An empirical investigation of IPO underpricing and the change to the LLP organization of audit firms.

INTRODUCTION

This paper provides evidence on the relationship between the change in audit firm legal structure to limited liability partnerships (LLPs) and the pricing of initial public offerings (IPOs). During the early 1990s, the auditing profession asserted that it faced a liability crisis." (1) In response to the adverse litigation climate, the profession successfully lobbied for changes to reduce audit firms' legal liabilities. One particularly significant change was the AICPA's by-law changes in 1992 that allowed audit firms to practice under any organizational form allowed by state laws. This change enabled audit firms to practice under limited liability (LL) organizational forms. As state laws were changed to allow LL forms of organization, many audit firms converted to LL forms of practice. By late 1994, all Big 6 audit firms converted from general partnerships to LLPs.

Audit firms provide implicit insurance in the case of corporate failures (Wallace 1980). Since audit firm liability arises from opining upon misleading financial statements, a firm's association with the financial statements provides insurance to investors and financial intermediaries who rely on the financial statements. Under a LLP, personal assets of individual partners, who were not directly involved in a client's litigation, are no longer available to pay a partnership's liabilities. Thus, the LLP form of practice reduces the implicit insurance provided by audit firms. (2) In addition, the reduction in auditor legal liability associated with the LLP form of practice can also reduce audit quality. In a general partnership, every partner is personally liable for all services provided by the audit firm, which provides an incentive for partners to monitor the quality of the services provided by their fellow partners. Under LLP provisions, nonnegligent partners are absolved of personal liability. To the extent that intrafirm monitoring incentives are reduced, audit quality could be reduced subsequent to the adoption of a LLP organizational form. (3)

Several features of the IPO market increase the importance of the services provided by audit firms that are associated with the IPOs. First, there is relatively little public information available about IPO organizations, so the proxy statement, financial reports, and the audit firm's opinion are vital sources of information for underwriters and investors. Second, companies entering the IPO market often have a high level of financial risk. For example, IPO companies more often exhibit financial distress than established companies (Ritter 1991; Beatty 1993). Finally, IPOs are covered by the 1933 Securities Act, a law with features favorable to plaintiffs for recovering damages.

We use IPO underpricing to measure the security pricing implications of the change in auditor liability status. Underpricing occurs when the initial offer price of a security is less than its trading price shortly after the security begins trading. Tinic (1988) proposes that underpricing is an implicit insurance premium charged by underwriters. Underwriters offer the securities at a discount to protect themselves and stock issuers against legal liabilities and associated damages. Generally, the IPO offer price sets an upper limit on the maximum damages that investors can sue for under the 1933 Securities Act. Lowering the initial offer price serves as a form of insurance for underwriters against post-offering litigation losses. In essence, IPOs contain a "put option"--that is, an option to sue to recover losses, given to the IPO purchasers, and underpricing reduces the cost of the "put option" to the underwriter.

The change to LLP status reduced the funds available to settle litigation related to failed IPOs. Underwriters may respond rationally to the reduction in funds available from audit firms as potential joint and several co-defendants in litigation by increasing IPO underpricing for IPOs with a significant litigation risk. The increase in underpricing would enable underwriters to protect themselves from the reduction in funds available from audit firms as co-defendants. Further, audit partners are likely to have less incentive to monitor the decisions of their fellow audit partners under LLPs since they no longer bear the risk of personal liability for other partners' actions. Beatty (1989) argues that lower audit quality increases the information asymmetry between entrepreneurs and potential investors, which may be associated with an increase in the amount of underpricing of IPOs to compensate investors for the increased risk they face when purchasing shares in IPOs. If the reduction in incentives to monitor reduces audit quality, then underwriters may further underprice IPOs in the post-LLP period.

We use high-technology industry membership, the size of the offering, and the 1POs subsequent standard deviation of returns as proxies for litigation risk, and find that IPOs with greater litigation risk experience more underpricing after audit firms changed to LLP status. Our findings suggest that underwriters perceived a decline in the value of services provided by audit firms associated with the audit firm's change in legal structure, although we are not able to distinguish whether the decline in value results from a reduction in implicit insurance or a reduction in audit quality. Even so, the analysis contributes to the understanding of the economic role of auditors by specifically examining whether the auditors' liability status is associated with valuation decisions made by underwriters and companies going public.