or low offer price (i.e., greater than $5 compared to less than or equal to $5) and the exchange or market where the IPO initially starts trading. We note that the limited sample sizes prevent a meaningful analysis of long-run returns using the Fama and French (1993) time-series approach. Insert Table V about here Table V shows that there are no IPOs with offer prices less than or equal to $5 listed on the NYSE and only nine on the AMEX. However, we find larger numbers of low-priced offerings for IPOs listed on the Nasdaq National Market (48) and Nasdaq SmallCap Market (251). 21 When we focus on the Nasdaq National and SmallCap markets (because of their larger sample sizes), our examination of the point estimates shows that initial returns are higher and long-run performance is poorer for low-priced stocks across both markets. In addition, holding the offer price range constant, IPOs listed on the Nasdaq SmallCap Market have similar initial returns, but lower long-run performance than do the IPOs listed on the Nasdaq National Market. The group with the highest initial returns and lowest long-run performance is our sample of 251 penny stocks. Several of the pair-wise comparisons do not exhibit statistically different means. However, this lack of significance might be driven by the relatively small sample sizes. Overall, our results suggest that differences in initial returns between penny stock and ordinary IPOs are primarily related to offer price, but both the offer price and the stock market where the IPO starts trading are related to long-run performance. E. Lockup Lengths Almost all IPOs are subject to a lockup agreement. This agreement essentially restricts insiders from selling shares for a prespecified time after the IPO without the written consent of the lead underwriter. Bradley, Jordan, Roten, and Yi (2001) and Field and Hanka (2001) find that the length of the lockup period for ordinary IPOs has become standardized at 180 days. Table VI contains an analysis of lockup lengths for penny stock IPOs, broken out by VC- and non-VC-backed issues. Because Bradley, Jordan, Roten, and Yi (2001) find that reported lockup periods of zero days in the SDC database are generally data errors, we drop issues with reported lockup periods of zero in all analyses related to lockup periods. Insert Table VI about here The conventional wisdom is that lockups serve as a commitment device designed to alleviate moral hazard and asymmetric information problems. Longer lockup times may be required when 22 such asymmetry, or the potential for fraud, are especially pronounced. Consistent with this idea, Table I shows that penny stock IPOs have longer lockup periods, on average, than do ordinary IPOs (452 days compared to 208 days, respectively). Table VI shows that 19% of penny stock IPOs have lockups of 180 days or less. In comparison, 86% of ordinary IPOs have lockups of 180 days or less (not reported). VC-backed firms in the penny stock IPO market have an average lockup period of 359 days, compared to 473 days for non-VC-backed firms, which is statistically different at the 1% level. This finding supports the proposition that VC backing reduces agency problems in the penny stock IPO market. In contrast to our results on initial and long-run returns, when we segregate our sample based on Enforce, we find no effect on lockup lengths for penny stock IPOs. For ordinary IPOs, issues led by the sanctioned underwriters have significantly longer lockup lengths. In this case, the difference probably reflects the general tendency for lockup lengths to be shortest for larger issues led by higher-prestige underwriters. Caution in warranted in interpreting differences in stated lockup lengths, particularly when fraud and/or manipulation are a concern. Since insiders can be released from lockups at the underwriter’s discretion, longer stated lockup periods might be used to fool investors into thinking that insiders will not sell out before the end of the stated period, when in fact the underwriter plans to release some (or all) of the shares early. Because public disclosure of early release is not required, it is difficult to determine if underwriters are playing this game. F. Gross Spreads Referring again to Table I, average reported gross spreads are higher for penny stock IPOs (9.7%) than for ordinary IPOs (7.2%). Higher gross spreads for penny stock IPOs are consistent with economies of scale in the offer process, as well as with the greater expenditures (per dollar raised) needed to value and market these more informationally problematic issues. 23 Chen and Ritter (2000) find that over 90% of moderate-sized equity IPOs (i.e., $20 million to $80 million in gross domestic proceeds, expressed in 1997 dollars) from 1995 to 1998 have gross spreads equal to 7%. Over the period we study, penny stock IPOs have a similar clustering around 10%. In fact, over the 1990-1998 period, 80.8% of penny stock issues have reported gross spreads of 10% while 74.9% of ordinary IPOs have gross spreads of 7%.8 Thus, we find that a single fixed spread does not characterize the IPO market. Rather, IPO spreads tend to cluster around two amounts: 7% for ordinary IPOs and 10% for penny stock IPOs. In unreported results, we also examine spreads from the 1980s. For penny stock IPOs, 81.3% have a reported gross spread equal to 10% during this period. Thus, it appears that penny stock gross spreads have remained relatively constant through time. In contrast, as Chen and Ritter (2000) note, the clustering of moderate-sized IPO spreads around 7% is a more recent phenomenon. The difference in gross spreads between penny stock and ordinary IPOs appears to be even wider than reported in Table I. When we reviewed prospectuses for penny stock IPOs listed on the SEC’s EDGAR database for the years 1997 and 1998, we found that for all penny stock IPOs with a 10% direct gross spread, the footnote to the underwriter’s commission included a nonaccountable allowance, almost always equal to 3%. We also examined a sample of ordinary IPOs over the same period, none of which include this allowance. So, penny stock IPOs typically have a true spread of 13%. Barry, Muscarella, and Vetsuypens (1991) observe that breaking the spread into two pieces may allow the underwriter to avoid certain NASD restrictions and state “blue-sky” laws regarding maximum permitted spreads. Second, Barry et al. note that warrants are prevalent in 8 To account for small rounding differences, IPOs with per share gross spreads within 1 penny of 10% (7%) of the offer price are defined as having 10% spreads (7% spreads). 24 smaller, more informationally problematic issues. Thus, the use of underwriter warrants may provide even more compensation to underwriters of penny stock IPOs. After segregating based on Enforce, we find no difference in reported gross spreads for the penny stock IPOs. Ordinary IPOs led by sanctioned underwriters have significantly greater reported spreads than issues led by other underwriters. However, as with lockup lengths, this difference is probably due to issue size. There is a general tendency for smaller issues led by lower prestige underwriters to have larger spreads. IV. Conclusions IPO researchers routinely screen out lower-priced issues and, as a consequence, penny stock IPOs have been largely ignored in the IPO literature. For the post-Penny Stock Reform Act (PSRA) era, after we control for a wide range of issue and market characteristics, we find that penny stock IPOs are significantly more underpriced than are ordinary IPOs. When we examine long-run returns, we find that penny stock IPOs underperform ordinary IPOs. Further tests suggest that higher initial returns for penny stock IPOs are primarily related to their low offer price. However, both the IPO’s offer price and the market or exchange on which it initially starts trading are related to the IPO’s long-run performance. We separately examine IPOs led by a group of 39 underwriters that were the subject of various penalties and enforcement actions in the 1990s and early 2000s. These underwriters account for 26% of our penny stock sample and 4% of our ordinary IPOs. The most notable result is that penny stock IPOs led by these 39 underwriters are significantly more underpriced and subsequently perform significantly worse over the long run than do ordinary IPOs led by other underwriters. This pattern of high initial returns, followed by especially poor long-run performance for penny stock issues led by these underwriters, suggests that market manipulation and/or fraud may explain a substantial part of the underpricing and long-run underperformance 25 of penny stock IPOs. These results also suggest that despite reforms such as the PSRA, the penny stock market remains a potentially fertile ground for market manipulation and fraud. We provide evidence that penny stock IPOs have substantially longer lockup periods and larger gross spreads than do ordinary IPOs. Longer lockup periods for penny stock IPOs can serve as a commitment device to reduce problems associated with moral hazard and asymmetric information. However, because underwriters can release shares from the lockup at their discretion without public notification, it is not clear how effective this device would be for penny stock IPOs if the underwriters are involved in stock price manipulation. We find that there are shorter lockups lengths for penny stock IPOs with venture capital backing, which suggests a potential certification role for VC firms. Higher gross spreads for penny stock IPOs are consistent with economies of scale in the offer process, as well as with the greater expenditures (per dollar raised) needed to value and market these more informationally problematic issues. 26 References Barry, C., Muscarella, C., and M. Vetsuypens, 1991, “Underwriter Warrants, Underwriter Compensation, and the Costs of Going Public,” Journal of Financial Economics 29, 113-135. Beatty, R. and P. Kadiyala, 2003, “Impact of the Penny Stock Reform Act of 1990 on the IPO Market,” Journal of Law and Economics 46, 517-542. Beatty, R. and I. Welch, 1996, “Issuer Expenses and Legal Liability in Initial Public Offerings,” Journal of Law and Economics 39, 545-602. Bradley, D., Cooney, J., Jordan, B., and A. Singh, 2004, “Negotiation and the IPO Offer Price: A Comparison of Integer Versus Non-integer IPOs,” Journal of Financial and Quantitative Analysis 39, 517-540. Bradley, D. and B. 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Hanley, K., 1993, “The Underwriting of Initial Public Offerings and the Partial Adjustment Phenomenon,” Journal of Financial Economics 34, 231-250. Houge, T., Loughran, T., Suchanek, G., and X. Yan, 2001, “Divergence of Opinion, Uncertainty, and the Quality of Initial Public Offerings,” Financial Management 30, 5-23. Lee, P. and S. Wahal, 2004, “Grandstanding, Certification and the Underpricing of Venture Capital Backed IPOs,” Journal of Financial Economics 73, 375-407. Ljungqvist, A. and W. Wilhelm, 2003, “IPO Pricing in the Dot-com Bubble,” Journal of Finance 58, 723-752. Loughran, T. and J. Ritter, 2002, “Why Don’t Issuers Get Upset About Leaving Money on the Table in IPOs?” Review of Financial Studies 15, 413-443. Loughran, T. and J. Ritter, 2004, “Why Has IPO Underpricing Changed over Time?” Financial Management 33, 5-37. New York State Attorney General, 1997, “Report on Microcap Stock Fraud,” Bureau of Investor Protection and Services. Ritter, J., 1991, “The Long-run Performance of Initial Public Offerings,” Journal of Finance 46, 3-27. Ritter, J. and I. Welch, 2002, “A Review of IPO Activity, Pricing, and Allocations,” Journal of Finance 57, 1795-1828. Seguin, P., and M. Smoller, 1997, “Share Price and Mortality: An Empirical Evaluation of Newly Listed Nasdaq Stocks,” Journal of Financial Economics 45, 333-363. Shumway, T., 1997, “The Delisting Bias in CRSP Data,” The Journal of Finance 52, 327-340. Shumway, T. and V. Warther, 1999, “The Delisting Bias in CRSP’s Nasdaq Data and Its Implications for the Size Effect,” Journal of Finance 54, 2361-2379. Smart, S. and C. Zutter, 2003, “Control as a Motivation for Underpricing: A Comparison of Dual- and Single-class IPOs,” Journal of Financial Economics 69, 85-110. White, H., 1980, “A Heteroskedasticity-Consistent Covariance Matrix and a Direct Test for Heteroskedasticity,” Econometrica 48, 817-838. 28 Table I. Firm Characteristics This table reports means and standard deviations for penny stock and ordinary IPOs. We define penny stock IPOs as offerings that are not issued by an investment advisor (e.g., not a closed-end fund), have an offer price at or below $5, and are not listed on a national exchange or market (i.e., not listed on the NYSE, AMEX, or Nasdaq National Market). All other offerings are ordinary IPOs. Offer price is the issue’s offer price. Offer size is the gross proceeds of the offer in millions of dollars, not including the over-allotment option, and is not inflation-adjusted. HT is a dummy variable equal to one if the issue is classified as high-tech, zero otherwise. VC is a dummy variable equal to one if the issue is venture capital- backed, zero otherwise. CM rank is the Carter and Manaster (1990) underwriter prestige ranking for the lead underwriter (as updated by Loughran and Ritter, 2004). Enforce is a dummy variable equal to one if the lead underwriter is one of a group of 39 that were the subject of SEC enforcement actions and/or other penalties during the 1990s and early 2000s, zero otherwise. Initial return is the percentage return from the offer price to the closing price on the first day of trading. Lockup is the length of the lockup period in days. Spread is the reported gross dollar spread (i.e., underwriting discount) paid to the underwriter as a percentage of the offer size, not including nonaccountable expense allowances. 3YrRet is the total dividend- and split-adjusted buy-and-hold return in percent, calculated from the end of the first trading day to three years (i.e., 756 trading days) after the first day of trading (or the delisting return date, whichever is earlier). 3YrMARet is equal to 3YrRet less the contemporaneous compounded return on the CRSP Nasdaq value-weighted market index. We obtain our data from Thomson Financial’s SDC New Issues database and the CRSP database. We obtain p-values from a t-test of equality of means between penny stock and ordinary IPOs, which we calculate by assuming equal or unequal variances, depending on a test of equality of variances. We assume independence of observations. The sample period is 1990– 1998. We exclude firms not identified on the CRSP database, limited partnerships, real estate investment trusts, spin-offs, reverse LBOs, mutual-to-stock conversions, American/global depositary receipts, units and unit trusts, shares of beneficial interests, and firms incorporated outside of the U.S., which results in a total of 251 penny stock and 2,707 ordinary IPOs. Penny Stock Compared to Penny Stock IPOs Ordinary IPOs Ordinary Variable N Mean Std dev N Mean Std dev p-value Offer price, $ 251 4.42 0.80 2,707 11.83 4.12 0.0001 Offer size, $ millions 251 5.7 2.3 2,707 43.6 58.7 0.0001 HT 251 0.32 0.47 2,707 0.42 0.49 0.0026 VC 251 0.16 0.36 2,707 0.44 0.50 0.0001 CM rank 251 2.6 1.1 2,707 7.1 2.1 0.0001 Enforce 251 0.26 0.44 2,707 0.04 0.20 0.0001 Initial return (%) 251 22.4 29.3 2,707 15.4 25.1 0.0003 Lockup (days) 207 452 226 2,297 208 102 0.0001 Spread (%) 250 9.7 0.6 2,706 7.2 0.8 0.0001 3YrRet (%) 251 -21.7 136.1 2,707 44.4 243.1 0.0001 3YrMARet (%) 251 -101.8 136.9 2,707 -39.9 242.8 0.0001 29 Table II. Initial Returns: Penny Stock IPOs Compared to Ordinary IPOs This table presents the mean for Initial return (the percentage return from the offer price to the closing price on the first day of trading) for penny stock IPOs and ordinary IPOs (first row), and for penny stock IPOs and ordinary IPOs based on whether the lead underwriter is one of a group of 39 that were the subject of SEC enforcement actions and/or other penalties during the 1990s and early 2000s (second and third rows). We label these underwriters as “sanctioned,” and all others as “nonsanctioned.” We define penny stock IPOs as offerings that are not issued by an investment advisor (e.g., not a closed-end fund), have an offer price at or below $5, and are not listed on a national exchange or market (i.e., not listed on the NYSE, AMEX, or Nasdaq National Market). All other offerings are ordinary IPOs. We obtain our data from Thomson Financial’s SDC New Issues database and the CRSP database. We obtain p-values in the last column from a t-test of equality of means between penny stock and ordinary IPOs. We obtain p- values in the last row from a t-test of equality of means between IPOs with sanctioned and nonsanctioned underwriters. We obtain the p-value in the lower right-hand corner from a t-test of equality of means between penny stock/sanctioned IPOs and ordinary/nonsanctioned IPOs. We calculate the p-values by assuming equal or unequal variances, depending on tests of equality of variances. We assume independence of observations. The sample period is 1990–1998. We exclude firms not identified on the CRSP database, limited partnerships, real estate investment trusts, spin-offs, reverse LBOs, mutual-to- stock conversions, American/global depositary receipts, units and unit trusts, shares of beneficial interests, and firms incorporated outside of the U.S., which results in a total of 251 penny stock and 2,707 ordinary IPOs. Penny Stock Compared to Ordinary Initial return (%) Penny Stock IPOs Ordinary IPOs p-values (1) (2) (3) All IPOs (1) 22.4 15.4 0.0003 (N = 251) (N = 2,707) Sanctioned (2) 31.6 13.3 0.0011 (N = 65) (N = 118) Nonsanctioned (3) 19.2 15.5 0.0522 (N = 186) (N = 2,589) Sanctioned Compared to Nonsanctioned p-value (4) 0.0228 0.2737 0.0023 30 Table III. Regression Results for Initial Returns This table provides regression results, with p-values in parentheses, for initial returns as follows: Initial return = α + β1PS + β2Enforce + β3PS × Enforce + β4VC + β5VC × Enforce + β6Over + β7HT + β8MedRank + β9HighRank + β10Secondary + β11LnSize + β12Integer + β13IPOLag + β14NasLag + β15Multiple + β16PartU + β17PartD + β18-25Year Dummies + ε where Initial return = percentage return from the offer price to the closing price on the first day of trading PS = dummy variable equal to one if the issue is a penny stock, zero otherwise Enforce = dummy variable equal to one if the lead underwriter is one of a group of 39 that were the subject of SEC enforcement actions and/or other penalties during the 1990s or early 2000s, zero otherwise PS × Enforce = interaction of PS and Enforce VC = dummy variable equal to one if the issue is VC-backed, zero otherwise VC × Enforce = interaction of VC and Enforce Over = “overhang,” which we measure as pre-IPO shares retained divided by total shares offered HT = dummy variable equal to one if the issuing firm is high-tech, zero otherwise MedRank = dummy variable equal to one if the lead underwriter has a Carter and Manaster (1990) rank greater than or equal to six and less than eight, zero otherwise HighRank = dummy variable equal to one if the lead underwriter has a Carter and Manaster (1990) rank greater than or equal to eight, zero otherwise Secondary = percentage of shares offered that are secondary shares LnSize = natural logarithm of the CPI-adjusted (1982-1984=100) offer size in millions of dollars Integer = dummy variable equal to one if the offer price is an integer, zero otherwise IPOLag = an underpricing index defined as the average initial return, in percent, for all IPOs in the sample for the month before the issue date NasLag = compounded return, in percent, for the CRSP Nasdaq value-weighted market index for the 21 trading days (i.e., one month) prior to the issue date Multiple = dummy variable equal to one if the firm has more than one class of common shares, zero otherwise PartU = percentage difference between the offer price and the original mid-file price if the adjustment is positive, zero otherwise PartD = percentage difference between the offer price and the original mid-file price if the adjustment is negative, zero otherwise, and, Year Dummies = eight dummy variables equal to one if the offering is in year 1991, … , 1998, zero otherwise Regressions (1) through (5) examine all IPOs over the period. Regression (6) uses only ordinary IPOs, and regression (7) uses only penny stock IPOs. Column (8) reports the p-value for a difference test between the coefficients from regressions (6) and (7). We define penny stock IPOs as offerings that are not issued by an investment advisor (e.g., not a closed-end fund), have an offer price at or below $5, and are not listed on a national exchange or market (i.e., not listed on the NYSE, AMEX, or Nasdaq National Market). All other offerings are ordinary IPOs. We obtain our data from Thomson Financial’s SDC New Issues database and the CRSP database. The sample period is 1990–1998. We exclude firms not identified on the CRSP database, limited partnerships, real estate investment trusts, spin-offs, reverse LBOs, mutual-to-stock conversions, American/global depositary receipts, units and unit trusts, shares of beneficial interests, and firms incorporated outside of the U.S., which results in a total of 251 penny stock and 2,707 ordinary IPOs. 31 Table III - Continued Dependent variable = Initial return p-value: Penny (6) Ordinary Stock Compared All IPOs IPOs IPOs to (7) (1) (2) (3) (4) (5) (6) (7) (8) Intercept 15.4 15.3 15.5 14.0 -0.5 -0.7 3.1 0.7008 (0.0001) (0.0001) (0.0001) (0.0001) (0.8635) (0.8180) (0.7958) PS 7.0 6.5 3.7 4.7 6.0 Na Na Na (0.0001) (0.0002) (0.0549) (0.0161) (0.0032) Enforce 2.1 -2.2 2.3 2.6 2.1 15.4 0.0032 (0.2882) (0.3538) (0.3774) (0.2867) (0.3885) (0.0013) PS × Enforce 14.6 12.8 10.7 Na Na Na (0.0009) (0.0035) (0.0069) VC 3.4 -1.2 -1.2 -2.7 0.7682 (0.0006) (0.2354) (0.2036) (0.6601) VC × Enforce -19.5 -11.0 -7.3 -21.1 0.2022 (0.0001) (0.0138) (0.1594) (0.0799) Over 2.0 1.9 4.9 0.0307 (0.0001) (0.0001) (0.0053) HT 3.5 3.9 -0.8 0.1564 (0.0002) (0.0001) (0.8355) MedRank -0.7 -0.7 Na Na (0.6556) (0.6132) HighRank 1.4 1.4 Na Na (0.3585) (0.3639) Secondary -0.4 -0.5 -22.2 0.2243 (0.8692) (0.8392) (0.3243) LnSize -1.5 -1.4 -4.6 0.5074 (0.0318) (0.0349) (0.4451) Integer 2.9 3.2 0.2 0.4204 (0.0028) (0.0015) (0.9619) IPOLag 0.3 0.2 0.9 0.0105 (0.0001) (0.0001) (0.0069) NasLag 0.5 0.5 -0.0 0.1460 (0.0001) (0.0001) (0.9885) Multiple -1.4 -1.5 25.1 0.0983 (0.4177) (0.3709) (0.2174) PartU 0.8 0.8 0.3 0.0104 (0.0001) (0.0001) (0.2605) PartD 0.2 0.3 -0.0 0.1405 (0.0001) (0.0001) (0.9541) Year Dummies Included Included Included Included Adj R2 0.0055 0.0055 0.0089 0.0156 0.2583 0.2785 0.1104 N 2,958 2,958 2,958 2,958 2,947 2,699 248 32 Table IV. Long-run Returns: Penny Stock IPOs Compared to Ordinary IPOs The table presents long-run returns for penny stock IPOs and ordinary IPOs (rows 1–5), and for penny stock IPOs and ordinary IPOs based on whether the lead underwriter is one of a group of 39 that were the subject of SEC enforcement actions and/or other penalties during the 1990s and early 2000s (rows 6–15). We label these underwriters as “sanctioned” and all others as “nonsanctioned.” We define penny stock IPOs as offerings that are not issued by an investment advisor (e.g., not a closed-end fund), have an offer price at or below $5, and are not listed on a national exchange or market (i.e., not listed on the NYSE, AMEX, or Nasdaq National Market). All other offerings are ordinary IPOs. We obtain our data from Thomson Financial’s SDC New Issues database and the CRSP database. 3YrMARet (5YrMARet) is the total dividend- and split-adjusted buy-and-hold return in percent, calculated from the end of the first trading day to 756 trading days, i.e., three years, (1,260 trading days, i.e., five years) after the first day of trading (or the delisting return date, whichever is earlier) minus the contemporaneous compounded return on the CRSP Nasdaq value-weighted market index. 3YrDelist (5YrDelist) is a dummy variable equal to one if the firm delists from the NYSE, AMEX, or Nasdaq within three years (five years) after the offer date due to liquidation (i.e., CRSP delist codes 400-490) or poor performance (i.e., CRSP delist codes 500 and 520-591), zero otherwise. FF alpha is the intercept from the Fama and French (1993) time-series regression of NetReturn (the monthly value-weighted returns from a portfolio of IPO stocks less the risk- free rate) against Mkt (the excess value-weighted total market return), SMB (the return from a portfolio of small capitalization less big capitalization stocks), and HML (the return from a portfolio of high minus low book-to-market stocks). Market returns, risk-free returns, and returns for the SMB and HML portfolios are from Ken French’s website (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/) from 1990 to 2003. The portfolio of IPO stocks used to compute NetReturn comprises all IPOs issued during the previous 60 calendar months (not including the month of issue) that are still CRSP-listed. We exclude a month if NetReturn for that month is computed with fewer than ten stocks. We obtain the p-values in rows 1-15 of the fifth column for 3YrMARet, 5YrMARet, 3YrDelist, and 5YrDelist from a t-test of equality of means between penny stock and ordinary IPOs. The p-value corresponding to FF alpha is the p-value from our test of whether the intercept is different from zero in the Fama and French (1993) regression in which the dependent variable, NetReturn, is from a portfolio that is long in ordinary IPOs and short in penny stock IPOs. We obtain the p-values in rows 16-20 of columns one and three for 3YrMARet, 5YrMARet, 3YrDelist, and 5YrDelist from a t-test of equality of means between IPOs with sanctioned and nonsanctioned underwriters. The p-value corresponding to FF alpha is the p-value from our test of whether the intercept is different from zero in the Fama and French (1993) regression in which the dependent variable, NetReturn, is from a portfolio that is long in IPOs with nonsanctioned underwriters and short in IPOs with sanctioned underwriters. We obtain the p-values in rows 16-20 of the fifth column for 3YrMARet, 5YrMARet, 3YrDelist, and 5YrDelist from a t-test of equality of means between penny stock/sanctioned IPOs and ordinary/nonsanctioned IPOs. The p-value corresponding to FF alpha is the p- value from our test of whether the intercept is different from zero in the Fama and French (1993) regression in which the dependent variable, NetReturn, is from a portfolio that is long in ordinary/nonsanctioned IPOs and short in penny stock/sanctioned IPOs. We calculate the p-values from the tests of differences in means by assuming equal or unequal variances, depending on a test of equality of variances. N is the number of IPOs in t-tests of equality of means and is the number of calendar months for Fama and French (1993) alphas. We assume independence of observations in our two-sample t-tests. The sample period is 1990–1998. We exclude firms not identified on the CRSP database, limited partnerships, real estate investment trusts, spin-offs, reverse LBOs, mutual-to-stock conversions, American/global depositary receipts, units and unit trusts, shares of beneficial interests, and firms incorporated outside of the U.S., which results in a total of 251 penny stock and 2,707 ordinary IPOs. 33 Table IV – Continued Penny Stock Compared to Penny Stock*** N Ordinary*** N Ordinary p-value (1) *** (2) (3)*** (4) (5) All IPOs 3YrMARet (1) -101.8%*** 251 -39.9%*** 2,707 0.0001 5YrMARet (2) -126.4%*** 251 -55.2%*** 2,707 0.0004 3YrDelist (3) 31.5%*** 251 6.4%*** 2,707 0.0001 5YrDelist (4) 51.4%*** 251 14.3%*** 2,707 0.0001 FF alpha (5) -1.69%*** 139 -0.01%*** 164 0.0136 Sanctioned 3YrMARet (6) -131.8%*** 65 -97.7%*** 118 0.0779 5YrMARet (7) -162.6%*** 65 -124.8%*** 118 0.1007 3YrDelist (8) 26.2%*** 65 18.6%*** 118 0.2375 5YrDelist (9) 44.6%*** 65 35.6%*** 118 0.2330 FF alpha (10) -2.73%*** 99 0.01%*** 116 0.0924 Nonsanctioned 3YrMARet (11) -91.3%*** 186 -37.3%*** 2,589 0.0001 5YrMARet (12) -113.8%*** 186 -52.0%*** 2,589 0.0168 3YrDelist (13) 33.3%*** 186 5.8%*** 2,589 0.0001 5YrDelist (14) 53.8%*** 186 13.4%*** 2,589 0.0001 FF alpha (15) -1.33%*** 137 0.02%*** 162 0.0746 Sanctioned Compared to Nonsanctioned p-value 3YrMARet (16) 0.0218*** 0.0001*** 0.0001 5YrMARet (17) 0.0896*** 0.0002*** 0.0001 3YrDelist (18) 0.2852*** 0.0006*** 0.0005 5YrDelist (19) 0.2055*** 0.0001*** 0.0001 FF alpha (20) 0.2211*** 0.7991*** 0.0151 *** ** * , , indicate that the mean for 3YrMARet, 5YrMARet, or FF alpha is statistically different from zero at the 0.01, 0.05, or 0.10 levels, respectively. A comparable test for 3YrDelist and 5YrDelist is not applicable. 34 Table V. Initial and Long-run Returns: Offer Price Compared to Stock Market This table presents mean initial and long-run returns based on the IPO’s offer price (above $5 compared to less than or equal to $5) and the exchange or market where the IPO starts trading (NYSE, AMEX, Nasdaq National Market, or Nasdaq SmallCap Market). Initial return is the percentage return from the offer price to the closing price on the first day of trading. 3YrMARet (5YrMARet) is the total dividend- and split-adjusted buy-and-hold return in percent, calculated from the end of the first trading day to 756 trading days, i.e., three years, (1,260 trading days, i.e., five years) after the first day of trading (or the delisting return date, whichever is earlier) minus the contemporaneous compounded return on the CRSP Nasdaq value-weighted market index. 3YrDelist (5YrDelist) is a dummy variable equal to one if the firm delists from the NYSE, AMEX, or Nasdaq within three years (five years) after the offer date due to liquidation (i.e., CRSP delist codes 400-490) or poor performance (i.e., CRSP delist codes 500 and 520- 591), zero otherwise. We obtain the p-values in rows 7-23 of the third column from a t-test of equality of means between IPOs with an offer price above $5 compared to IPOs with an offer price less than or equal to $5. We obtain the p-values in rows 25-29 in columns one and two from a t-test of equality of means between IPOs that are initially listed on the Nasdaq National Market compared to the Nasdaq SmallCap Market. We obtain the p-values in rows 25-29 of the third column from a t-test of equality of means between IPOs with an offer price greater than $5 and listed on the Nasdaq National Market compared to IPOs with an offer price less than or equal to $5 and listed on the Nasdaq SmallCap Market. We calculate p-values by assuming equal or unequal variances, depending on a test of equality of variances. We assume independence of observations. The sample period is 1990–1998. We obtain our data from Thomson Financial’s SDC New Issues database and the CRSP database. We exclude firms not identified on the CRSP database, limited partnerships, real estate investment trusts, spin-offs, reverse LBOs, mutual-to-stock conversions, American/global depositary receipts, units and unit trusts, shares of beneficial interests, and firms incorporated outside of the U.S., which results in a total of 2,958 IPOs. 35 Table V – Continued Offer price > $5 Compared to. ≤ $5 Offer Price > $5 Offer Price ≤ $5 p-value (1) (2) (3) NYSE Initial return (1) 11.2% NA NA 3YrMARet (2) -52.0% NA NA 5YrMARet (3) -53.1% NA NA 3YrDelist (4) 2.4% NA NA 5YrDelist (5) 9.3% NA NA N (6) 246 0 AMEX Initial return (7) 5.0% 8.8% 0.3612 3YrMARet (8) -82.6% -162.1% 0.0019 5YrMARet (9) -65.6% -218.0% 0.0407 3YrDelist (10) 10.0% 11.1% 0.9209 5YrDelist (11) 20.0% 22.2% 0.8814 N (12) 50 9 Nasdaq National Initial return (13) 16.0% 21.3% 0.1637 3YrMARet (14) -33.6% -36.4% 0.9409 5YrMARet (15) -48.4% -125.0% 0.0066 3YrDelist (16) 5.3% 12.5% 0.1468 5YrDelist (17) 12.5% 35.4% 0.0020 N (18) 2187 48 Nasdaq SmallCap Initial return (19) 16.3% 22.4% 0.0249 3YrMARet (20) -86.4% -101.8% 0.3538 5YrMARet (21) -114.3% -126.4% 0.6048 3YrDelist (22) 22.2% 31.5% 0.0372 5YrDelist (23) 37.7% 51.4% 0.0059 N (24) 167 251 Nasdaq Natl. Compared to Nasdaq SmallCap p-value Initial return (25) 0.8776 0.8057 0.0010 3YrMARet (26) 0.0006 0.0925 0.0001 5YrMARet (27) 0.0002 0.9635 0.0002 3YrDelist (28) 0.0001 0.0012 0.0001 5YrDelist (29) 0.0001 0.0426 0.0001 36 Table VI. Lockup Times for Penny Stock IPOs This table shows the distribution of lockup times for penny stock IPOs. We also compare lockup times for penny stock IPOs that are VC-backed compared to those that are not VC-backed. We define penny stock IPOs as offerings that are not issued by an investment advisor (e.g., not a closed-end fund), have an offer price at or below $5, and are not listed on a national exchange or market (i.e., not listed on the NYSE, AMEX, or Nasdaq National Market). We obtain our data from Thomson Financial’s SDC New Issues database and the CRSP database. The sample period is 1990–1998. We exclude firms not identified on the CRSP database, limited partnerships, real estate investment trusts, spin-offs, reverse LBOs, mutual-to- stock conversions, American/global depositary receipts, units and unit trusts, shares of beneficial interests, and firms incorporated outside of the U.S., which results in a total of 251 penny stock IPOs. VC-backed Non-VC-backed Combined Days in Firms Cumulative Firms Cumulative Firms Cumulative lockup percentage percentage percentage <90 0 0.0 1 0.6 1 0.5 90 1 2.6 9 5.9 10 5.3 91-179 2 7.9 2 7.1 4 7.2 180 9 31.6 16 16.6 25 19.3 181-359 2 36.8 4 18.9 6 22.2 360-366 9 60.5 43 44.4 52 47.3 367-540 8 81.6 37 66.3 45 69.1 541-549 2 86.8 8 71.0 10 73.9 550-719 0 86.8 0 71.0 0 73.9 720-732 4 97.4 44 97.0 48 97.1 >732 1 100.0 5 100.0 6 100.0 38 100.0 169 100.0 207 100.0 Mean 359 days 473 days 452 days 37 Figure 1. Distribution of IPOs by Carter and Manaster (1990) Underwriter Rank The figure provides the percentage distribution of IPOs by Carter and Manaster (1990) rank (as updated by Loughran and Ritter, 2004), where nine is the highest rank. Penny stock IPOs appear in grey, ordinary IPOs in black. We define penny stock IPOs as offerings that are not issued by an investment advisor (e.g., not a closed-end fund), have an offer price at or below $5, and are not listed on a national exchange or market (i.e., not listed on the NYSE, AMEX, or Nasdaq National Market). We obtain our data from Thomson Financial’s SDC New Issues database and the CRSP database. The sample period is 1990– 1998. We exclude firms not identified on the CRSP database, limited partnerships, real estate investment trusts, spin-offs, reverse LBOs, mutual-to-stock conversions, American/global depositary receipts, units and unit trusts, shares of beneficial interests, and firms incorporated outside of the U.S., which results in a total of 251 penny stock IPOs and 2,707 ordinary IPOs. 45% 40% 35% 30% Percent of IPOs 25% 20% 15% 10% 5% 0% 1 2 3 4 5 6 7 8 9 Carter and Manaster (1990) Rank Penny Stock IPOs Ordinary IPOs 38 Figure 2. Initial Returns by Year This figure shows initial returns by year. Initial return is the percentage return from the offer price to the closing price on the first day of trading. Penny stock IPOs appear in grey, ordinary IPOs in black. We define penny stock IPOs as offerings that are not issued by an investment advisor (e.g., not a closed-end fund), have an offer price at or below $5, and are not listed on a national exchange or market (i.e., not listed on the NYSE, AMEX, or Nasdaq National Market). We obtain our data from Thomson Financial’s SDC New Issues database and the CRSP database. The sample period is 1990–1998. We exclude firms not identified on the CRSP database, limited partnerships, real estate investment trusts, spin-offs, reverse LBOs, mutual-to-stock conversions, American/global depositary receipts, units and unit trusts, shares of beneficial interests, and firms incorporated outside of the U.S., which results in a total of 251 penny stock IPOs and 2,707 ordinary IPOs. 40% 35% 30% 25% Initial Return 20% 15% 10% 5% 0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 Year Penny Stock IPOs Ordinary IPOs 39

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