Does Disclosure Regulation Work?

Evidence from International IPO Markets

Charles Shi NUS Business School National University of Singapore Kuntara Pukthuanthong Department of Finance College of Business Administration San Diego State University Thomas Walker Department of Finance John Molson School of Business Concordia University

We are grateful for the comments and suggestions of Zhihong Chen, Gilles Hilary, Mingyi Hung, Christo Karuna, Bin Ke, Clive Lennox, Chul Park, Mort Pincus, Siew Hong Teoh, T.J. Wong, Jerry Zimmerman and seminar participants at the 2007 American Accounting Association FARS Midyear Conference, the 2007 American Accounting Association Annual Meeting, UC-Irvine, China Europe International Business School (CEIBS), the Chinese University of Hong Kong, Hong Kong City University, Hong Kong University of Science and Technology, and Singapore Management University. We are especially grateful to Ellen Hui Ling Lin for providing us with the international IPO sample and to Carol Frost, Elizabeth Gordon, and Andrew Hayes for providing us with their international stock exchange disclosure data.

Correspondence can be addressed to: Charles Shi NUS Business School National University of Singapore, Singapore 119245 Email: bizshiy@nus.edu.sg 1

Does Disclosure Regulation Work? Evidence from International IPO Markets

ABSTRACT The economic consequences of disclosure regulation have been the subject of much debate. This study contributes to the debate by examining the informational effect of disclosure regulation and the extent to which the disclosure effect is altered by institutional and firm-level factors in the context of international IPO markets. Our empirical analysis uses a unique sample of 6,025 IPOs from 34 countries over the period from 1995 to 2002. We show for the first time that the stringency of disclosure requirements for IPO prospectuses is negatively associated with the extent of IPO underpricing, after controlling for various country- and firm-level determinants of underpricing. Moreover, we find that the mandatory disclosure effect on IPO underpricing is more pronounced in countries whose capital markets are less integrated and for IPO issuers whose prospectuses are audited by lower-quality auditors. Taken together, our findings are consistent with the view that increased disclosure regulation reduces IPO underpricing in international IPO markets, consequently lowering the cost of equity financing, and that both institutional and firm-specific factors play an important role in understanding the economic consequences of mandatory disclosure in international IPO markets. Key Words: Disclosure Regulation, Mandatory Disclosure, International IPO Underpricing, Cost of Equity, Auditor Quality JEL Classification: G12, G14, K22, M41

Does Disclosure Regulation Work? Evidence from International IPO Markets

1. INTRODUCTION Regulations governing corporate disclosure practices exist in all countries around the world. Despite the crucial role regulation plays in disclosure, research on mandated disclosures, either theoretical or empirical, is surprisingly limited in accounting (Dye, 2001; Healy and Palepu, 2001).1 As a result, many fundamental issues concerning disclosure regulation remain unanswered. For example, what is the economic rationale justifying the regulation of corporate disclosure? Is regulated disclosure effective in solving the information problems that hinder the proper functioning of capital markets? In this study we attempt to fill a gap in the extant disclosure literature by examining whether country-specific IPO disclosure requirements as promulgated by each countrys securities laws are related to information asymmetries in the IPO market and therefore the degree of IPO underpricing around the world.2 If our findings suggest that increased disclosure requirements reduce information asymmetries in international IPO markets and consequently lower the cost of new equity, they would provide an economic rationale for disclosure regulation. Our choice of an international IPO setting to examine the economic consequences of mandatory disclosure is motivated by several considerations. First, IPOs play a crucial role in resource allocation in economies and are regulated in all the markets around the world. Despite the enormous importance of IPOs, little is known about the economic consequences of IPO

In an evaluation of the theoretical accounting disclosure literature, Dye (2001, p. 184) notes that I believe there is, presently, no received theory on mandatory disclosures in accounting In view of the overwhelming importance of mandatory disclosures in accounting practice, this is unfortunate and something accounting researchers should strive to rectify. In a similar vein, Healy and Palepu (2001, p. 412) conclude in their review of the empirical disclosure literature that empirical research on the regulation of disclosure is virtually nonexistent. This is surprising given the central role regulation plays in disclosure, and the limitations of the economic arguments supporting regulation. Underpricing means that the shares of companies that go public are offered to investors at prices that are below the price at which they are subsequently traded on the stock market.

disclosure regulation. Second, the evidence of substantial variations in IPO underpricing across countries has long perplexed IPO researchers. More research has been called for to gain a better understanding of this important empirical regularity (Ritter and Welch, 2002). Our use of a large international IPO sample from 34 countries helps shed light on this apparent puzzling issue by showing a significant role disclosure regulation plays in influencing the variations of IPO underpricing across countries. Finally, and perhaps most importantly, a multi-country sample provides a setting in which there is considerable cross-sectional variation in disclosure regulation and institutional factors. Differences in country- and firm-specific factors enable us to examine their respective role in affecting the disclosure-underpricing relation that cannot otherwise be analyzed in a single-country sample. The economic consequences of disclosure regulation have been the subject of much debate. Critics of disclosure regulation contend that if additional disclosures could reduce information asymmetries between firms and investors and thus lower the cost of external financing, then firms would disclose such information voluntarily. That is, mandatory disclosure rules are redundant because market forces will ensure that firms voluntarily disclose the optimal level of information (Ross, 1979; Grossman, 1981; Romano, 1998). Some further argue that forcing firms to disclose could have detrimental effects due to high implementation costs and the revelation of proprietary information to competitors (Dye, 1986). On the other hand, proponents of disclosure regulation contend that mandatory disclosure can serve as a commitment device and hence be less susceptible to managers self-serving incentives and opportunistic reporting commonly associated with voluntary disclosure (Verrecchia, 2001). Moreover, information has characteristics of a public good that will be underproduced without regulation (Simon, 1989). Admati and Pfleiderer (2000) provide a third rationale for disclosure regulation. They illustrate analytically that one firms disclosures may improve the stock price accuracy of other firms. 4

Since the firms disclosure strategies will unlikely take this positive externality into account, mandatory disclosure is warranted to improve pricing efficiency. The ongoing debate about the need for disclosure regulation based primarily on the secondary market in the U.S. is further complicated in an international context as cross-country differences in the institutional environment can alter the effects of disclosure (Francis, Khurana, and Pereira, 2005; Hail and Leuz, 2006). Taken together, it is unclear whether mandatory disclosure is necessarily informative and consequently affects the underpricing of IPOs across countries. In addition, it is much less clear to what extent the relation between mandatory disclosure and IPO underpricing is impacted by country- and firm-specific factors. We measure the strength of a countrys IPO disclosure regulation using the disclosure index from a new securities law database compiled by La Porta, Lopez-de-Silanes, and Shleifer (2006). The index captures six specific disclosure requirements for an IPO prospectus as of December 2000. Larger index values indicate more stringent IPO disclosure requirements. Our empirical analysis uses a unique international IPO sample of 6,025 IPOs from 34 countries over the period from 1995 to 2002. We show that the extent of IPO underpricing is on average negatively associated with the strength of disclosure requirements, after controlling for various country- and firm-level factors known to affect underpricing. The evidence is consistent with the argument that disclosure regulation reduces information asymmetries and consequently leads to lower IPO underpricing. A battery of sensitivity checks show that it is unlikely that our findings are driven by potentially omitted correlated variables, and that our results are robust to alternative measures of disclosure regulation, changes in sample composition, alternative model specifications and estimation methods. In addition, we examine the extent to which the disclosure-underpricing relation is affected by country- and firm-level factors. Such an analysis yields additional insight into the effect of 5

disclosure on underpricing because different institutional settings can potentially alter the role of disclosure in international IPO markets. Specifically, we find that the disclosure effect on IPO underpricing is more pronounced for IPO issuers audited by lower quality auditors than those audited by higher quality auditors. That is, all else being equal, a countrys disclosure regulation becomes more effective in lowering IPO underpricing for issuers whose auditors are perceived to have lower quality. With respect to capital market integration, we show that consistent with the findings from the secondary markets documented by Hail and Leuz (2006) the regulation of IPO disclosures is less important in countries whose capital markets are more integrated with other markets around the world. Our study makes several important contributions. First, we contribute to the disclosure literature by being the first to provide evidence on the effect of mandatory disclosure on international IPO markets. Hail and Leuz (2006) find that firms from countries with more stringent disclosure requirements have a lower cost of equity capital. We differ from Hail and Leuz (2006) in at least two ways. First, IPO markets have unique institutional features3 that result in information environments and pricing phenomena (initial underpricing and subsequent long-term underperformance) that are very different from secondary markets.4 Hence, the results derived from secondary markets, as is the case with Hail and Leuz (2006), cannot be generalized to IPO markets. A second difference pertains to the measurement of the cost of capital. Hail and Leuz (2006) proxy for the cost of equity using the internal rate of return imputed from various valuation models for seasoned stocks. In contrast, our variable IPO underpricing

represents the actual amount of money initial owners leave on the table for new shareholders. In
3

For example, unlike in the secondary market where all investors can participate in the trading of shares, the allocation of IPO shares is typically controlled by underwriters. Mauer and Senbet (1992) show that limited investor access plays an important role in the pricing of IPOs. Ritter and Welch (2002) argue that the average first-day IPO underpricing of 18.8 percent during the period from 1980 to 2001 in the U.S. cannot be explained by fundamental risks or liquidity constraints in the secondary market. They conclude (p. 1803) that the solution to the underpricing puzzle has to lie in focusing on the setting of the offer price, where the normal interplay of supply and demand is suppressed by the underwriter.

other words, underpricing constitutes an actual cost of new equity financing to the initial owners.5 Therefore, our study complements Hail and Leuz (2006). Together, the two studies fill an important gap in the disclosure literature by documenting the importance of mandatory disclosure for both the primary and secondary markets. Second, we add to the debate on the economic consequences of mandated disclosures by showing the critical role of institutional and firm-specific factors in disclosure outcomes. For example, we provide new evidence that suggests that auditor quality impacts not only IPO underpricing in itself but also the extent to which mandatory disclosure affects the information environment in international IPO markets. This study also contributes to the IPO literature. Despite the presence of a vast and growing body of research in that area, almost all of the existing studies have focused on IPOs in single countries, predominantly in the U.S. (Loughran, Ritter, and Rydqvist, 1994; Jenkinson and Ljungqvist, 2001; Ritter and Welch, 2002). Consequently, little is known about IPO

performance in a cross-country context. A seminal study by Ljungqvist, Jenkinson and Wilhelm (2003) provides a comprehensive and controlled analysis of international differences in the primary markets. Using a sample of 2,143 non-U.S. IPOs from 65 countries during the period from 1992 to 1999, they show that bookbuilding efforts, if conducted by U.S. investment banks and targeted at U.S. investors, lead to lower underpricing than do fixed-price methods.6 We add
5

Other costs of going public include primarily the fees charged by underwriters. They are usually expressed in percentage terms as a gross spread charged by the investment bank. In the U.S., there is heavy clustering of gross spreads around 7 percent (Chen and Ritter, 2000). Yet, such spreads are dwarfed by the average underpricing of nearly 19 percent (Ritter and Welch, 2002). The two most popular methods for pricing and allocating IPOs have been the fixed-price method and the bookbuilding method. Under the fixed-price method, the issue price is set first and is usually guaranteed by the underwriter, and then orders are taken from investors who often have to pay in advance for all the shares they purchase. Bookbuilding typically starts with the setting of a filing price range and the commencement of a road show that usually lasts two weeks. During the road show, the underwriter canvasses institutional investors with respect to their demand before setting the issue price. In the bookbuilding method, the underwriter has great discretion over allocation and usually sells the shares to institutional investors. Globally, the bookbuilding method has now become the most popular mechanism for pricing and marketing IPOs (Ljungqvist et al., 2003; Ritter, 2003; Sherman, 2005).

to the IPO literature by being the first to show that differences in disclosure regulation are an important determinant of cross-country variations in IPO underpricing. Furthermore, we contribute to an evolving literature that examines the impact of legal factors on the financial development of countries. Important contributions include Frost,

Gordon, and Hayes (2006), La Porta, Lopez-De-Silanes, Shleifer, and Vishny (1997, 1998), La Porta et al. (2006, 2008), and Djankov, La Porta, Lopez-De-Silane, and Shleifer (2004, 2008). We extend this literature by finding evidence suggesting that disclosure requirements mandated by securities laws reduce the cost of new equity. Finally, our findings have potential implications for regulatory choices. The quality of disclosure regulation has become a focal point in the aftermath of the East Asian crisis of 19971998, which some have attributed in part to poor disclosure quality in the region (e.g., Mitton, 2002). As a result, a number of developing and developed countries have strengthened or are considering strengthening mandatory disclosure requirements for their publicly traded firms (Asian Development Bank, 2000; European Commission, 2001). Moreover, the recent global financial crisis has once again brought to the forefront the debate over the need for broad regulations of capital markets. Our findings help inform regulators about the usefulness of mandated disclosure as a corporate governance mechanism. The remainder of the paper is organized as follows. Section 2 reviews the related literature and institutional background. Section 3 describes our research design and provides variable definitions. Section 4 discusses the sample and provides descriptive statistics. Section 5

presents the empirical results. Section 6 concludes. 2. RELATED LITERATURE AND INSTITUTIONAL BACKGROUND 2.1. Related Literature

The underpricing of IPOs is generally explained in the IPO literature with asymmetric information about the issues value. The well-known signaling models of IPO underpricing posit that the issuing firm knows more about its prospects than do outside investors and underwriters (e.g., Grinblatt and Hwang, 1989; Chemmanur, 1993). To distinguish themselves from low quality issuers, high quality issuers deliberately sell their shares at a price lower than their market value. Underpricing, hence, is used as a credible signal of firm quality. Issuers recoup the money they leave on the table in the IPO by benefiting from higher issue proceeds of a subsequent seasoned offering (Welch, 1989), favorable market responses to future dividend announcements (Allen and Faulhaber, 1989), or analyst coverage (Chemmanur, 1993). Other theoretical explanations of IPO underpricing include Barons (1982) principalagent model, Rocks (1986) adverse selection model, and bookbuilding theories (e.g., Benveniste and Spindt, 1989). Although these theories focus on different aspects of information asymmetry among IPO market participants, a common prediction from all information-based theories is that the degree of underpricing is positively associated with the extent of information asymmetry in the IPO market.7 Thus, if mandatory disclosure is informative, it is expected to reduce IPO underpricing. The informational effect of mandatory disclosure, however, is far from clear and hotly debated. The classical argument against disclosure regulation draws upon the well-known

unraveling results from the theoretical works by Ross (1979) and Grossman (1981). In their models, firms have strong incentives to disclose private information about their quality because a lack of such disclosures would be interpreted as bad news by investors. Thus, in equilibrium, firms will voluntarily make full disclosure so as not to be confused with lower-quality firms.8 In
7

There are also underpricing theories that do not rely on asymmetric information. For a comprehensive review of theoretical IPO models and empirical evidence, see Ritter and Welch (2002). Consistent with the argument that voluntary disclosure is informative, several studies show that the extent of voluntary disclosure by IPO firms is negatively associated with IPO underpricing in the U.S. (Beatty and Ritter, 1986; Schrand and Verrecchia, 2005, Leone, Rock and Willenborg, 2007).

this case, regulation that requires additional disclosures is redundant.

Relying on these

theoretical arguments, Romano (1998) advocates the removal of mandatory disclosure requirements because market forces will ensure the optimal level of voluntary disclosure. Proponents of mandatory disclosure argue that voluntary disclosure is sub-optimal or insufficiently credible on the following grounds. First, information on firms financial

conditions has many characteristics of a public good. Firms cannot confine information that is costly to produce to the exclusive use of their shareholders. The free-rider problem will result in an underproduction of securities information relative to total demand and regulation is needed to assure that socially optimal amounts of information are produced (Simon, 1989). Second, the theory of market-induced disclosure assumes that managers choose disclosure policies to maximize firm value. However, managers interests are not always aligned with those of

shareholders. It is often argued that voluntary disclosure is subject to managers self-serving incentives. For example, managers have incentives to enhance the value of their compensation package by withholding adverse information and to undertake preemptive buyouts of their own firm, which are facilitated by withholding positive information (Coffee, 1984). Regulation will help inhibit such opportunistic disclosure practices by management and enhance the credibility of disclosure (Verrecchia, 2001). Externalities provide another rationale for disclosure regulation. Dye (1990) and Admati and Pfleiderer (2000) argue that voluntary disclosure may be suboptimal because of the divergence of private and social benefits of information. To the extent that firms cash flows are correlated, disclosures improve the stock price accuracy of firms other than the disclosing firm. Given that disclosures are costly, firm disclosure decisions will not incorporate these positive externalities, and regulation is therefore warranted to increase the informational value of disclosure. The authors, however, recognize that the effects of disclosure regulation are rather 10

complicated and that there are cases where regulation is superfluous because the optimal level of mandated disclosures coincides with firms voluntary disclosure decisions. A small body of empirical research on disclosure regulation yields mixed evidence.9 Several early studies on the Securities Act of 1933 and the Exchange Act of 1934 find that the disclosures required by those SEC regulations have no significant effect on the information provided to investors (Stigler, 1964; Benston, 1973). These studies have attracted substantial criticism on the grounds that the research methods are problematic and that the findings are no longer applicable to contemporary securities markets as much has changed since the 1930s (Coffee, 1984). Indeed, a later study by Simon (1989) finds that the dispersion of abnormal returns is significantly lower following the Securities Act of 1933, consistent with the argument that the regulation results in new information to investors. In contrast, Mahoney and Mei (2006) find no evidence that the new disclosures required by the Securities Act of 1933 and the Exchange Act of 1934 reduce information asymmetry in the stock market. Bushee and Leuz (2005) examine the economic consequences of a regulatory change by the SEC mandating that the Exchange Act of 1934 be extended to firms trading on the OTC Bulletin Board (OTCBB). They show that the imposition of new disclosure requirements forces 76% of the sample firms that previously did not file with the SEC off the OTCBB, presumably due to the costs of disclosure being higher than its benefits. However, the remaining firms, generally larger in size, exhibit significant increases in stock liquidity, consistent with disclosure regulation reducing information asymmetry. Their results highlight the complex nature of

disclosure regulation. The effects of mandatory disclosure are further complicated in a crosscountry setting because of the interactions of institutional factors with disclosure regulation (Hail
9

There is a vast accounting literature on the relation between accounting numbers generated pursuant to pronounced accounting standards and stock valuation. The literature provides evidence on the informativeness of regulated financial numbers to investors. Healy and Palepu (2001, p.413), however, argue that because this research does not compare the relative informativeness of regulated and unregulated financial information, it does not necessarily imply that regulation is superior to a free market approach to disclosure.

11

and Leuz, 2006) and by IPO markets whose unique institutional features lead to information environments that are very different from those of secondary markets (Ritter and Welch, 2002). We contribute to the disclosure literature by being the first to examine the informational effect of disclosure regulation in international IPO markets. 2.2. Institutional Background The process of going public typically starts with the choice of exchange upon which the new shares will be traded. The next step is for the issuer to file a prospectus with the relevant statutory authority, which is then followed by a period of marketing and public subscription to the IPO. The process concludes with the public trading of the issue. Every country in our sample requires a prospectus before securities are sold. The

prospectus is the single most important document through which the issuer discloses material information to prospective investors. Production of the prospectus generally involves a number of different parties including auditors, lawyers, and investment banks. For example, the

investment bank chosen as the lead manager works closely with the issuer to perform due diligence investigations and to gather information to satisfy the appropriate regulatory authorities such as the SEC in the U.S., the Financial Services Authority in the U.K., and/or the particular stock exchange on which the issues will be listed. In the U.S., the regulations are based on the Securities Act of 1933. Under the Act, the issuer must disclose pertinent facts about its business, management, primary shareholders, and past financial performance in the prospectus. Disclosure regulation for the IPO prospectus, however, varies considerably across countries. Our examination of the prospectus disclosure regulations issued by the major stock exchanges and/or regulatory authorities in the 34 sample countries reveals that while the overwhelming majority of the countries require the reporting of three years of financial statements prior to the IPO, exceptions also exist. For example, the required number of annual 12

statements is two in Japan and Taiwan and only one in New Zealand and Turkey. In contrast, Mexican IPO issuers must report financial information for the last five years, and pro forma financial statements indicating changes resulting from the IPO. Large differences also exist in the extent of regulatory mandates for the disclosure of particular information, such as the insiders compensation and ownership structure, in the prospectus. The disclosure regulation variable we use is from La Porta et al. (2006), who collect six proxies for the strength of specific mandatory disclosure rules governing the IPO prospectus (see Section 3.1 for a description of the La Porta et al disclosure measure).10 Some of the information in the prospectus (e.g., future business plans and forwardlooking financial data) is disclosed on a voluntary basis. Indeed, many IPO issuers in the U.K., New Zealand, Australia, Canada, and countries in South East Asia region provide earnings forecasts in their prospectuses. This practice, however, is virtually non-existent in the U.S., presumably due to the high litigation risk in that country. To the extent that voluntary disclosure is not correlated with mandatory disclosure, the presence of voluntary disclosure is not expected to create a systematic bias for the effect of mandatory disclosure we seek to document. We will revisit this concern in Section 5.2.1. 3. RESEARCH DESIGN AND VARIABLE DEFINITION 3.1. Empirical Models and Key Variables We examine the association of disclosure regulation with IPO underpricing using the following regression model (time subscript omitted): Underpricingk,j = 0 + 1 Disclosurej +

Control
i=2 i

+ k,j

(1)

10

La Porta et al.s (2006) disclosure variable does not capture the number of annual reports required in the prospectus.

13

where Underpricingk,j is the extent of IPO underpricing for firm k in country j, measured as the market-adjusted percentage return from the offer price to the closing price on the fifteenth calendar day after the IPO. Note that our definition of underpricing is consistent with prior international IPO studies that generally measure IPO initial returns over a period of several weeks (e.g., Loughran et al., 1994; Ljungqvist et al., 2003; Ritter, 2003). The reason for the use of a longer return window is twofold. First, in some countries trading does not commence promptly after the IPO date. Second, price movements during the initial days of trading are sometimes restricted by exchange regulation, delaying the emergence of an equilibrium price. 11 As discussed later, our findings remain unchanged when we narrow the return window to 7 days. Our variable of interest, Disclosurej, is a country-specific prospectus disclosure regulation index for country j. It is constructed by La Porta et al. (2006) based on a survey of securities law attorneys from 49 countries. This variable captures prospectus disclosure requirements

applicable to IPO issuances in each countrys largest stock exchange as of December 2000. Specifically, La Porta et al. (2006) gauge the strength of disclosure requirements in six areas: (1) prospectus delivery; 12 (2) insiders compensation; (3) ownership structure; (4) insider ownership; (5) irregular contracts; and (6) transactions with related parties such as the issuer, its directors and large shareholders. Each of the six disclosure components takes on a value of zero, one half, or one with a higher value indicating more stringent disclosure requirements. The disclosure index is the arithmetic mean of the six proxies. Hence, the index value ranges from zero to one. In subsequent analyses, we convert the index to a 100-point scale to make it consistent with the

11

12

For instance, in France and Japan, circuit breakers are installed to limit post-IPO daily price fluctuations within a certain preset limit. La Porta et al. (2006, p. 10) note that Since every country requires a prospectus before securities are sold and listed, the operational word here is delivering. In some countries, it is possible to sell securities after a prospectus is deposited at the company, or with the Supervisor, without delivering it to investors. Delivering a prospectus to potential investors is an affirmative step in making disclosures to them. As of December 2000, many of the 49 countries surveyed by La Porta et al. such as Germany, South Korea, and the U.K did not have a prospectus delivery requirement.

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measurement unit of two alternative disclosure variables used in Section 5.2.2. If the disclosure requirements are informative, then we expect the coefficient on Disclosure to be negative. We estimate equation (1) using a pooled sample of 6,025 IPOs from 34 countries. Our approach of estimating equation (1) on a firm level is consistent with that used by existing crosscountry studies (Ball, Kothari, Robin, 2001; Ljungqvist et al., 2003; Defond and Hung, 2004; Choi and Wong, 2007; Defond, Hung, and Trezevant, 2007). An alternative specification is to run country-level regressions (Leuz, Nanda and Wysocki, 2003; Bushman, Piotroski and Smith, 2004). The firm-level specification offers several advantages over the country-level

specification. First, IPO underpricing varies not only across countries but also within countries and over time. The firm-level analysis utilizes the information in our IPO dataset more fully and allows us to directly control for within-country and time-series variations in underpricing. A second benefit of the firm-level specification is that it allows us to directly employ firm-specific underpricing determinants as control variables. Moreover, firm-level regressions enable us to control for time-series and industry effects of underpricing, which cannot be incorporated in country-level regressions. Finally, the larger number of observations makes the firm-level

analysis less susceptible to influential values than the country-level analysis. Nonetheless, we also recognize some potential drawbacks of the firm-level specification. For example, it gives undue weight to several countries with a large number of IPOs. Subsequent sensitivity checks, however, show that our findings are unlikely driven by those large countries. 3.2. Control Variables We derive control variables from the extant IPO literature. They include issue-, firm-, and country-specific determinants of IPO underpricing, which we discuss below. The first control variable is the natural logarithm of issue proceeds (Log_Proceeds). Larger firms are generally considered less risky than smaller firms. Hence, the size of the issue 15

(in U.S. dollars) is expected to be negatively correlated with underpricing (Beatty and Ritter, 1986; Ljungqvist et al., 2003). The second control variable is underwriter ranking (Underwriter_Rank). Several earlier studies find that underwriter reputation tends to reduce IPO underpricing because prestigious investment banks help resolve information asymmetries in the IPO market (Carter and Manaster, 1990; Carter, Dark and Singh, 1998). The relationship, however, is reversed to be positive for IPOs issued in the 1990s and onwards (Cliff and Denis, 2004; Loughran and Ritter, 2004; Butler, Keefe, and Kieschnick, 2009; Hanley and Hoberg, 2009). Plausible explanations for the positive association include the changing issuer objective function hypothesis (Loughran and Ritter, 2004) as well as issuers using underpricing to compensate highly ranked analysts in prestigious investment banks for their post-IPO research coverage (Cliff and Denis, 2004). To measure underwriter reputation, the extant literature typically adopts the Carter and Manaster (CM) rankings of underwriter reputation which take on discrete values from 0 to 9 with 9 (0) representing the most (least) prestigious underwriter. This measure, however, is limited to U.S. underwriters. Following the idea that more prestigious investment banks generally

underwrite more and larger offerings, we construct a discrete measure of global underwriter reputation that ranges from 0 (least prestigious) to 9 (most prestigious), Underwriter_Rank_G, by classifying each lead investment bank for our sample IPOs into one of 10 categories according to the total proceeds of the IPOs the investment bank underwrote during our 1995 2002 sample period.13 Note that our measure is consistent with that used by Megginson and Weiss (1991) who gauge underwriter quality by considering the average market share of each underwriter. In addition, we construct an alternative measure that aims to capture the local rank
13

Specifically, we assign a discrete integer to each lead underwriter as follows: 9 if its total proceeds are no less than $20 billion; 8 if proceeds are between $10 and $20 billion; 7 if proceeds are between $5 and $10 billion; 6 if proceeds are between $2 and $5 billion; 5 if proceeds are between $1 and $2 billion; 4 if proceeds are between $0.5 and $1 billion; 3 if proceeds are between $0.2 and $0.5 billion; 2 if proceeds are between $0.1 and $0.2 billion; 1 if proceeds are below $0.1 billion; and 0 if the lead underwriter is not ranked among the top 500 investment banks by the SDC.

16

of the underwriter, Underwriter_Rank_L, based on its market share within each country. Ex ante, it is unclear whether it is the global rank of the underwriter (Underwriter_Rank_G) or its local rank that better captures underwriter reputation.14 The third control variable is IPO volume (IPO_Volume). The extant IPO literature has long recognized that cycles exist in both the volume and the average initial returns of IPOs. For example, Ibbotson and Jaffe (1975) and Lowry and Schwert (2002) find a strong pattern of negative associations between current IPO underpricing and prior IPO volume. To control for cyclical patterns in the IPO market, we construct an IPO volume variable for every IPO, which is defined as the total number of domestic IPOs issued in that country over the 12-month period ending in the month in which the IPO was issued. Fourth, we control for the pricing mechanisms used to bring the IPO to market, which include bookbuilding, fixed-price, hybrid, and auction offerings. Ljungqvist et al. (2003) argue that the mechanism for bringing the IPO to market should matter. While there is little variation in the U.S., international issuers can often choose different pricing methods. Similar to

Ljungqvist et al., we use three dummies to reflect four possible pricing methods in regression analyses. Fifth, we add privatization dummy as another control variable. Jones et al. (1999) suggest that privatization IPOs are deliberately underpriced. In terms of country-level controls, we include two legal variables liability standards (Liability_Standards) and public enforcement (Public_Enforcement) from La Porta et al. (2006). The two variables measure the extent of private and public enforcement of securities laws when investors seek to recover damages from firms and related intermediaries that are
14

The two measures are not highly correlated (see Table 2-C). To assess the relative validity of each measure, we correlate each variable with the Carter-Manaster (CM, updated by Ritter) measure for the U.S. IPOs in our sample. We find that the correlation of the global measure with the CM measure is 0.42, significant at the 1% level. In contrast, the local measure is not significantly correlated with the CM measure at all (the correlation coefficient is -0.02).

17

responsible for failing to disclose material information in the prospectus. La Porta et al. use these variables along with disclosure regulation to measure securities laws and regulations around the world and find that such measures are correlated with stock market development. 15 The liability standards index is the arithmetic mean of three liability standards for the issuer and its directors, distributors, and accountants, respectively. The higher the index value, the lower the burden of proof for investors to sue the issuer, its distributors, and/or accountants to recover losses due to misleading information in the prospectus. Public enforcement reflects regulations and enforcement by government regulators who supervise securities markets. A public enforcer can be a Securities Commission, a Central Bank, or some other regulatory body. The higher the public enforcement index, the stronger the public enforcement applicable to the issuer, its directors and accountants in the case of a misleading prospectus. The values for the liability standards and public enforcement indexes range from zero to one. Moreover, to the extent that information asymmetry tends to be similar within industries, industry effects provide some control for cross-sectional variation in information asymmetry (Ljungqvist et al., 2003). As a result, we construct a series of industry dummies that are based on 2-digit SIC codes and include them in our regressions. Our industry partitions 62 in total are more refined than a binary dummy as has been used in many prior studies to distinguish IPOs in the technology sector from other IPOs (Cliff and Denis, 2004; Loughran and Ritter, 2004). Finally, we add year dummies to control for time-series variation in underpricing

(Loughran and Ritter, 2004). It is worth noting that the relatively weak reporting standards implemented in many of our sample countries limit the size and breadth of international IPO data (Ljungqvist et al., 2003).
15

In subsequent sensitivity checks we also include other legal variables such as the rule of law index and legal origins. Our conclusions remain intact.

18

Consequently, we do not have as many firm-level control variables as most U.S.-based studies. While not controlling for some of the IPO determinants will undoubtedly reduce the overall explanatory power of our regression models, it is unlikely to create a bias for the disclosure effect we seek to report at least to the extent that the country level disclosure regulation is uncorrelated with these firm-level IPO variables. Indeed, subsequent sensitivity checks in

Sections 5.2 and 5.3 show that our findings are unlikely driven by potentially omitted correlated variables. 4. 4.1. Sample Selection We first identify all IPOs issued between 1995 and 2002 from the Securities Data Corporation (SDC) Global New Issues database. Because we are interested in the relation between disclosure regulation and IPO underpricing, we limit our sample to the 49 countries with disclosure regulation data provided by La Porta et al. (2006). Following the extant IPO literature, we exclude financial firms, unit offers, private placements, IPOs that result from spinoffs, and issues with SDC share types other than Class A Shares, Common Shares, Ordinary Shares, Ordinary/Common Shares, or Equity Shares. Furthermore, our focus on country-specific disclosure regulation necessitates the exclusion of non-domestic IPOs (i.e., cross-listings and foreign-only listings) from our sample.16 We then match the remaining firms against Datastream by requiring them to have closing stock prices available in Datastream on the fifteenth calendar day after the IPO. We conduct the matching manually based on firm name due to the lack of SAMPLE AND DESCRIPTIVE STATISTICS

16

Foreign firms cross-listed on a U.S. exchange need to comply with the U.S. disclosure and listing requirements. They, however, are not subject to the same regulations as the U.S. firms. For example, cross-listings in the U.S. are exempt from the SECs Regulation Fair Disclosure (Jorion, Liu, and Shi, 2005). Moreover, they are also allowed to obtain a waiver from most corporate governance listing requirements that otherwise apply to U.S. firms (Coffee, 2002). The disparity in the treatment of foreign and domestic issuers makes it very difficult to correctly classify the actual type of disclosure regulations to which a cross-listed firm actually becomes subject. We therefore limit our main sample to domestic IPOs only.

19

other matching firm identifiers.

Finally, some of the firm-level variables such auditor

information and financial data are collected from Compustat Global Vantage. Our close examination of the SDC database reveals several data problems. First, we find errors in IPO issue dates for the majority of our sample countries. 17 For example, the SDC often mistakenly provides announcement or subscription dates as issue dates.18 Over 50 percent of the IPOs in Canada, Hong Kong, Italy, Japan, Malaysia, Singapore, South Korea, Taiwan, and the U.K. are affected by this issue. To overcome this data problem, we manually cross-reference each of our sample IPOs with Bloomberg to identify and correct the erroneous issue dates. Another major data problem is that many offer prices in the SDC database are incorrect or missing. This problem pertains to eight countries19 in our sample with South Korean IPOs being most affected. To the extent possible, we use Bloomberg to revise inaccurate offer prices and fill in missing offer prices. For Canadian IPOs, we also use the Record of New Issues published by the Financial Post for corrective measures. Our final sample consists of 6,025 IPO firms from 34 countries, including 3,747 issues outside the U.S.20 4.2. Descriptive Statistics Panel A of Table 1 provides an overview of IPO underpricing by country. Several

observations emerge from the panel. First, IPOs are on average underpriced in all 34 countries in
17

18

19

20

The affected sample countries (27 in total) include Argentina, Australia, Austria, Belgium, Canada, Finland, France, Germany, Greece, Hong Kong, Indonesia, Italy, Japan, Malaysia, the Netherlands, New Zealand, Norway, the Philippines, Singapore, South Korea, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, and the U.K. The announcement date generally refers to the date when the issuer files a prospectus with the relevant regulatory body. Since the length of the subscription period varies from multiple days to several weeks, it is tricky to pick a day as the subscription date. Our comparison of the SDC data with information provided by Bloomberg reveals that there is no consistency in the SDCs determination of the subscription date, which tends to be reported somewhat inconsistently between the beginning and closing of subscription. Fortunately, Bloomberg provides IPO issue dates directly. Note that the accuracy of issue dates is very crucial for us because we rely on the issue dates as a reference time point for calculating initial IPO returns. The eight affected countries are Australia, Belgium, Canada, Greece, Indonesia, the Philippines, South Korea, and the U.K. Our sample selection leaves unanswered two selection issues. One is a firms decision to go public or not. The other is where to list its stock, namely, in the home country or/and on a foreign exchange. Both issues are rather complicated. For example, there are numerous ways through which firms can obtain financing. For example, in the U.S. a private firm can gain funding through an IPO, a private placement, bank lending, bond issuance, and/or a take-over by a public acquirer (Brau, Francis, and Kohers, 2003). Given the complexity of the issues coupled with data constraints on private firms, they can be fruitful topics for future research.

20

our sample. This is consistent with the stylized fact of IPO underpricing in many countries as summarized in Jenkinson and Ljungqvist (2001) and Ritter (2003). Not surprisingly, there is a wide variation in the mean and median levels of underpricing across countries. Further analysis reveals that within each country there exist substantial differences in IPO underpricing across industries and over time (not tabulated). For example, South Korea stands out as the country with the highest average underpricing (121%). That figure is mainly driven by IPOs in the agricultural and mining industry as well as the transportation industry sectors whose average underpricing is over 390%. In stark contrast, South Koreas IPOs in the construction industry exhibit average underpricing of less than 10%. Underpricing levels of the countrys IPOs also vary substantially over time, ranging from nearly -10% for IPOs issued in 2000 to an average underpricing of more than 300% in 1998. At the other end of the spectrum, Thailand exhibits the lowest average underpricing of 1.21%. It, too, shows large variations in underpricing ranging from an average underpricing level of less than -30% in 1997 and 2000 to average underpricing of more than 25% in 2002. Among the developed economies, Canada has the highest average underpricing of nearly 100%. Its high underpricing is primarily driven by the fact that a large fraction of its IPOs are risky penny stocks. Subsequent regression analyses control for industry and time-series effects. Our results are also robust if we exclude penny stocks. Sample clustering exists. For example, nearly 38 percent of the sample comes from the U.S. market. This is not surprising since the U.S. had the largest and most active IPO market in the world during our sample period. At the other end of the sample distribution lie several countries like Argentina, Egypt and Portugal, each of which has less than 10 IPOs. To assess whether our findings are affected by few countries with a large or small number of IPOs, we later replicate our main analyses by excluding such countries.

21

Panel B of Table 1 details the sample composition by year. Again, we can observe large fluctuations in volume and underpricing levels across the sample years. Descriptive statistics of the independent variables for the main regression model-equation (1) are provided in Table 2. As indicated in Panel A, the prospectus disclosure regulation varies substantially from the most stringent (Disclosure = 100 for the U.S. and Singapore) to the most lenient requirements (Disclosure = 25 for Austria). The mean value of Disclosure is 65,

corresponding approximately to the disclosure score for Italy, New Zealand and Switzerland. There are large cross-sectional variations in the Liability_Standards and Public_Enforcement variables. As is typical in cross-country studies, the three country-level securities regulation variables are highly correlated with each other. Following La Porta et al. (2006), we include all three variables in our regression analyses as they are shown to be related to stock performance. Note that the high correlations tend to inflate standard errors. This would result in a bias against our finding of the incremental effect of disclosure regulation. To further alleviate the collinearity concern, we perform a principal component analysis and use an alternative disclosure variable (see Section 5.2.2) to help isolate the incremental effect of disclosure regulation. Panel B of Table 2 provides descriptive statistics for our firm-level control variables. Those variables by and large exhibit considerable cross-sectional variations, enhancing their explanatory power. Pearson correlations of the firm-level variables are reported in Panel C of Table 2. 5. EMPIRICAL ANALYSES

5.1. Main Results: Disclosure Regulation and IPO Underpricing Table 3 reports the regression results for equation (1). Inspection of the table reveals that there is a negative association between disclosure regulation and IPO underpricing, as reflected in the coefficient on the Disclosure variable equal to -0.99 and significant at the one percent 22

level. This implies that a one-standard deviation increase in disclosure regulation (= 20, roughly the distance from the U.K. to the U.S.) is associated with a reduction of 19.8% in IPO underpricing. Therefore, the effect of disclosure regulation is not only statistically significant but also economically meaningful. Both country-level control variables, Liability_Standards and Public_Enforcement, are positive and significant at the one percent level.21 The significant positive coefficient on

Liability_Standards suggests that higher liability standards, which represent a lower burden of proof for investors who seek to recover losses resulting from a misleading prospectus, are associated with higher IPO underpricing. This is consistent with the lawsuit avoidance

hypothesis that suggests that issuers underprice their IPOs as a form of insurance to reduce potential legal liability (Tini, 1988; Lowry and Shu, 2002). The firm-level control variables are mostly significant at the conventional levels. The coefficient of Log_Proceeds is significantly negative supporting the notion that larger issues are less risky. Between the two underwriter measures, only the one based on the global influence of underwriters, Underwriter_Rank_G, is significant. Its positive coefficient is consistent with the finding in many recent IPO studies (Cliff and Denis, 2004; Loughran and Ritter, 2004; Butler, Keefe, and Kieschnick, 2009; Hanley and Hoberg, 2009). Finally, the negative coefficient on IPO_Volume suggests that the hot issue market phenomenon in the U.S. may not be generalized to an international setting. 5.2. Sensitivity Analysis In this section, we perform an extensive series of sensitivity analyses to check the robustness of our findings. First, we conduct additional tests to assess the impact of omitted
21

It is not uncommon that the coefficients of two positively correlated variables have opposite signs in a regression analysis. For example, Guo and Savickas (2008) find that average idiosyncratic volatility and stock market volatility, while highly correlated (=0.77 in the U.S.), have significant, opposite associations with future stock market returns. Moreover, when we use an alternative disclosure regulation variable that is uncorrelated with Liability_Standards (see Section 5.2.2), the coefficient of the disclosure variable remains positive and significant.

23

correlated variables. We then examine if our results are sensitive to multicollinearity, changes in disclosure regulation or sample composition, and to different estimation methods. The results are summarized in Tables 4 and 5. Note that the number of observations varies from test to test due to additional data requirements or changes in sample composition. In the interest of brevity, Table 5 reports only the coefficient estimates and White (1980) heteroskedasticity-consistent standard errors of the Disclosure variable. 5.2.1. Potentially Omitted Correlated Variables A common limitation of cross-country studies is that regression results are likely affected by omitted correlated variables (Bushman and Smith, 2001; Bushman et al., 2004). We address this problem using three different approaches: (1) instrumental variables estimation, (2) inclusion of additional control variables, and (3) country random effects estimation. (1) Two Stage Least Squares (2SLS) Estimation of the Instrumental Variables The presence of omitted correlated variables would imply that the disturbance of equation (1) is correlated with the Disclosure variable. A standard econometric remedy is instrumental variables estimation. Suitable instrumental variables are difficult to obtain. Prior work has used countries legal origins and wealth as instrumental variables (Leuz et al., 2003; Choi and Wong, 2007). A countrys legal origin can be viewed as pre-determined and exogenous to our analysis. Legal origin is also shown to influence the countrys securities laws (La Porta et al., 2006). Moreover, the creation, implementation and enforcement of disclosure regulation are costly, hence they are likely affected by a countrys economic resources. As a result, we adopt a common law dummy variable (Common_Law, which is equal to one if the countrys legal origin is common law and zero otherwise) and the natural logarithm of the countrys per capita GDP (Log_GDP_Per_Capita) to instrument for disclosure regulation. Table 4 presents the results for our 2SLS estimation of the instrumental variables regression. Panel A indicates that the 24

coefficient estimate on Disclosure remains significantly negative.

To the extent that our

instrumental variables are valid, this finding suggests that the disclosure effect estimated from the main regression model (1) in Table 3 is unlikely driven by potentially omitted correlated variables. Panel B of Table 4 reports results from the first-stage regression for disclosure regulation. The common law dummy variable and the logarithm of per capita GDP show a significant relation with disclosure regulation, justifying their selection as instrumental variables for the Disclosure variable. Further, the positive coefficient on Common_Law indicates that common law countries have more stringent disclosure requirements than civil law countries. Finally, the positive association between Log_GDP_Per_Capita and Disclosure suggests that countries wealth is indeed an important factor in determining disclosure regulation. (2) Inclusion of Additional Control Variables We include various country-level control variables in equation (1) that may be correlated with disclosure regulation and IPO underpricing. Country-level variables tend to be highly correlated. Therefore, as in Hail and Leuz (2006), we introduce each control variable one at a time into equation (1). As a robustness check, we also try to include all those control variables simultaneously. The regression results are summarized in Panel A of Table 5. Specifically, we perform eight regressions that we outline below. (a) Equity Market Development La Porta et al. (2006) show that a countrys equity market size is influenced by its securities laws. Better-developed equity markets that are usually accompanied by higher quality disclosure likely have lower information asymmetry and consequently less IPO underpricing. When we add the ratio of the countrys stock market capitalization to its GDP (our proxy for equity market development) as a control, the coefficient on Disclosure remains negative and significant. 25

(b) Corruption Next, we examine whether our results are robust when we control for corruption. In many countries such as Malaysia, Korea and Japan, deeply discounted IPOs have reportedly found their way into the pockets of the politically influential and privileged few. To buy political influence, offer prices were sometimes set based on who you are (Jenkinson and Ljungqvist, 2001). To control for the effect of corruption on IPO underpricing, we include a corruption index from La Porta et al. (1998) in our regression analysis of equation (1). As indicated in Panel A of Table 5, our finding is robust to this control. (c) Analyst Following The extent of analyst following in a country may affect information asymmetries in the IPO process. For example, increased participation of analysts in the IPO market may exacerbate the extent of information asymmetry between uninformed and informed investors, consequently increasing IPO underpricing (Rock, 1986). In addition, Lang and Lundholm (1996) document that corporate disclosure policies are associated with analyst following. Following Bushman et al. (2004), we proxy for the extent of analyst activity in a given country by the average number of analysts following the 30 largest firms in the country as reported in Chang, Khanna and Palepu (2000). The inclusion of the number of analysts does not affect our inferences. (d) Legal Enforcement Prior research shows that legal enforcement is associated with the effectiveness of securities rules (La Porta et al., 1998). To ensure that the Disclosure variable does not pick up the enforcement effect, we include the rule of law index from La Porta et al. (1998) in our analysis.22 Several studies use this variables as a measure of the quality of a countrys legal enforcement system (Dyck and Zingales, 2004; Choi and Wong, 2007; Hail and Leuz, 2006; La
22

Note that our regression equation (1) includes the Liability_Standards and Public_Enforcement variables that also control for the enforcement of securities laws.

26

Porta and Schleifer, 2008). We find that the previously documented relation between disclosure regulation and IPO underpricing remains qualitatively unchanged.23 (e) Ownership Structure La Porta et al. (1998) show that ownership structures vary considerably around the world. Controlling shareholders have incentives to divert corporate resources to themselves at the expense of minority shareholders (Johnson, La Porta and Shleifer, 2000; Dyck and Zingales, 2004). Recognizing the agency cost arising from conflicts of interests between minority and controlling shareholders, the new minority shareholders will likely price-protect themselves by demanding a deeper discount when they purchase new issues at the IPO. Moreover, the extent of the agency conflict is likely affected by disclosure regulation because increased disclosure requirements will make it easier for shareholders and regulators to discover when, how and to whom firm resources are being diverted, consequently discouraging controlling shareholders from engaging in egregious conduct. Indeed, La Porta et al. (2006) find that more extensive disclosure requirements tend to lower agency costs. To control for the variation in agency costs across countries, we include an average country-level ownership concentration variable from La Porta et al. (1998) in equation (1). Panel A of Table 5 shows that the inclusion of the variable somewhat attenuates the magnitude of the coefficient on Disclosure. It does not change the essence of our findings, however. (f) Voluntary Disclosure If voluntary disclosure is credible, it may be informative to investors and reduce IPO underpricing. However, to the best of our knowledge, there is no theory that suggests a

systematic correlation between mandatory and voluntary disclosures. Hence, not controlling for

23

In addition, we replicate the regression analysis of equation (1) by including the country-specific inflation and risk-free interest rate, respectively, because inflation and the local risk-free rate may affect the extent of IPO underpricing. Our analyses, however, indicate that neither of the control variables is significant and that our inferences are not affected by the inclusion of either of the variables.

27

voluntary disclosure is unlikely to inflate the effect of disclosure regulation we estimate. To be sure, we conduct an additional robustness check. First, we construct a country-level measure of voluntary disclosure by decomposing total disclosure quality in a given country into a mandatory and voluntary component. Specifically, we regress a measure of total disclosure quality on the disclosure regulation variable Disclosure. The residuals from the regression representing the portion of total disclosure not attributable to mandatory disclosure are used as a proxy for country-level voluntary disclosure. We employ two alternative variables to gauge a countrys total disclosure quality. One is the CIFAR disclosure index, which has been used in prior studies (Bushman et al., 2004; Francis et al., 2005). We construct the CIFAR index by averaging 1995 CIFAR firm-level disclosure scores by country. The second disclosure variable is constructed using a more recent database the Transparency and Disclosure Survey developed by Standard and Poors (S&P) in 2002. S&P computes the disclosure score by examining a firms annual reports and standard regulatory filings for the disclosure of 98 items.24 One point is awarded when information on an item is available and no point is awarded otherwise. We construct a countrys overall disclosure quality by calculating the mean of all firm-level S&P scores in the country. Panel A of Table 5 indicates that the coefficient on Disclosure remains negative and significant at the one percent level with the inclusion of either measure of voluntary disclosure into equation (1).25 (g) All Control Variables Our approach of including country-level variables one at a time as a control is consistent with many prior cross-country studies (Leuz, Nanda and Wysocki, 2003; Hail and Leuz, 2006).
24

25

The same database is used by Khanna et al. (2004), Durnev and Kim (2005), and Black, Jang, and Kim (2006). See the Appendix in Khanna et al. (2004) for the list of 98 questions surveyed by S&P. Alternatively, we use the CIFAR index directly to proxy for voluntary disclosure (Bushman et al., 2004; Hail and Leuz, 2006) and include it as a control variable in equation (1). The coefficient on Disclosure remains significantly negative. Similar results are obtained when we use the S&P score instead.

28

This approach intends to strike a balance between the need to control for potential omitted variables and the importance of avoiding multicollinearity among those country level variables which are known to be highly correlated with each other. As a robustness check, we re-run the main regression model (1) by including all the country-level controls from (a) to (f) above. As reported in Table 5-A (g), the coefficient on Disclosure is -0.81, significant at the 1% level. It is also worth noting that one drawback of including all the country variables is a sizable loss of sample observations. (3) Country Random Effects Estimation Despite our examination of a long list of potentially correlated omitted variables, one may still argue that our analyses cannot exhaust all potentially omitted correlated variables. This criticism, applicable to virtually all cross-country studies, cannot be answered definitively without specifying the omitted variable itself. To further alleviate the concern, we estimate a country random effects model of equation (1) (see also Durnev and Kim, 2005). The country random effects model accounts for differences in country-level factors through a country-specific random element in the disturbance (Greene, 2003). As shown in the last row of Panel A of Table 5, our finding remains intact with respect to this alternative model specification. The collective consistency from the numerous robustness checks above makes a strong case that the effect of disclosure regulation we document is unlikely driven by potentially omitted correlated variables. 5.2.2. Multicollinearity It is well known that country-level variables tend to be highly correlated (Bushman and Smith, 2001). As shown in Panel A of Table 2, this is also the case with our data. Dropping variables is not a viable solution as doing so results in the omission of relevant variables that would lead to a biased estimate of our Disclosure variable (Greene, 2003). We deal with the 29

multicollinearity problem in two ways: (1) we apply a principal component analysis (PCA) to the correlated variables; and (2) we use an alternative measure of disclosure regulation that is uncorrelated with Liability_Standards or Public_Enforcement. (a) Principal Component Analysis A common approach for dealing with multicollinearity is to perform PCA (for applications of PCA in cross-country studies, see Bushman et al., 2004; La Porta et al., 2006). The idea of PCA is to derive a set of new variables called principal components that are orthogonal to each other and that account for most of the variation in the original data set. In our case, we derive three principal components from the three country-level variables that are linear combinations of the original variables.26 Relying on the correlations between the three variables and the derived principal components, we interpret the component that is the most highly correlated with the Disclosure variable as the Disclosure component that primarily captures prospectus disclosure regulation. The other two components are interpreted in a similar fashion as the Note that by

Liability_Standards and Public_Enforcement components, respectively.

construction the three principal components are uncorrelated. We then re-perform the OLS estimation of equation (1) by replacing the original three country-level variables with the three principal components. As summarized in Panel B of Table 5, the coefficient on the Disclosure component is negative and significant at the one percent level. This implies that our findings are unaffected by the presence of collinearity in the data. (b) Alternative Measurement of Disclosure Regulation A second approach we use to overcome multicollinearity is to replace the Disclosure variable in equation (1) with an alternative measure of disclosure regulation constructed by Frost,
26

While PCA is often used as a variable reduction technique by retaining only those components with large variances, we decide to keep all three components for two reasons. First, it has been shown that components with small variances can be just as important as those with large variances in a PCA regression analysis (Jolliffe, 1982). Second, there is little to gain from reducing the number of variables given that we have only three country-level variables.

30

Gordon, and Hayes (2006, hereafter FGH). The FGH measure consists of five components that capture the disclosure requirements of each of the 50 major stock exchanges around the world. 27 A higher value of the FGH measure implies more stringent disclosure requirements. Importantly, the FGH measure has two desirable features: (1) it has a high correlation with the Disclosure variable (Pearson correlation of 0.28) and (2) it is uncorrelated with either Liability_Standards (Pearson correlation of 0.02) or Public_Enforcement (Pearson correlation of -0.02). The results for regressing IPO underpricing on the FGH measure are shown in Panel B of Table 5. The significant and negative coefficient of the FGH measure corroborates our finding of the negative relation between disclosure regulation and IPO underpricing. 5.2.3. Alternative Specifications and Estimation Methods (a) Potential Changes in Disclosure Regulation Recall that our variable of interest disclosure regulation reflects securities laws that were effective as of December 2000 (see La Porta et al., 2006). Our analyses assume that disclosure regulation remains unchanged throughout our 1995 2002 sample period. This assumption would be violated if some of our sample countries substantially revised their securities laws during that time. To assess whether our results are sensitive to this assumption, we extract a subsample of IPOs that were issued between 1999 and 2002 (i.e., two years before and after the survey date). Panel C of Table 5 shows that the estimation of equation (1) based on the subsample yields the same conclusion. In fact, the magnitude of the Disclosure coefficient is about 30% larger than that from the full sample in Table 3. Our findings (not tabulated) remain robust when we restrict our sample to only one year before and after December 2000. (b) Exclusion of Several Countries

27

The FGH measure is called Disclosure without Monitoring and Enforcement in Frost et al. (2006). Readers are referred to Frost et al. for a detailed discussion of this variable. Note also that three of our 34 sample countries (Egypt, Pakistan, and Sri Lanka) are not covered by the FGH measure and are thus omitted in our analysis.

31

Another concern is that there are substantial variations in the number of observations per country. For example, the U.S. alone accounts for nearly 38% of the sample. At the other extreme of the sample spectrum lie countries such as Argentina, Egypt and New Zealand, each of which has less than 10 observations. This may raise concerns about our results being unduly influenced by these countries. To address these concerns, we re-run our analysis of equation (1) using a subsample excluding the U.S. as well as seven countries with less than 10 IPOs per country (see Table 1 for the sample distribution by country). As indicated in Panel C of Table 5, altering our sample in this manner does not change our conclusion. Moreover, our findings (unreported) remain unchanged when we exclude only U.S. IPOs, a large fraction of which were issued during the bubble period in the late 1990s. (c) Weighted Least Squares Regression Another approach designed to address concerns about the unbalanced sample distribution across countries is to estimate equation (1) by means of a weighted least squares (WLS) regression. Specifically, we assign a weight to the observations in a given country that equals one minus the ratio of the number of IPOs in that country to the total number of IPOs in the whole sample. As a result of our weighing scheme, countries with a larger (smaller) number of observations receive smaller (larger) weights and therefore have a smaller (greater) influence on the coefficient estimates. As shown in Panel C of Table 5, the WLS estimate of the coefficient on Disclosure is much larger in magnitude (-1.87 vs. -0.99 in Table 3) and remains highly significant, suggesting that our findings do not appear to be unduly influenced by several countries with relatively very large or small numbers of IPOs. (d) Potential Cross-Sectional Correlation If the error terms of equation (1) were correlated, it would lead to an underestimation of the standard errors and an overstatement of the significance of the coefficient estimates. We note 32

that the extant IPO literature treats IPO underpricing levels (i.e., initial returns) across firms as independent observations. Nonetheless, to ensure that our results are not affected by this

potential problem, we repeat the regression analysis of equation (1) using Newey-West heteroskedasticity and autocorrelation corrected standard errors. As shown in Panel C of Table 5, the Newey-West standard error is higher (by construction) than the White heteroskedasticityconsistent standard error in Table 3. The Disclosure variable, however, remains significant at the one percent level. In addition, we perform two more tests by running: (1) a Prais-Winstern regression of equation (1) that allows for heteroskedasticity, within-panel serial correlation and cross-sectional dependence; and (2) an OLS regression of equation (1) using robust standard errors adjusted for country clustering. We obtain essentially the same conclusions (unreported). Collectively, the analyses suggest that our findings are not affected by potential cross-sectional correlation in the error terms. (e) Alternative Dependent Variable We construct market-adjusted 7-day IPOs initial returns. As expected, the number of observations in our sample is reduced considerably (from 6,025 to 4,384) when the 7-day return window is implemented. As reported in Table 5-C-(e), the coefficient on Disclosure is 1.08, significant at the one percent level. (f) Endogenous Pricing and Distribution Methods Ljungqvist et al. (2003) argue for the importance to control for the endogeneity associated with a firms choice of different pricing and distribution methods. To examine the potential impact of endogeneity of IPO pricing and distribution choices, we follow the two-stage least squares estimation used by Ljungqvist et al. (2003, p. 91). Specifically, we divide all

bookbuilding IPOs in our sample into four categories depending on whether the issuing firm engages a U.S. underwriter and/or targets U.S. investors. In the first stage, we run a multinomial 33

logit regression of a firm choosing one of these four categories over a fixed-pricing offering. We then use the predicted probabilities from the first-stage regression to instrument for the endogenous IPO pricing and distribution methods in our main regression model (1). As

summarized in Table 5-C (f), the Disclosure variable remains negative and significant at a conventional level, suggesting that our key conclusion is not affected by any potential endogeneity in pricing or distribution methods. To summarize, we find strong evidence that more stringent disclosure requirements are on average associated with lower IPO underpricing, ceteris paribus. Numerous sensitivity analyses indicate that our findings do not appear to be driven by potentially omitted correlated variables or multicollinearity, and are robust to alternative measures of disclosure regulation, changes in sample composition, and alternative model specifications and estimation methods. 5.3 The Effect of Disclosure Regulation on IPO Underpricing: Evidence from Dual Listed IPOs In this section, we provide further evidence on the effect of disclosure regulation using two complementary samples of dual listed IPOs we collect from the SDC. The first sample consists of 297 domestic Canadian IPOs and 41 Canadian IPOs which are simultaneously listed in both Canada and U.S. from 1995 to 2002. We compare the IPO underpricing of the 297 domestic

Canadian IPOs with the underpricing of the Canadian shares of the 41 dual listed firms. This approach takes advantage of the fact that both types of shares are listed in Canada, therefore institutional factors of being a Canadian firm are naturally controlled for. However, the two types of shares are affected by different disclosure regulations. This is because dual listed firms are required to do filings with both Canadian and U.S. regulators and their Canadian prospectuses are influenced also by the more stringent U.S. disclosure requirements.28 We
28

Please note that we do not require the dual listed firms file the same prospectuses in Canada and the U.S although our inspection of several randomly selected dual listings reveals that they indeed filed essentially the same prospectuses. Further, any major information advantage in the U.S. prospectus can be easily overcome by

34

expect that the prospectuses submitted to the Canadian regulators by the dual listed firms are likely more informative than those of the domestic Canadian IPOs. To control for the

endogenous nature of listing decisions, we adopt a two stage least squares regression (e.g, Lang, Lins, and Miller, 2003). In the first stage, we regress a dual listing decision dummy on firm characteristics including total assets, sales growth, leverage, and standard deviation of post-IPO stock returns. We also control for year and industry effects. The regression result is reported in Panel B of Table 6. Panel A of Table 6 summarizes the second stage regression of IPO underpricing on the predicted probability of dual listing, controlling for common underpricing determinants. The coefficient on Predicted Dual-Listing is negative and significant at the one percent level. That is, the Canadian listings of the dual-listed IPOs influenced by more stringent U.S. disclosure regulation are less underpriced than the domestic Canadian IPOs. This

corroborates our main finding that the level of IPO underpricing is negatively associated with the stringency of disclosure regulation. While the above sample provides a nice setting to isolate disclosure regulation from the other country factors, it remains susceptible to potentially omitted firm-level IPO variables. To

address this concern, we construct a second sample. This sample comprises 227 non-U.S firms that simultaneously listed their IPOs in the U.S. market and their home market from 1995 to 2002. This results in a dual-listings sample of 454 IPOs. Table 7, Panel A, presents distribution statistics on IPO underpricing for these IPOs in the home and U.S. markets, respectively. The mean and median underpricing levels are 20.37% and 10.31% for the IPOs cross-listed in the U.S., which are roughly 50% of the mean and median underpricing for the home listings. Note that the comparative analysis of the home offerings vs. their U.S counterparts is not affected by firm-level variables because the dual-listed IPOs are issued by the same firms. Panel B of Table 7 presents the results of an OLS regression of IPO underpricing on
investors access to the U.S. prospectuses through the SEC Edgar.

35

disclosure regulation (Disclosure), controlling for other country-level variables. The dependent variable is the market-adjusted 15-day returns from the IPO. The first specification is a base-line regression that includes the three institutional factors in the main regression model (1). The second specification includes the other country-level control variables in Panel A of Table 5. The Disclosure variable is negative and significant at the one percent level in both specifications, consistent with our hypothesis that stricter disclosure rules are associated with less IPO underpricing. After establishing the average effect of disclosure regulation, we now turn to the issue of whether the linkage between disclosure and IPO underpricing is affected by firm characteristics and cross-country institutional factors. Such an analysis should yield further insight into the role of disclosure regulation in international IPO markets. Moreover, as argued by Hail and Leuz (2006), if we can provide evidence that the effects of disclosure differ across countries in ways consistent with theoretical predictions, it can serve as an additional validity check of our finding. 5.4. Do the Effects of Disclosure Vary with Firm Characteristics and Institutional Factors? In this section, we examine how an issuers IPO auditor quality and the extent of a countrys market integration with the rest of the world interact with disclosure regulation. We first develop theoretical predictions on how the two factors affect the disclosure-underpricing relation. Our empirical analysis follows. 5.4.1. Interactions of Auditor Quality and Market Integration with Disclosure Effect The role of the auditor. A review of the listing requirements of the major exchanges in our sample countries indicates that annual financial statements disclosed in the prospectuses are generally audited by an independent accounting firm.29 Extant evidence shows that auditor quality reduces IPO underpricing as financial reports audited by higher quality auditors are more
29

Egypt may be an exception to the rule. Article Seven of the listing requirements of the Cairo Stock Exchange indicates that annual financial statements of a listing firm are reviewed by an Audit Committee. The Committee includes at least three non-executive qualified independent directors selected by its Board of Directors.

36

precise and hence more effective in mitigating information asymmetries between the firm and investors, and between uninformed and informed investors (Balvers, McDonald and Miller, 1988; Beatty, 1989; Hogan, 1997). There are large variations in auditor quality around the world (Francis et al., 2003; Choi and Wong, 2007). Conceivably, in countries where auditing functions are weaker, the role of auditors in alleviating information asymmetry is more limited. Hence, the ability of IPO firms to rely on reputable auditors to mitigate information problems is more constrained. To the extent that both auditors and disclosure regulation can help lower

information asymmetries in the IPO process, it is an empirical question of how the disclosure effect interacts with auditor quality. With respect to the measurement of auditor quality, existing studies generally use the BigFive vs. non-Big-Five dichotomy to distinguish between auditor types because Big-Five firms are found to provide higher quality auditing services than do non-Big-Five firms both in the U.S. and abroad (Simon, Teo and Trompeter, 1992; Teoh and Wong, 1993; Defond, Francis and Wong, 2000; Weber and Willenborg, 2003). We collect information on firm-specific auditors from the SDC and Compustat Global Vantage. Except for CUSIPs for the U.S. IPOs, there is no standardized firm I.D. linking the SDC database to Global Vantage. We thus rely on firm name to manually collect auditor information for non-U.S. IPOs. Egypt and Sri Lanka are excluded from our analyses due to a lack of auditor data. Our resulting sample consists of 6,019 IPOs from the 32 sample countries. The role of capital market integration. Several theoretical and empirical studies suggest that the effects of cross-country differences in institutional factors on asset-pricing become less significant when the capital markets are more integrated (Bekaert and Harvey, 1995; Stulz, 1999; Errunza and Miller, 2000; Pukthuanthong and Roll, 2009). The rationale underlying this finding is that in integrated markets there are few barriers to the free flow of capital. Therefore, it is 37

easier to find close substitutes in other countries, and investors can diversify their portfolios globally. As a result, investors are less constrained by country-specific regulation and

institutional factors. Consistent with these arguments, Hail and Leuz (2006) find that the effects of country-specific legal institutions on the cost of equity are significantly smaller in more integrated markets. The above discussion leads to the prediction that the effect of disclosure on IPO underpricing is more pronounced in countries with segmented capital markets than in countries with integrated capital markets, ceteris paribus. As to the measurement of market integration, we follow Hail and Leuz (2006) and gauge the extent of capital market integration based on portfolio flows across countries, defined as the sum of a countrys portfolio inflows and outflows normalized by its GDP. This measure, hence, captures the

degree of freedom to which the countrys capital flows across borders. Greater portfolio flows indicate a higher extent of market integration.30 5.4.2. Empirical Results To investigate whether the effect of disclosure regulation on underpricing varies with auditor quality and market integration, we estimate the following regression models: Underpricingk,j = 0 + 1 Disclosurej + 2 Disclosurej*Auditor_Quality_Dummyk + 3 Auditor_Quality_Dummyj +

Control
i=4 i

+ k,j

(2a)

Underpricingk,j = 0 + 1 Disclosurej + 2 Disclosurej*Integration_Dummyj + 3 Integration_Dummyj +

Control
i=4 i

+ k,j

(2b)

30

Hail and Leuz (2006) also use a second variable to measure market integration. The variable is equal to one if the countrys equity market is in the MSCI Developed Markets Index and zero otherwise. Our results are robust to this alternative measure.

38

where Auditor_Quality_Dummyk is a issuer-level binary dummy, equal to one if an IPO is audited by a Big-Five auditor and zero otherwise. The dummy variable for market integration is a country-level dummy, equal to one for countries with above median portfolio inflows and outflows in percent of GDP, as reported in Table 1 of Hail and Leuz (2006). One advantage of using dummy variables instead of continuous

values is that the dummy specification allows for nonlinearities in the interactions of the country-level factors with the Disclosure variable. Nonetheless, our conclusions do not change when we re-run equation (2a) and (2b) using the continuous values of market integration (unreported). The control variables are the same as those in our main regression model (1). The regression results for equation (2) are summarized in specifications 1 and 2 of Table 8, which correspond to auditor quality and market integration, respectively. emerge. First, the coefficients on both the Several findings terms

interactive

Disclosure*Auditor_Quality_Dummy and Disclosure*Integration_Dummy are both positive and significant at conventional levels, suggesting that the effect of disclosure regulation on IPO underpricing is significantly less pronounced if an IPO is audited by higher quality auditor or is issued in a country with a greater extent of capital market integration. Moreover, the coefficient on the auditor dummy is significantly negative. This is consistent with the findings of several U.S.-based studies that auditor quality reduces IPO underpricing (Balvers et al., 1988; Beatty, 1989; Hogan, 1997). The negative and significant coefficient on the market integration dummy suggests that the greater extent of capital market integration is associated with lower underpricing.

39

To investigate whether auditor quality and market integration represent distinctive effects, we let both the auditor and integration dummy interact with the Disclosure variable simultaneously. The regression results are summarized in specification 3 of Table 8. Although the magnitude of the coefficients on the auditor dummy and its interaction with Disclosure is reduced, their significant levels and signs remain qualitatively unchanged. The same holds for the integration dummy and its interactive variable Disclosure*Integration_Dummy. Taken

together, the findings in Table 8 show that the effect of disclosure regulation varies with the quality of the issuers auditor and the extent of a countrys capital market integration. 5. CONCLUSIONS Corporate disclosure is critical for the efficient functioning of capital markets. Firms provide information to investors through voluntary communication, audited financial statements, and disclosures mandated by securities laws. The purpose of this study is to examine whether the strength of prospectus disclosures required by securities laws can explain cross-country differences in IPO underpricing and to what extent institutional factors impact the disclosureunderpricing relation. Employing a unique international IPO sample of 6,025 IPOs from 34 countries that differ considerably in mandatory disclosure requirements for IPO prospectuses and in IPO underpricing, we find a significant negative association between IPO underpricing and disclosure regulation, corroborating the argument that more extensive disclosure requirements reduce information asymmetry in IPO markets and consequently lower IPO underpricing. In addition, we show that the disclosure effect on underpricing is moderated by the issuers auditor quality as well as the extent of a countrys capital market integration. Taken together, we contribute to the disclosure literature by providing evidence consistent with the argument that mandatory disclosure plays an important role in the functioning of primary markets. Our results, hence, provide an important economic rationale for disclosure regulation in the IPO markets. In 40

addition, our findings shed light on the well-documented, yet little understood, empirical regularity of considerable cross-country variations in IPO underpricing. Given the critical role of IPOs in allocating resources in economies, our results may be of interest to regulators in different countries who are now contemplating more stringent regulations of capital markets in the wake of the recent global financial crisis.

41

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Table 1: Descriptive Statistics of IPO Underpricing

Panel A: Sample Distribution and IPO Underpricing by Country Average Country N Underpricing (%)
Argentina Australia Austria Belgium Canada Denmark Egypt Finland France Germany Greece Hong Kong Indonesia Italy Japan Malaysia Mexico Netherlands New Zealand Norway Pakistan Philippines Portugal Singapore South Korea Spain Sri Lanka Sweden Switzerland Taiwan Thailand Turkey United Kingdom United States Total Sample Minimum Maximum Mean Median

Median Underpricing (%) 16.71 0.00 3.08 7.40 31.35 4.68 5.33 0.00 7.81 15.38 32.18 6.00 24.00 0.34 5.88 35.83 1.13 7.58 12.00 0.00 11.63 12.00 17.77 8.81 49.08 11.36 20.00 0.86 5.21 16.53 -6.55 -0.64 12.08 16.25 -6.55 49.08 11.50 8.31

1 289 12 26 297 15 1 29 306 281 82 225 53 86 903 134 5 20 5 21 10 19 4 172 126 16 5 29 24 202 38 6 305 2,278 6,025 1 2,278 177 29

16.70 17.33 25.61 14.81 98.50 7.54 5.32 14.09 18.70 45.84 102.08 16.23 68.57 20.39 26.14 60.11 0.11 25.78 29.92 1.67 55.34 14.54 17.94 18.98 121.13 25.87 9.26 6.62 12.97 24.54 1.21 1.81 36.62 34.79 0.11 121.13 29.33 18.84

48

Standard Deviation

410

29.68

11.95

49

Panel B: IPO Underpricing by Year Year 1995 1996 1997 1998 1999 2000 2001 2002 N 730 943 792 576 833 1,125 531 495 Average Underpricing (%) 27.14 29.55 28.91 28.03 69.22 38.94 31.75 29.60 Median Underpricing (%) 14.47 11.46 10.00 12.86 26.04 9.28 8.46 6.67

The sample consists of 6,025 IPOs from 34 countries issued during the period from 1995 to 2002. In Panel A, we provide information on the number of IPOs as well as mean and median IPO underpricing across countries. Panel B provides the same information by year. IPO underpricing is defined as the market-adjusted return from the offer price to the closing price on the fifteenth calendar day after the IPO, measured in percentage terms.

Table 2: Descriptive Statistics of the Independent Variables

Panel A: Descriptive Statistics of the Country-Level Independent Variables (N=34) Country Disclosure Liability_Standards Argentina 50 22 Australia 75 66 Austria 25 11 Belgium 42 44 Canada 92 100 Denmark 58 78 Egypt 50 22 Finland 50 66 France 75 22 Germany 42 0 Greece 33 44 Hong Kong 92 66 Indonesia 50 66 Italy 67 22 Japan 75 66 Malaysia 92 66 Mexico 58 11 Netherlands 50 100 New Zealand 67 44 Norway 58 44 Pakistan 58 44 Philippines 83 100 Portugal 42 66 Singapore 100 66 South Korea 75 66 Spain 50 66 Sri Lanka 75 44 Sweden 58 33 Switzerland 67 44 Taiwan 75 66 Thailand 92 33 Turkey 50 22 United Kingdom 83 66 United States 100 100 Distributional Statistics Minimum Maximum Mean Median Standard Deviation Pearson Correlations Disclosure Liability_Standards Public_Enforcement 25 100 65 63 20 1.00 0 100 52 55 27 0.47 1.00 0 90 49 42 25 0.66 0.39 1.00 Public_Enforcement 58 90 19 19 86 27 33 35 80 25 35 88 56 38 0 84 25 38 40 40 50 81 50 88 29 38 33 44 21 44 67 56 67 88

Panel B: Descriptive Statistics of the Firm-Level Independent Variables (N=6,025) Mean Fixed Bookbuilding Auction Hybrid Privatization Log_Proceeds Underwriter_Rank_G Underwirter_Rank_L IPO_Volume 0.05 0.61 0.08 0.25 0.01 16.59 3.15 3.02 273.48 Median 0 1 0 0 0 16.72 0 3 175 Std Deviation 0.22 0.49 0.28 0.43 0.11 1.59 3.82 1.21 235.96 Minimum 0 0 0 0 0 8.85 0 0 1 Maximum 1 1 1 1 1 22.78 9 9 806

Panel C: Pearson Correlations of the Firm-Level Independent Variables (N=6,025) Hybri d -0.14 -0.73 -0.18 Underwriter_Rank_ G -0.07 0.18 0.12 -0.23 0.05 0.28 Underwriter_Rank_ L -0.02 -0.00 0.01 0.00 -0.00 -0.01 0.03

Fixed Bookbuilding Auction Hybrid Privatization Log_Proceeds Underwriter_Rank_ G Underwriter_Rank_L

Bookbuilding -0.29

Auction -0.08 -0.38

Privatization 0.03 0.04 -0.01 -0.06

Log_Proceeds -0.13 0.21 0.02 -0.18 0.02

IPO_Volume -0.22 0.63 -0.20 -0.46 0.01 0.23 0.09 -0.00

The sample consists of 6,025 IPOs from 34 countries issued during the period from 1995 to 2002. In Panel A (B), we provide descriptive statistics for all country-level (firm-level) variables used in our analysis. Pearson correlation coefficients for the country-level variables are reported at the bottom of Panel A, while firm-level correlations are provided in Panel C. The variables are defined as follows. Country-Level Variables: Disclosure: an index measure of the strength of a countrys prospectus disclosure regulation from La Porta et al. (2006). The higher the index value, the more stringent the disclosure regulation. The index values are measured on a 100-point scale. Liability_Standards: an index measure of the burden of proof required by a countrys securities laws for investors to recover losses due to misleading information in the prospectus. The higher the index value, the lower the burden of proof. The index is from La Porta et al. (2006). The index values are measured on a 100-point scale. Public_Enforcement: an index measure that reflects a countrys regulations and enforcement by government regulators. The higher the index value, the stronger the public enforcement. The index is from La Porta et al. (2006). The index values are measured on a 100-point scale. Firm- and Issue-Level Variables: Fixed: a dummy variable, equal to one if the firm adopts a fixed pricing method where the offer price is determined before the IPO is marketed to investors, and zero otherwise. Allocation decisions of the fixed pricing method are nondiscretionary. Bookbuilding: a dummy variable, equal to one if the firm adopts a bookbuilding pricing method where the offer price is entirely determined after the investors interests are identified, and zero otherwise. Under bookbuilding, investment bankers are not restricted by a mandatory price rule and allocation decisions are discretionary. Auction: a dummy variable, equal to one if the firm adopts an auction pricing method where the offer price is determined by a mandatory or a discretionary clearing rule, and zero otherwise. Under an auction, allocations to bidders are nondiscretionary. Hybrid: a dummy variable, equal to one if the firm adopts a bookbuilding pricing method involving a public offer tranche after the issue has been priced, and zero otherwise. The hybrid method requires some participation by retail investors. Privatization: a dummy variable, equal to one if the IPO is the result of a privatization IPO, and zero otherwise. Log_Proceeds: the natural logarithm of IPO issue proceeds. Proceeds are measured in U.S. dollars. Underwriter_Rank_G: a ranking measure of global underwriter reputation on a scale from 0 to 9, where 0 (9) represents the least (most) reputable underwriter group. This rank is based on the underwriters relative importance in global offerings and is measured as the rank (decile) of the total global offering proceeds of all IPOs underwritten by the underwriter during our sample period relative to all other underwriters. Underwriter_Rank_L: a ranking measure of local underwriter reputation on a scale from 0 to 9, where 0 (9) represents the least (most) reputable underwriter group. This rank is based on the underwriters relative importance in an offering country and is measured as the rank (decile) of the total local offering proceeds of all IPOs underwritten by the underwriter during our sample period relative to all other underwriters in the offering country. IPO_Volume: the total number of domestic IPOs issued in a country over the past 12-month period including the month in which the IPO was issued.

Table 3: OLS Regression of IPO Underpricing on Disclosure Regulation

Intercept Disclosure Liability_Standards Public_Enforcement Bookbuilding Auction Hybrid Privatization Log_Proceeds Underwriter_Rank_G Underwriter_Rank_L IPO_Volume Industry and Year Dummies Observations Adjusted R2 F-Stat Coefficient 209.73*** -0.99*** 0.60*** 0.32*** 22.70** -10.21 -15.47*** 6.54 -10.13*** 1.01*** 1.54 -0.08*** Included 6,025 0.06 6.61*** Std. Error 27.54 0.19 0.09 0.08 9.12 6.87 5.84 8.55 1.59 0.33 0.98 0.02

The sample consists of 6,025 IPOs from 34 countries issued during the period from 1995 to 2002. The dependent variable is IPO underpricing which is defined as the market-adjusted return from the offer price to the closing price on the fifteenth calendar day after the IPO, measured in percentage terms. Industry dummies are constructed based on 2-digit SIC codes while year dummies are constructed for all years from 1996 to 2002. All other variables are as defined in Table 2. Standard errors are White (1980) heteroskedasticity-consistent standard errors. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% level (two-tailed), respectively.

Table 4: Two-Stage Least Squares Regression of IPO Underpricing on Disclosure Regulation

Panel A: Second-Stage Regression of IPO Underpricing on the Predicted Value of Disclosure Regulation Coefficient Std. Error Intercept 308.66*** 41.23 Disclosure Liability_Standards Public_Enforcement Bookbuilding Auction Hybrid Privatization Log_Proceeds Underwriter_Rank_G Underwriter_Rank_L IPO_Volume Industry and Year Dummies Observations Adjusted R2 F-Stat -2.56*** 1.09*** 0.64*** 4.36 -24.12*** -39.17*** 7.56 -10.41*** 1.49*** 1.49 -0.07*** Included 6,025 0.04 6.54*** 0.55 0.19 0.12 10.18 8.79 9.94 8.53 1.59 0.36 0.97 0.02

Panel B: First-Stage Regression Results for Disclosure Regulation Coefficient Intercept 16.17*** English_Legal_Origin Log_GDP_Per_Capita Liability_Standards Public_Enforcement Bookbuilding Auction Hybrid Privatization Log_Proceeds Underwriter_Rank_G Underwrrter_Rank_L IPO_Volume Industry and Year Dummies Observations Adjusted R2 F-Stat 4.94*** 5.00*** 0.28*** 0.19*** -12.38*** -9.09*** -15.79*** 0.59 -0.23*** 0.22*** 0.02 0.00 Included 6,025 0.85 512.71***

Std. Error 3.61 0.94 0.33 0.01 0.01 0.66 0.79 0.50 0.37 0.07 0.02 0.07 0.00

The sample consists of 6,025 IPOs from 34 countries issued during the period from 1995 to 2002. We present results for a two-stage least squares regression. Panel A presents results for the second-stage regression of IPO underpricing on disclosure regulation. The dependent variable is IPO underpricing which is defined as the market-adjusted return from the offer price to the closing price on the fifteenth calendar day after the IPO, measured in percentage terms. Panel B presents results from the first-stage regression for disclosure regulation. The instrumental variables for Disclosure are an English common law dummy variable (English_Legal_Origin) that is equal to one if the countrys legal origin is English common law and zero otherwise, and the natural logarithm of the countrys per capita GDP (Log_GDP_Per_Capita) in 2000 from La Porta et al. (2006) Industry dummies are constructed based on 2-digit SIC codes while year dummies are constructed for all years from 1996 to 2002. All other variables are as defined in Table 2. Standard errors are White (1980) heteroskedasticity-consistent standard errors. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% level (two-tailed), respectively.

Table 5: Sensitivity Analyses for the Relation between IPO Underpricing and Disclosure Regulation
Panel A: Robustness Checks for Potentially Omitted Correlated Variables Variable Additional Control Variable (a) Equity_Market_Size (b) Corruption (c) Analyst_Following (d) Legal_Enforcement (e) Ownership_Concentration (f) Voluntary_Disclosure_CIFAR Voluntary_Disclosure_SP_Score (g) All Control Variables Country Random Effects 6,02 5 6,02 5 6,02 4 6,00 2 6,02 5 5,97 1 5,72 2 5,70 7 6,02 5 -0.89*** -0.96*** -0.90*** -0.80*** -0.87*** -0.86*** -0.78*** -0.81*** -0.83*** 0.20 0.19 0.19 0.20 0.18 0.19 0.19 0.20 0.21 N Disclosure Coefficient Std. Error

Panel B: Robustness Checks for Multicollinearity N (a) Principal Component Analysis (b) FGH Disclosure Variable 6,02 5 6,00 9 Disclosure Coefficient -26.08*** -1.08*** Std. Error 4.14 0.19

Panel C: Alternative Model Specifications and Estimation Methods N 2,98 4 3,72 1 Disclosure Coefficient -1.30*** -0.98*** Std. Error 0.28 0.21

(a) Years 1999-2002 Only (b) Exclusion of Countries with Less than 10 or more than 2,000 Observations (c) Weighted Least Squares Regression

6,02 5

-1.87***

0.34

(d) Newey-West Standard Errors (e) 7-Day IPO Underpricing (f) Endogenous Pricing and Distribution Methods

6,02 5 4,38 4 6,02 5

-0.99*** -1.08*** -0.47**

0.36 0.24 0.22

Regressions are based on a sample of 6,025 IPOs from 34 countries issued during the period from 1995 to 2002. In some cases, the sample size varies because of additional data requirements or different model specifications. Standard errors are White (1980) heteroskedasticity-consistent standard errors unless otherwise indicated. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% level (two-tailed), respectively. The dependent variable is IPO underpricing which is defined as the market-adjusted return from the offer price to the closing price on the fifteenth calendar day after the IPO, measured in percentage term. Panel A reports the coefficient estimates of disclosure regulation (Disclosure) from the OLS regression of equation (1) plus one of the following variables as an additional control variable: (a) the countrys equity market size measured as the ratio of the countrys stock market capitalization to its GDP from La Porta et al. (2006), (b) the corruption index from La Porta et al. (1998), (c) the average number of analysts following the 30 largest firms in the country as reported in Chang et al. (2000), (d) a legal enforcement variable proxied by the rule of law index from La Porta et al. (1997), (e) ownership concentration from La Porta et al. (1998) measured by the average percentage of common shares owned by the top three shareholders in the 10 largest nonfinancial, privately owned domestic firms in a given country, (f) a country-level measure of voluntary disclosure (Voluntary_Disclosure_CIFAR or Voluntary_Disclosure_SP Score) derived from the residuals of regressing a measure of total disclosure quality on disclosure regulation, and (g) all control variables together from (a) to (f). The last row of Panel A presents the country random effects estimation of equation (1). Note that the two alternative measures of total disclosure we employ in (f) are the country means of the 1995 CIFAR firm-level disclosure scores and the country means of the 2002 S&P firm-level disclosure scores, respectively. Panel B reports regression results for equation (1) by (a) replacing the three institutional variables (Disclosure, Liability_Standards, and Public_Enforcement) with their three principal components, respectively, and (b) by replacing the Disclosure variable with an alternative disclosure measure constructed by Frost, Gordon, and Hayes (2006). The FGH measure gauges the stock exchange disclosure requirements in each sample country. Panel C reports regression results for equation (1) by (a) only considering IPOs that occurred between 1999 and 2002, (b) excluding countries with less than 10 or more than 2,000 IPOs, (c) performing a weighted least squares estimation, (d) using Newey-West standard errors, (e) using the market-adjusted 7-day IPO return as the dependent variable, and (f) controlling for the potential endogeneity of pricing and distribution methods. For (f), we follow the two-stage least squares estimation used by Ljungqvist et al. (2003, p. 91)). Specifically, we divide all bookbuilding IPOs in our sample into four categories depending on whether the issuing firm engages a U.S. underwriter and/or targets U.S. investors. In the first stage, we run a multinomial logit regression of a firm choosing one of these four categories over a fixed-pricing offering. We then use the predicted probabilities from the first-stage regression to instrument for the endogenous IPO pricing and distribution methods in our main regression model (1).

Table 6: Two Stage Least Squares Regression Analysis of the Effect of Dual Listing on Canadian IPO Underpricing
Panel A: Second-Stage Regression of IPO Underpricing on the Predicted Probability of Dual-Listing Coefficient Intercept Predicted Dual-Listing Log_Proceeds Underwriter_Rank_G Underwriter_Rank_L IPO_Volume 145.49*** (52.28) -2.59*** (0.81) -2.39 (3.91) -0.50 (2.42) -5.42 (6.02) -0.22* (0.12) Included 338 0.03 1.37

Industry and Year Dummies Observations Adjusted R2 F-Stat

Panel B: First-Stage Binary Logit Regression of Dual-Listing Dummy on Listing Choice Variables Coefficient Intercept Log_Assets Sales_Growth Leverage Std_Deviation_of_Stock_Returns Industry and Year Dummies Observations McFadden R2 Prob(LR statistic) -29.44** (11.23) 0.26** (0.13) 0.01 (0.00) -0.02** (0.01) -0.02** (0.01) Included 338 0.21 0.00

The sample consists of 297 domestic Canadian IPOs and 41 Canadian IPOs which are also simultaneously crosslisted in the U.S. The sample period spans from 1995 to 2002. Panels A provides results for the second stage regression of IPO underpricing on the predicted probability of dual listing from the first-stage binomial logit regression presented in Panel B, controlling for firm-level IPO determinants. The dependent variable is IPO underpricing in Canada, which is defined as the market-adjusted return from the offer price to the closing price on the first trading day after the IPO in Canada, measured in percentage terms. Panel B summarizes the results from the first stage binomial logit regression of a dual-listing dummy on listing choice determinants. The explanatory variables are log of total assets, sales growth, the firms leverage ratio (ratio of total debt to total assets), the standard deviation of monthly stock returns of the IPO within a 1-year period after going public, and industry and year dummies. All accounting variables are based on information in the most recent fiscal year prior to the firms IPO. Industry dummies are constructed based on 2-digit SIC codes. All other variables are as defined in Table 2. Standard errors are White (1980) heteroskedasticity-consistent standard errors. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% level (two-tailed), respectively.

Table 7: Effect of Disclosure Regulation on IPO Underpricing for Dual-Listed IPOs

Panel A: Distribution Statistics on IPO Underpricing of Dual-Listed IPOs U.S. Cross-Listing Mean Median 1st Quartile 3rd Quartile Std Deviation Observations 20.37 10.31 -0.93 33.26 36.35 227 Home Listing 40.74 22.52 -4.55 62.84 86.97 227 P-Value for Mean and Median Test 0.00 0.01

Panel B: OLS Regression of IPO Underpricing on Disclosure Regulation for Dual-Listed IPOs Specification 1 Intercept Disclosure Liability_Standards Public_Enforcement Equity_Market_Size Corruption Analyst_Following Legal_Enforcement Ownership_Concentration Voluntary_Disclosure_SP_Score Observations Adjusted R2 F-Stat 454 0.06 11.16*** 115.13*** (18.45) -1.11*** (0.32) 0.08 (0.19) 0.06 (0.27)

Specification 2 99.17 (83.60) -2.03*** (0.69) -0.20 (0.29) 0.13 (0.28) 0.001*** (0.00) 27.23** (13.43) 0.40 ((1.25) -19.58 (15.53) 1.16* (0.68) -1.93*** (0.74) 403 0.11 6.63***

The sample consists of 454 IPOs dual-listed in the U.S. and their home markets during the period from 1995 to 2002. The dependent variable is IPO underpricing which is defined as the market-adjusted return from the offer price to the closing price on the fifteenth calendar day after the IPO, measured in percentage terms. Disclosure is an index measure of the strength of a countrys prospectus disclosure regulation from La Porta et al. (2006). The higher the index value, the more stringent the disclosure regulation. The index values are measured on a 100-point scale. All the other variables are as defined in Table 5. Standard errors are White (1980) heteroskedasticityconsistent standard errors. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% level (two-tailed), respectively.

Table 8: Regression of IPO Underpricing on Disclosure, Conditional on Auditor Quality and/or Market Integration
Intercept Disclosure Disclosure*Auditor_Quality_Dummy Auditor_Quality_Dummy Disclosure*Integration_Dummy Integration_Dummy Liability_Standards Public_Enforcement Bookbuilding Auction Hybrid Privatization Log_Proceeds Underwriter_Rank_G Underwriter_Rank_L IPO_Volume Industry and Year Dummies Observations Adjusted R2 F-Stat 0.60*** (0.09) 0.40*** (0.11) 24.91*** (8.94) -5.90 (6.59) -12.97** (6.34) 6.38 (8.60) -9.81*** (1.60) 0.93** (0.34) 1.55 (0.97) -0.09*** (0.02) Included 6,019 0.06 6.65*** Specification 1 253.64*** (35.50) -1.64*** (0.35) 1.39** (0.54) -125.96*** (42.28) Specification 2 254.42*** (35.16) -0.99** (0.33) Specification 3 256.86*** (36.24) -1.12*** (0.34) 0.39** (0.19) -42.58** (21.32) 0.63* (0.36) -82.10*** (27.12) 0.32*** (0.08) 0.25** (0.12) 32.82*** (9.82) -9.33 (6.58) -3.39 (8.23) 6.25 (8.35) -10.06*** (1.59) 1.20*** (0.33) 1.35 (0.97) -0.07*** (0.02) Included 6,013 0.06 7.20***

0.77* (0.31) -93.62** (25.47) 0.29*** (0.09) 0.16* (0.09) 33.45*** (9.94) -9.79 (6.85) -2.20 (7.01) 6.48 (8.38) -10.44*** (1.60) 1.25*** (0.33) 1.37 (0.97) -0.06*** (0.02) Included 6,019 0.07 7.36***

The sample for specification (1) and (2) consists of 6,019 IPOs and for specifications (3) of 6,013 IPOs issued during the period from 1995 to 2002. Egypt and Sri Lanka are excluded from our sample because of missing data for auditor quality. Turkey is excluded because of missing data for market integration. The dependent variable is IPO underpricing which is defined as the market-adjusted return from the offer price to the closing price on the fifteenth calendar day after the IPO, measured in percentage term. Auditor_Quality_Dummy is equal to one if an IPOs prospectus is audited by a Big-Five auditor, and zero otherwise. Integration_Dummy is equal to one for countries with above median portfolio inflows and outflows in percent of GDP, as reported in Table 1 of Hail and Leuz (2006), and zero otherwise. Industry dummies are constructed based on 2-digit SIC codes while year dummies are constructed for all years from 1996 to 2002.

All other variables are as defined in Table 2. The numbers in parentheses are White (1980) heteroskedasticity-consistent standard errors. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% level (two-tailed), respectively.