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Journal of Financial Economics 15 (1986) 261-281.

North-Holland

CAPITAL RAISING, UNDERWRITING AND THE


CERTIFICATION HYPOTHESIS

James R. BOOTH and Richard L. SMITH, II*


Arironu Slute Unioersit): Tempe, AZ 85287, USA

Received February 1985, final version received September 1985

This paper develops a theory of the role of the underwriter in certifying that risky issue prices
reflect potentially adverse inside information. The theory derives from the literature on the use of
reputational capital to guarantee product quality. An underwriting cost/benefit paradigm is
employed to generate testable implications related to announcement effects, issue underpricing, the
choice of competitive versus negotiated underwriting, and the level of underwriter compensation as
a function of firm-specific information. Existing empirical literature is reviewed in the context of
the certification hypothesis and several new tests are conducted. All of the findings are supportive
of the hypothesis.

1. Introduction

This paper develops a model of the decision to employ an underwriter as an


integral part of the capital raising decision. The model is based on the
assumption of asymmetric information between insiders who are shareholders
and outsiders who are prospective subscribers to new issues. We hypothesize
that an underwriter can be employed to certify that the issue price is
consistent with inside information about future earnings prospects of the firm.
The hypothesis derives from expanding literature on reputational signaling,
most notably the work by Klein and Leffler (1981). They demonstrate the
conditions under which a non-salvageable capital expenditure can serve as an
effective bond to guarantee the quality of a firms products. The non-salvage-
able investment is perceived by customers as a commitment to product quality.
Their willingness to pay a premium over product cost for the commitment
provides a stream of quasi-rents on the initial investment which will only
continue to be paid as long as the firm does not cheat. Recent extensions of the
Klein and Leffler reputational capital reasoning to financial markets include:
Easterbrook (1984) on the role of dividends in guaranteeing future financial
performance, DeAngelo (1981) on the role of auditor reputation in accounting

We appreciate the helpful comments from Benlamin Klein, Clifford Smith, Janet Smith,
participants of the MERC Conference on Investment Banking and the Capital Acquisition Process
at the University of Rochester and the participants of the Sloan Workshop at UCLA.

0304-405X/86/$3.506 1986, Elsevier Science Publishers B.V. (North-Holland)


262 J.R. Booth and R.L. Smith, II, Underwiring and certification

Table 1
Alternative methods of security issuance by type of security (1977-1982). The table summarizes
data from the Registered Offering Statistics Tape provided by the Securities and Exchange
Commission. Data include all issues listed on the tapes where type of underwriting arrangement
could be identified. Rule 415 security issues are excluded. The type of underwriting arrangement
varies based on security type and whether the offering is an initial registration. Firm commitment
is the most common arrangement. Among firm commitment issues, choice of competitive versus
negotiated offering is related to the priority of the security claim. Competitive underwriting is less
common despite its lower level of underwriter compensation.

Type of security
Convertible
Method of Mortgage Straight Preferred Convertible preferred Common
security issuance bonds bonds stock bonds stock stock

Use of underwriters

Non-initial registered
offerings (NIR)a
Firm commitmentb 454 896 221 240 70 1.008
Best effort 2 128 0 5 1 27
Rights with standby 0 7 1 4 0 29
Rights without standby 1 2 3 3 1 6-l
Self-registeredc 2 205 7 2 2 106
Percent firm commitment 98.9 72.4 95.3 94.5 94.6 81.5
Initial registered
offerings (IR)
Firm commitmentb 29 68 1 14 4 396
Best effort 3 22 0 2 0 470
Rights with standby 0 0 1 0 0 5
Rights without standby 1 0 1 1 0 14
Self-registered 1 28 3 3 3 106
-
Percent firm commitment 87.9 57.6 16.7 70.0 57.1 40.0

Types ofjirm commitment undetwriting arrangements

Non-initial registered
offerings (NIR)
Utilities
Negotiated 201 58 122 5 7 413
Competitive 199 12 61 0 0 43
Percent negotiated 50.2 82.9 67.7 100.0 100.0 90.6
Other industries
Negotiated 35 816 36 235 63 551
Competitive 19 25 2 0 0 1
- - -
Percent negotiated 64.8 97.0 94.7 100.0 100.0 99.8

aIncludes initial otTers of securities for firms already registered with the SEC
Data set includes all firm commitment offerings that could be identified as being underwritten
either competitively or on a negotiated basis for the 1977-1982 period,
CIncludes issues where no underwriter was utilized. Self-registration tends to occur between
issuers and investors with much in common and where an active securities market is of little value.
For example, shares of cooperative ownership such as a grocery cooperative are often issued
without use of an investment banker.
J.R. Booth and R. L. Smith, II, Underwriting and certificafron 263

statement certification, Wakeman (1981) on the reputations of bond rating


agencies, and Mayers and Smith (1982) on the use of corporate insurance to
guarantee contractual performance.
This paper extends the reputational capital paradigm to explain the role of
the investment banker in certifying the pricing of equity and risky debt issues.
Issuing firms are viewed as effectively leasing the brand name of an invest-
ment banker to certify that the issue price reflects available inside information.
Several apparently paradoxical relationships with respect to the type of
underwriting arrangement can be understood in the context of the certification
hypothesis. To illustrate, table 1 presents statistics on methods of security
issuance by type of security over the 1977-1982 interval. The first panel
contrasts non-initial registrations including new debt issues of firms previously
registered with the SEC (NIR) with initial registrations (IR) in terms of issue
arrangement.* The table indicates that firm commitment issues of all types of
securities are far more common than all other issues combined (best efforts,
rights offerings and self-registrations), despite the lower direct cost of non-
firm-commitment issues.3 The percent of NIRs that are firm commitment is
substantially higher than the percent of IRS for all types of issues. The second
panel of table 1 breaks down firm commitment NIRs into competitive versus
negotiated arrangements. Results are presented separately for public utilities
versus other industries. The percent underwritten on a negotiated basis is
higher for all types of public utility issues. 4 More importantly, the percent
negotiated increases dramatically for both groups as the securitys effective
priority claim on assets declines. This study indicates that both of the above
are implications of the certification role of investment bankers in mitigating the
asymmetric information problem between insiders and outsiders.

2. Informational asymmetrj

The fundamental problem with issuing equity or risky debt is potential


opportunism by insiders/shareholders with superior knowledge. Myers and
Majluf (1984) and others have recognized that insiders have an information

Gilson and Kraakman (1984) identify certification as a plausible explanation of the role of
investment bankers.
This classification is established by the Securities and Exchange Commission (SEC) for data
reporting. IRS include only issues of firms not previously registered with the SEC. All other issues
are classified as NIRs. Because of this classification structure, some initial public offerings of
equity for which previous debt issues had been registered would be classified as NIRs by the SEC.
See Smith (1977) and Hanson and Pinkerton (1982) for documentation of the cost difference
between firm commitment and rights offerings.
4Rule 50 of the Public Utility Holding Company Act of 1935 requires all registered public utility
holding companies and their subsidiaries to sell securities only through competitive bidding unless
exempted by the SEC. Bhagat and Frost (1986) suggest that the SEC generally grants exemptions
primarily during unstable market conditions and when few bids are forthcoming.
264 J. R. Booth and R. L. Smith, II, Underwriting and cerrifcation

advantage that enables them to exploit situations where outsiders have over-
estimated the future cash flows to be received by investors in a new issue.5
Absent the ability of insiders to credibly communicate their beliefs or the
ability of outsiders to buy inside information, a potential market failure of the
type identified by Akerlof (1970) results. This motivates use of an investment
banker to certify the issue price.
The incentive to issue arises partly from the opportunity to effect a wealth
transfer from outsiders. The result, other things equal, is that the proportion of
over-valued firms seeking new outside equity will be greater than the propor-
tion in the population. Hence, the announcement by insiders of their intent to
raise outside equity provides information about the probability that the firm is
over-valued. The response is an instantaneous decline in firm market value
according to the degree of over-valuation perceived by outsiders to be reflected
by the announcement.
In such situations, financing is warranted only if investment opportunities
are sufficiently valuable to overcome the loss on announcement and cannot be
deferred at low cost until more favorable conditions prevail. In the limit, only
more over-valued firms with more valuable and transitory investment oppor-
tunities would choose to issue new equity.

3. The certification hypothesis and the role of the underwriter

3.1. The gain from certication and the bonding mechanism


Insiders benefit to the extent they are able to communicate the consistency
of the firms stock price with inside information. To see this, let Xl represent
the time t value to existing shareholders of projects that can be profitably
undertaken at time t if outsiders know the issue price is consistent with inside
information. Similarly, let Xp (< X:) be the time t value to existing share-
holders of such projects if outsiders respond negatively to an announced new
issue .6 Thus, X, - Xp = Y, is a quasi-rent which is earned if outsiders believe
insiders will not cheat on the issue price.

See Rock (1986) Beatty and Ritter (1986). Ritter (1985) Campbell (1979) Campbell and
Kracaw (1980). Leland and Pyle (1977) Bhattacharya and Ritter (1983), Rendleman (1980).
Giammarino and Neave (1982), Miller and Rock (1985) and Chalk and Peavy (1985) for analyses
of various issues related to the informational asymmetry problem between insiders and outside
investors.
In effect we are assuming insiders expect to issue new equity in every period, but that the size of
the issue is smaller (possibly zero) if outsiders discount the announcement. On average the stock
price at the time of announcement could be consistent with insider information, but since actual
issue size would vary depending on the true state of nature, outsiders would be correct in
discounting the new issues.
Since Y, is actually a random variable, it is possible that investors would incorrectly interpret
low next period earnings as an incident of cheating or over-pricing by the issuing firm. Generaliza-
tion of the analytical model to deal with this type of uncertainty is beyond the scope of this paper.
J. R. Booth and R. L. Smith, II, Underwriting and certrjication 265

Any firm which is expected by outsiders to price correctly can cheat by


over-pricing. By doing so, existing shareholders receive a one-time gain of W.
The cost of cheating is the loss of a perpetuity of quasi-rents. Thus, the
necessary condition to induce non-cheating is

Y/(er - 1) > W/e". (1)


The discount rate, r, represents cost of capital and t is defined as the
interval between issues.8 Condition (1) states that the present value of the
perpetuity of quasi-rents must exceed the present value of the one-time wealth
transfer from over-pricing. If it were clear to outsiders that this condition held
in all states, then a bonding investment would not be required since insiders
would have no incentive to cheat. However, since only insiders know directly
whether condition (1) holds, outsiders will require proof that can be supplied
in the form of a bond, B. To insure non-cheating, rational investors will
require the investment in the bond to exceed the value of the potential
one-time gain from cheating,

B > W/e. (4

If condition (2) is recognized to be satisfied, then outsiders can infer, at the


time of the investment, that insiders intend not to cheat. Thus, outsiders must
be able to assess the re!ative magnitudes of the bond and the gain from
cheating. They must not directly know that condition (1) is satisfied or
cheating is impossible. These information requirements appear to be generally
satisfied based on outsiders ability to infer that condition (2) is satisfied from
observable proxies such as past experience with similar issues or with the
underwriter.
Insiders maximize the value of their investment with respect to choice of the
bond and will provide a bond whenever the cost is less than the present value
of quasi-rents that can be earned. It is in their interest to make the bond as
small subject to the limitation that condition (2) must be recognized by
outsiders to be satisfied. This suggests a rationale for the use of underwriters in
reducing the cost of a credible bond, and in reducing the interval between
successive uses of the bonding investment.

We assume the first issue occurs at time r. The discount rate applied to the potential wealth
transfer is assumed to be the same as that applied to the perpetuity of Y. These assumptions serve
only to facilitate the presentation and do not limit the generality of the analysis.
Telser (1980) makes essentially the same argument in his analysis of self-enforcing contracts.
r We assume the investment in the bond must occur at least one issue interval prior to the first
opportunity to cheat. This is appropriate since one way to provide B involves under-pricing of
earlier issues, Modification of the assumption would not alter our conclusions.
tt We are grateful to Benjamin Klein for calling our attention to the informational requirements
of outsiders.
266 J. R. Booth and R.L.. Smith, II, Underwriting and certification

The bonding investment can be either fixed or variable, but a fixed bond will
maximize the net quasi-rent gain. This is because the bond must be perceived
by outsiders to exceed the value of the wealth transfer for each new issue. If B
is even partly variable, the increased present value of investment opportunities
with bonding must be sufficient to justify any marginal expenditure on B
necessary to cause condition (2) to hold.
Since the necessary bond is limited by the potential one-time wealth transfer,
the underwriters ability to intercede and provide third-party certification
increases the flow of capital to firms where asymmetric information would
otherwise lead to reduced investment. To illustrate, consider a firm that has
only limited investment opportunities such that, given the scale economies
associated with new issues, it will seek new equity infrequently (say, every t
years). The bond provided by such a firm is non-productive except in those
infrequent periods when the firm elects to seek new capital. If instead, it can
(in effect) lease the use of a bond from an underwriter for the period necessary
for inside information to become public, then a perpetuity of rental payments
with frequency I can be substituted for the investment of B in determination
of firm value.12 Thus, B(e rf/ - 1) is the periodic rent for the interval of l/n th
of the issue interval where t/n is the interval necessary for cheating to be
detected. Thus, n such firms could successively employ the underwriters
bonding investment over a single issue interval of length t. An underwriter can
be viewed as a firm specializing in leasing the bonding investment to other
firms seeking to raise capital.

3.2. The cost of certijkation

For the underwriter to be able to certify the price of a new issue, it must
spend resources to become an insider. Accordingly, the gain in firm value from
bonding is reduced by the certification cost, C, incurred. Thus, the cost to the
issuing firm of employing an underwriter consists of the rental price for the
bonding investment plus the certification cost incurred by the underwriter. The
condition under which an issuing firm would gain from underwriter certifica-
tion is

Y - C > B(erln - 1).

If the increased value from bond provision net of certification cost is greater

12The bond of an issuing firm can also certify against other opportunistic behavior by insiders
such as failure to disclose adverse information at other times. Likewise, the investment bankers
bond can be employed in other uses such as merger and acquisition work.
J.R. Booth and R. L. Smith, II, Underwrirlng and certification 261

than the periodic rental value of the underwriters reputation then certification
will increase the value of the issuing firm.13
The analysis implies that, on average, equity securities will be over-valued by
the market at the time of an announced new issue of risky debt or equity.
Absent a credible guarantee of the market price, the equity will decline in value
when the intent to issue is announced. If bonding is used to fully certify
consistency of the stock price with inside information, no certification-related
announcement effect will be observed. Any remaining announcement effect is
attributable to other factors. This holds even if certification is costly, since the
cost would be effectively netted from the present value of investment opportun-
ities.
Incomplete certification gives rise to an announcement effect price decline
since the underwriter must substitute for the lack of complete certification. If
the underwriter certifies a lower price to protect or help establish his reputation
or uses discounting as a substitute for full certification, a drop in value
followed by either normal or positive abnormal returns from offer price to first
aftermarket price is expected. Since full certification is unlikely to be optimal
for all issues, a price decline should be expected on average. Furthermore, the
average magnitude of the decline should be related to the magnitude of
potentially adverse inside information. Thus, equity issues will experience the
greatest decline and low risk debt issues the smallest.14
The more costly is external certification relative to the benefit, the more
likely the stock or risky debt is to be issued at a discount. The underwriter will
incur direct costs of certification only to the point where marginal cost of
certification equals marginal benefit so that net issue proceeds are maximized
subject to the constraint that the issue is not over-priced. This provides a
means of protecting the bonding investment of the underwriter without having
to incur the entire cost of certification. Thus, other things equal, discounting
will be greater when the percentage cost of becoming an insider is high and
when the expected value of existing inside information is large (i.e., small issues
of equity and low rated debt and new issues).
An ordering of certification activities such that the marginal net benefit of
more complete certification is declining implies an empirical relationship
between the type of issue (e.g., debt versus equity) and the magnitude of the
announcement effect equity price decline. Since low risk debt issues require
certification only that inside information would not result in bankruptcy, only
the more extreme states of nature need be precluded. In contrast, complete

13See &Angelo (1981) for a similar analysis regarding certification of audits by accounting
firms.
I4 Conceivably, the announcement to issue low risk debt could cause the stock price to increase
since it implies that insiders do not regard equity to be sufficiently over-valued to warrant an
equity issue.
268 J. R. Booth and R. L. Smith, II, Underwriting and certification

equity certification would require that all adverse inside information be dis-
covered.
The existing literature on announcement effects is fully consistent with this
implication of the certification hypothesis. Asquith and Mullins (1986)
Masulis and Korwar (1986), Mikkelson and Partch (1986) Dann and Mikkel-
son (1984), and Eckbo (1986) all provide evidence of an equity price drop after
announcement of a seasoned new issue, followed by generally normal returns.i5
A number of studies have documented the cross-sectional relationship between
the magnitude of the announcement effect and the risk of the issue (as proxied
by issue priority).16

3.3. Credibility of underwriter certijcation

The maximum gain to an underwriter who falsely certifies an issue is W,


since this is the maximum that insiders will pay for false certification and since
certification cost in this case can be zero. Thus, underwriter credibility depends
on existence of a bonding investment greater than the discounted value of W.
This is identical to the issuers condition (2). To justify investment in the bond,
the underwriter must be paid a premium over his direct cost of certification.
Competition among potential underwriters suggests that the net gain (from
resulting quasi-rents) would be competed away at least for the marginal
firms.* In other words, the underwriter must effectively post a bond of B
which earns a normal return of B(e/ - 1) provided he does not falsely
certify the price of an issue, but zero otherwise. An observable bonding
investment (the underwriters reputation) is the guarantee required by inves-
tors before they will regard the certification as credible. The resulting equi-
librium implies that for an underwriter with an established reputation, the
price charged for underwriting services will exceed marginal cost by the
amount of the quasi-rent on the underwriters reputation.
There are alternative ways in which the underwriter can accumulate the
necessary reputational capital. Darby and Lott (1982) and DeAngelo (1981)
have shown the requisite investment can be created by deliberate sacrifice of
short-run profit. A new underwriter can build his reputation by under-pricing

lSThe hypothesis implies a similar announcement effect price decline associated with block
trades. Evidence by Dann, Mayers and Rabb (1977) and Scholes (1972) is consistent with the
hypothesis.
16See Smith (1986) in this issue for a summary of these results.
Once investors recognize that certification is false, it is assumed that all future benefits of the
bonding investment are lost.
If the cost of reputation is the same for all firms. then the net present value of the bonding
investment is zero for all firms.
J. R. Booth und R. L. Smith, II, Underwriting and certification 269

issues in the short-run and absorbing the under-pricing 10~s.~ This is equiv-
alent to reducing the maximum W to W* such that W/e > B > W*/e. Since
the short-run sacrifice is warranted only by the potential to earn future
quasi-rents, sacrificing some of the underwriter spread in the short-run results,
over time, in creation of a bond.
A second way to establish reputation is through the willingness to be
penalized for over-pricing. A reputable underwriter will maintain sufficient
capital reserves or insurance to meet the liabilities stemming from over-pricing
and may voluntarily make restitution to purchasers when security prices fall
after the issue. Less reputable underwriters are more likely to be poorly
capitalized and less concerned with maintaining their reputations.21

3.4. Alternative means of bond provision

An alternative to underwriter certification is for the issuing firm to provide


its own bond. Fig. 1 illustrates the condition under which a firm could gain by
providing a bond against over-pricing as well as the condition under which use
of an underwriter would be preferred. The horizontal axis depicts frequency, t,
of use of the bonding investment. The vertical axis is present valued dollars.
The economic rationale for the use of underwriters is that the frequency of
issues associated with a given investment in reputation can be increased via
underwriting. Fig. 1 depicts the relationship of conditions (1) and (2) to
frequency of issue. The vertical distance, Y/(er - 1) - W/e, measures poten-
tial gain from bond provision by the issuing firm. Minimum issue frequency at
which the reputational investment of B is marginally profitable is t*. A firm
that expects to go to the risky capital market infrequently (located to the right
of t*) cannot independently justify the investment.22 As issue frequency

Alternatives to under-pricing such as correct pricing with an over-payment to the issuer are
also possible. The main concern is that returns to the underwriter seeking to develop a reputation
be subnormal in the short-run.
2 Purchasing insurance is analytically equivalent to posting a bond. The ability to use insurance
as a substitute requires that some mechanism be devised to guarantee that the investment banker
will not cheat the insurance company. See Mayers and Smith (1982) for the rationale for the
corporate demand for insurance.
zi Investment banking firms can underwrite issues for which they do not have a sufficient bond
or reputation. If trading of the warrants is restricted for a sufficient time to insure that the
underwriter bears any possible loss of value associated with inside information becoming public,
warrants can reduce but not eliminate the requisite bond. The potential wealth transfer from a
given amount of new equity capital is reduced because a fraction of the new equity is sold to the
insider (the underwriter). If the cost of external certification is sufficiently high to preclude use of
an underwriter, it may become advantageous for the issuing firm to provide its own bond. The
alternatives available to the issuer are essentially the same as for the underwriter.
22Fig. 1 correctly implies that by reducing issue size and increasing frequency, a firm could
independently move to the region where the bond would be of positive value. Economies of scale
with respect to issue size mitigates against this except for firms with very large capital demands.
270 J.R. Booth and R.L. Smith, Ii, Underwriting and certificotron

Present
Value
($1

W/ert

I I
I I

L I 1 Time (t)
1, t*

Fig. 1. Relationship of gain from reputational investment to issue frequency. The figure indicates
the gain from bonding that a new issue is correctly priced as a function of duration between
successive new issues of the same firm. Intersection t* is the indifference point where the benefit
from the bond provision, Y/(e - l), equals the potential wealth transfer from cheating, W/e.
At that point, r* is the duration between issues and B is the bond that must be provided by the
issuer as evidence of intent not to overprice. In contrast, t+ is the indifference point where the gain
from provision of the bond by an underwriter who must incur certification cost, (Y - C)/(e< ~ 1).
equals the cost to the issuing firm of using the underwriters reputation to guarantee non-cheating,
We In - l)/(e - 1). However, for points to the right of r*, the underwriter would be unwilling
to provide a bond, since the condition necessary to prevent cheating by the issuing firm is not
satisfied to the right of t*. For a firm with issue frequency lo, the net gain from using an
underwriter to provide the bond is the difference between the gain from underwriter provision.
distance cd, and the gain from self provision, distance uh.

increases, the minimum sufficient investment in reputation increases gradually


according to W/e and the gain, Y/(er - l), increases rapidly.23 The net gain
from bond provision is the vertical distance between Y/(e - 1) and W/e.
Thus, a firm with issue frequency t, would gain distance, ab, by providing the
bond without use of an underwriter.
The underwriters ability to provide certification can increase the net flow of
risky capital to issuing firms. This gain is illustrated in fig. 1. The function

z3The necessary increase in B as frequency rises is an assumption of the model. B is assumed to


be invested one issue interval prior to its first use. An alternative assumption that the interval
between bonding and first use is unaffected by issue frequency could be represented as a horizontal
line. The analysis does not depend on the particular assumption about the timing of bond creation.
J. R. Boorh and R. L. Smith, II, Undenvntmg and cert~jkatmn 211

labeled (Y - C)/(er - 1) is the increase in present value, net of certification


cost, that results from using an underwriter to provide the bond for all future
new issues of the firm. Offsetting the reduced value [relative to Y/(e - l)]
is the reduced cost per issue of providing the bond. The function,
B(e rr/n - l)/(e - l), is the present value of the perpetuity of rental cost of
using the underwriters reputation. For n = 1 the cost is equal to B and no
saving results. At higher values of n, the cost to the issuer of providing the
bond via the underwriter declines sharply.
For firms located to the right of t*, no bond is provided by either the issuing
firm or the underwriter. This is true since the underwriter will not commit
unless it determines that condition (1) is satisfied. In such case, the firm either
relies on internally generated risky capital or issues without certification and
accepts the negative announcement effects. Conversely, firms to the left of t*
will always bond, but the choice of using an underwriter to produce the bond
depends on comparison of the relative net benefits of self- versus underwriter-
provided certification. Thus, for the firm located at t,, the gain from using an
underwriter, cd, exceeds the gain from independent provision.of the bond, ab.
In the example depicted, the gain from use of an underwriter relative to
independent bond provision is maximized at t* and declines gradually as issue
frequency increases. For very high levels of issue frequency, the net gain to
underwriter certification becomes negative. Thus, firms which issue frequently
would have a lower tendency to rely on certification from the underwriter.

4. Empirical results

4.1. Relationship of issue cost to certijcation cost

Underwriting cost to the issuing firm reflects, among other things, costs
incurred by the investment banker to certify the issue. This applies whether the
security is issued at a pre-specified price by general cash offer or at market in a
rights offer with standby agreement. 24 Provided that investment banker services
such as certification and issuance are competitively supplied, it follows from
the relationship of certification cost to security type that, other things equal,
the cost of underwritten debt issues will be less than the cost of underwritten
equity. More generally, underwriting cost is a function of the potential impact
of asymmetric information. There are two reasons to expect this proposition to
hold. First, the expected wealth transfer on debt issues is less since in many
states of nature the debt service cash flows are not affected by opportunism.

Z4Statement of a price at which the investment banker stands ready to purchase the issue is
appropriately regarded as an opinion of value. In cases where securities drop below these prices
shortly after issue, investment bankers may directly or indirectly compensate regular customers for
the loss of value.
272 J. R. Booth and R. L. Smith, II, Underwriting and certification

Second, the cost of certification is reduced since there are states of nature
where no cheating can occur.
For equity issues, Smith (1977) shows that compensation of investment
bankers is only slightly less for standby agreements to rights offerings than for
underwritten cash offers. Conversely, both Smith and the SEC (1974) docu-
ment that underwritten cash offers are considerably more expensive than
non-underwritten rights offers of similar size. Two factors contribute to the
cost differences described above: one is underwriting cost and the other is
issuing costs such as postage and registration. These relationships suggest that
the difference in issue cost between firm commitment issues and rights issues is
relatively small, thus, underwriting cost appears to represent a substantial
fraction of the total difference.
Additional suggestive evidence concerns the relationship between issue size
and cost. Smith, for example, finds increasing returns to issue scale and the
relationship of cost to issue size is approximately the same for standby
agreements as for underwritten cash offers. Similar results suggesting increas-
ing returns to issue scale for municipal and public utility debt financing are
reported by Joehnk and Kidwell (1984) and Dyl and Joehnk (1976). Assuming
that underwriting services are competitively supplied, the cross-sectional varia-
tion with respect to issue size may be due either to bonding cost or marketing
cost economies. These findings indicate the potential importance of the certifi-
cation hypothesis.
A more discriminating test of the certification hypothesis is focused on the
relationship between issue cost and the magnitude of the potential wealth
transfer from asymmetric information. Certification is more valuable the
greater the potential wealth transfer. Since, as the size of the potential wealth
transfer increases, the amount of price discounting in the absence of certifica-
tion also increases, the level of expenditures to certify a higher price should
also rise 25 The certification activity of the underwriter involves discovery of
(the absence of) inside information which may diminish firm value. Since such
information is largely firm-specific, it is hypothesized that the amount of
certification cost a firm would be willing to incur is an increasing function of
firm-specific risk.
To test the hypothesis that issue cost depends on the potential magnitude of
asymmetric information, we employ monthly stock market return data for
firms involved in 964 seasoned new issues over the period from 1971 to 1982.
The sample represents all issues over the period that are listed on the 1983
Registered Offering Statistics Tape and for which at least 60 monthly returns

25Jbehnk and Kidwell (1984) and Dyl and Joehnk (1976) in studies of competitive versus
negotiated underwritings of municipal and public utility debt, reveal that underwriter spread
increases with the risk of the issue as measured by Moodys rating class. In a competitive
underwriting market, this result implies that the cost of using an underwriter increases with risk
and is suggestive evidence that the certification component of underwriting cost is rising.
J. R. Booth and R. L. Smith, II, Underwriting and certification 213

immediately preceding the new issue announcement are available from the
Compustat price-dividend-earnings tape. Total variance of equity returns for
each issuing firm is partitioned into market and non-market risk by regressing
firm returns on contemporaneous market returns. Market risk is measured as
the variance of predicted returns and non-market risk is measured as the
variance of residuals. The latter variable proxies for the potential value of
inside information. The measure is imperfect since non-market risk is not
entirely firm-specific. However, it is reasonably expected to be correlated with
potential firm-specific information. Three separate data subgroups are ex-
amined: industrial firms, public utilities and banking firms. These groupings
are necessary since the relationship of the proxy variable to firm-specific risk
would be different for regulated than unregulated industries but is presumed to
be more homogeneous within groupings.
The certification hypothesis implies that underwriter compensation as a
percent of issue proceeds will be an increasing function of the relative
proportions of non-market to market risk as a measure of the magnitude of the
informational asymmetry and a decreasing function of issue size, reflecting
economies of scale in underwriting. Market risk is also included in the model
even though the certification hypothesis implies no necessary relationship to
underwriter compensation. In contrast, the risk-bearing hypothesis advanced
by Mandelker and Raviv (1977) implies a positive sign on market risk. The
model was estimated as follows:

COMP, = a, + a,VAR~ + u2( VARY/VAR) + a,log(SZZE,) + e,, (4)

where COMP, is tmderwriter compensation as a percent of issue proceeds for


the ith issue, VARS is systematic variance of monthly returns, VAR is
unsystematic variance, log(SZZE) is the log of issue size, and e, is a random
error term.
Results of the analysis are presented in table 2. Contrary to the implication
of the risk-bearing hypothesis, there is no significant relationship between
underwriter compensation and market risk for any of the three groups ex-
amined. In contrast, as implied by the certification hypothesis, the ratio of
non-market to market risk, which proxies for firm-specific information, is
significantly related to underwriter compensation for industrial companies.26
The relationship is of the same sign but not significant for public utilities and
banking firms. This is consistent with the fact that these industries are
regulated in ways that tend to limit certification cost so that non-systematic

26T~ test the possibility of an interrelationship between the independent variables. underwriter
compensation was regressed on the ratio of non-systematic to systematic risk, excluding other
variables. The relationship is essentially unchanged. The coefficient on VA RP/ VA R: = 0.084,
r-value = 2.32.
274 J.R. Booth und R.L. Smith, II, Underwriting and cer@caflon

Table 2
Underwriter compensation as a percent of issue proceeds as a function of unique and systematic
risk (1971-1982). The table indicates that underwriter compensation is: positively related to the
ratio of unique to systematic risk which proxies for potential asymmetric information and
negatively related to the natural log of issue size, but unrelated to systematic variance. Data
include all seasoned new equity issues over the 1971-1982 period that were listed on the
Registered Offering Statistics Tape of the SEC and for which at least 60 monthly returns prior to
issuance were available from Compustat. Public utilities and banking firms are examined sep-
arately since regulation tends to weaken the relationship between unique risk and the magnitude of
asymmetric information.

Regression results by industry grouping


Industrial Public Banking
Independent variables companies utilities firms

Intercept - 0.280 - 2.212h - 0.168


(1.63) (8.38) (0.21)
Systematic variance - 0.0001 - 0.024 0.173
(0.00) (0.80) (1.37)
Unique/systematic variance 0.081b 0.035 0.157
(3.24) (1.22) (1.17)
log( SIZE) - 0.275b ~0.130b -0.199b
(19.01) (10.65) (3.62)
R2 0.61 0.15 0.45
Observations 279 685 20

Absolute r-values in parentheses


Significant at 0.05 level.

variance does not proxy as well for inside information. As expected, issue size
is negatively related to underwriter compensation for all three groups.*

4.2. The use of underwriters

Firms will employ underwriters when the expected benefit of external


certification is sufficient to justify the additional cost. Different types of
arrangements involve different levels of certification effort. For example, a
rights issue without standby and best efforts underwritings involve no credible
expression of value by the underwriter, and thus can be regarded as essentially
uncertified. Also, since competitive underwriting precludes possibly lower cost
means of acquiring inside information, the level of certification activity tends
to be lower for competitive than for negotiated issues. The willingness of an

*A similar result with respect to the importance of non-systematic risk his recently been
obtained by Bhagat and Frost (1986) for new equity offerings of public utilities. However. unlike
our result, they find issue cost to be a positive function of both beta and the standard deviation of
residuals from the market model.
J. R. Booth and R. L. Smith, II, Underwriting and certification 215

issuer to avoid more complete certification indicates that the marginal benefit
of additional expenditures on certification is limited, and thus the asymmetric
information problem is relatively small.**
Previous research relevant to the decision to employ underwriters by type of
arrangement has focused on the difference in net interest cost for like-rated
competitive versus negotiated issues. Downs and Heinkel (1982) find lower
total net interest cost to be associated with competitive bid underwritings. But
for the Baa rating class the underwriter spreads are virtually identical and the
issues by negotiated underwriting are priced to yield less than those done
competitively. Thus, the advantage of competitive underwriting declines as the
risk of the issue increases. This suggests a relationship between the level of
certification effort and the potential gain from certification.
To analyze the cost/benefit trade-off from certification expenditures more
directly, a positive relationship is hypothesized between issue size and the
incurrence of certification cost as proxied by the type of underwriting arrange-
ment. The analytical model implies scale economies with respect to the
certification activities of underwriters. Thus, the net benefit of more complete
certification will increase with issue size. To examine the relationship, we
employ the Registered Offering Statistics Tape data. The decision to externally
certify and the degree of external certification are hypothesized to be positively
related to issue size. The certification decision is represented by two different
decision variables: firm commitment underwriting versus other (best effort or
self-registration) and negotiated versus competitive underwriting. To control
for some of the other factors affecting the value of external certification we
focus separately on NIRs and IRS of non-utility issuers with respect to the firm
commitment versus other decision and separately on public utilities and
industrials for the negotiated versus competitive decision. A debt versus equity
binary variable and an ordinal bond rating variable are included in the model
to control for some of the additional factors that would be related to the value
of inside information. The relationship of the decision variable to issue size is
estimated separately for debt and equity where size is specified in log form.
The model is as follows:

DECISION=a,+a,DEBT+a2RATING+u,logSZZE(EQUZTY)

+a,logSIZE(DEBT).

The model is estimated by maximum likelihood logit for each of the four
separate data groupings. Results are presented in table 3. The hypothesis
implies a positive relationship between each dependent variable and issue size.

2Because Rule 50 requires that certain utilities employ competitive underwriting, the competi-
tive/negotiated decision is not entirely market determined. Any interpretation of empirical results
must recognize this potential problem.
216 J. R. Booth und R. L. Smith, II, Undenwting und certificution

Table 3
Estimated coefficients from logit analysis of the relationship between type of underwriting
arrangement and issue size for various types of security issues (1977-1982). The analvsis is based
on data from the Registered Offering Stat&tics Tape of-the SEC: Independent variables are defined
as follows: DEBT is a binary variable which takes on the value 1 for debt issues; RATlNG is an
ordinal variable which takes on the value 0 for non-rated debt, the value 1 for debt rated below B,
and increasing numbers thereafter; log SIZE( EQUITY and DEBT) are the natural logs of issue
size for equity and debt issues, respectively. The binary dependent variables reflect choice of the
type of underwriting arrangement and are scaled by the natural logs of the odds ratios for various
types of issues and issue arrangements. The table indicates that more complete certification as
proxied by use of firm commitment underwriting and negotiated issues is generally positively
related to issue size for both debt and equity issues.

Log of the odds of firm Log of the odds of


commitment versus other for negotiated versus
non-utilities= competitive

Non-initial Initial Public Non-utilities


registrations registrations utilities (debt only)

Constant - 2.1960b - 3.2824b 6.7950b 3.6491h


(5.8878) (10.1504) (7.5851) (3.7368)
DEBT - 0.2954 4.5211b - 5.2991h
(0.6091) (7.8623) (5.2188)
RA TING 0.7291b 0.4259b -0.3112h --0.5853h
(10.2084) (2.2222) (6.2673) (4.4364)
log SIZE (EQUITY) 1.045Sb 0.8829b - 0.6660h
(9.9996) (9.4129) (4.4878)
log SIZE (DEBT) 0.4849b - 0.2021b 0.1723h 0.2505
(8.2450) (1.9119) (2.0698) (1.4889)
Observations 1857 1078 2313 895
No. firm commitment 1447 479
No. negotiated 299 44

Absolute r-values in parentheses


bSignilicant at 0.05 level.

Results are as expected for the firm commitment versus other choice among
NIRs of non-utility debt and equity, as well as for equity IRs.*~ The negative,
non-significant relationship of debt issue size to the decision variable for IRS
was not expected. A possible explanation is related to the small number of
debt IRS. Within the group, issue size is correlated with bond rating, and the
variance of issue sizes is small so that the true relationship is difficult to
estimate.30

29An additional test of the firm commitment decision was conducted bv excluding self-registra-
tions from the non-firm commitment group. Results from that analysis are similar to those
reported in table 3.
3o When bond rating is dropped from the initial registration model as a test for collinearity, the
size variable becomes less negative and is no longer significant.
J. R. Booth und R. L. Smrh, II, Underwriting and certljicudon 27-l

With respect to the negotiated versus competitive decision, the size variable
for both public utility and industrial bond issues is correctly signed, though the
industrials coefficient is not significant. The sign on issue size of equity,
however, is negative for public utilities and cannot be estimated for industrials
due to the lack of competitive equity issues for that group. Relationships
involving public utility issues must be interpreted with caution since the
decision is affected by regulation in several ways. For example, if large public
utilities are more heavily scrutinized by their regulatory authorities or if those
authorities are more responsive to investors than the authorities of smaller
utilities, then a negative relationship could result from the possibility that gains
from underwriter certification are reduced by the actions of the regulatory
authority. Other relationships in the table could not be signed ex ante. For
example, the sign on bond rating, which is ordered from best (Aaa = 6) to
worst (less than B = 0), is positive for firm commitments, but negative for
negotiated issues relative to competitive. The sign on this variable is determined
by the interaction of demand for certification with cost of certification.

4.3. Issue under-pricing

Under-pricing refers to the observation of systematically positive abnormal


returns from offer price to first aftermarket price. Empirical documentation of
under-pricing has previously appeared in the literature for both debt and
equity issues. See Smith (1986) in this issue for a review of empirical results on
issue under-pricing.
Attempts to theoretically account for under-pricing have only recently been
offered. Rock (1986) contends that under-pricing occurs as an inducement to
get relatively uninformed investors to participate in the new issue market. The
certification hypothesis suggests another (non-mutually exclusive) explanation.
As previously discussed, underwriters attempting to establish reputations for
correct pricing can build their reputations by deliberately under-pricing and
absorbing the under-pricing loss. This implies that initial public offerings, since
they tend to be handled by smaller, less established investment bankers, would
tend to be relatively more under-priced. Furthermore, even underwriters with
established reputations can underprice to protect their reputations. The degree
of underpricing is hypothesized to be inversely related to completeness of the
certification effort and positively related to the potential impact of adverse
inside information.
It is expected that, for like-rated bonds, under-pricing will increase as the
rating of competitively underwritten issues decreases, since, other things equal,
certification is more difficult for competitive issues. Certification costs can be
reduced by routinely apprising the underwriter of inside information, for
example through a continuing negotiated arrangement (e.g., placing the inveut-
ment banker on the board of directors of the firm). An implication is that the
278 J. R. Booth and R. L. Smith, II, Underwriting and cert$cation

cost, including under-pricing, of competitive issues will tend to rise relative to


negotiated issues as the potential informational asymmetry of the issue
increases. Otherwise the firms which are most over-priced, relative to inside
information, would tend to adversely select into competitive underwriting. The
expected result is that, for like-rated bonds, negotiated issues will reflect more
complete certification and thus will exhibit a reduction in the magnitude of the
underpricing.
To test this implication, we again employed the Registered Offering Statistics
data. A sample of all public utility bonds issued between 1977 and 1982 was
selected. This represents all public utility bonds for which complete data were
available on the tape. Secondary market price data subsequent to the issue
were collected from the Commercial and Financial Chronicle. These prices were
generally first reported several weeks after the original issue. The data collected
were the first reported secondary market prices up to twelve weeks after the
issue. For each bond, benchmark data was also collected on the contempora-
neous price change for outstanding public utility bonds of the same rating class
as reported by Moodys. The benchmark price change is estimated by con-
structing a hypothetical seasoned bond that sold at par with a twenty-year
maturity on the issue date of the subject bond. The change in yield from issue
date to the time of the first secondary market price of the new bond is used to
infer the price change of the hypothetical bond.
The analysis is summarized in table 4. The first three columns of the table
are self-explanatory. Column (4) is the average reported underwriter spread as
a percent of par value and confirms the finding of previous studies that
competitive underwriter spreads are less than negotiated spreads on average. It
is also consistent with previous studies in that the competitive spread rises
rapidly with increased risk, and slightly exceeds the negotiated spread for Baa
rated bonds.
Columns (5) and (6) are the calculated price change from time of issue to
first available secondary market observation for the issue and for the
benchmark of a hypothetical like-rated seasoned bond. The price change is
expressed as a difference between the secondary market observation, P, and
the issue price, PO. As it turns out, during the time period considered
secondary market prices were typically less than prices at time of issue. This
was true for both the new issues and their respective benchmarks. When the
difference is netted out in column (7) we find that the new issue price generally
declined less than the benchmark. This is the same kind of new issue under-
pricing result that has previously been observed in various studies of the stock
market.
Systematic under-pricing of bond issues has not previously been recognized
as part of the cost of the issue despite the indication from this empirical study
that the cost of under-pricing typically exceeds the direct spread to the
underwriter. More significantly, column (7) reveals that the magnitude of the
J. R. Boorh and R. L. Smith, II, Underwriting and certification 219

Table 4
Underwriter spread and price discount of competitive and negotiated public utility debt issues by
Moodys rating (1977-1982). The data include all public utility debt issues where aftermarket price
data were available from the Commercial and Financial Chronicle within twelve weeks of issue. Net
discount is calculated by comparing the price change from issue to first published aftermarket
price on the newly issued bond to the comparable price change on a hypothetical benchmark bond
with the same rating. For each issue, PO is the offer price and P, is the first known aftermarket
price. For the related index, PO is 100 and P1 is the implied benchmark price based on the change
in yield to maturity for outstanding public utility bonds assuming a twenty-year maturity.
-
(P, -PO) Spread
Price change
Moodys Number Average Underwriter Net plus
rating of issues size (MM) spread Bond Benchmark discount discount
(1) (2) (3) (4) (5) (6) (7) (8) = (4 + 7)
- -
Competitive issues

Aaa 16 192.5 0.580 - 1.690 - 1.602 0.088 0.492


Aa 17 125.7 0.718 - 0.167 - 1.664 0.987 1.615
A 15 99.8 0.665 - 0.442 - 1.638 1.196 1.861
Baa 16 92.4 0.876 - 3.578 - 5.948 2.370 3.246
Sum 64
Average 128.0 0.711 - 1.643 2.731 1.088 1.799
Negotiated issues

Aaa 17 291.5 0.757 - 3.281 - 6.254 2.973 3.750


Aa 9 150.9 0.769 1.108 0.809 0.299 1.068
A 23 112.3 0.808 - 1.608 - 3.785 2.177 2.985
Baa 19 93.7 0.848 - 0.787 - 2.561 1.774 2.622
Sum 68
Average 157.0 0.802 - 1.436 - 3.450 2.014 2.816

discount is systematically related to ratings class for competitive underwritings,


ranging from -0.09 for Aaa rated to +2.37 for Baa rated issues. In contrast,
there is no systematic pattern for the negotiated issue discounting.31 The total
of underwriter spread plus net discount is calculated in column (8) and
indicates rising cost associated with competitive issues in contrast to essentially
a flat cost of negotiated issues. There again is evidence of a cross-over in terms
of expected issue cost between the A and Baa ratings classes. Column (8) does
not exhibit constant cost for negotiated issues, however, it does not appear that
issue cost is increasing with risk. Results of the analysis suggest that issue price
discounting can substitute for the incurrence of direct certification cost. The
tendency for this to occur is related to the inability of the investment banker to

311n a study of bond issue discounting Weinstein (1978) estimated an average discount of 0.383
percent of par. His estimate covered the time period from 1962 to 1974, most of which period was
characterized by relatively low bond yields and less volatile interest rate fluctuations. Recognizing
these differences, the magnitude of the discounts are consistent with our findings.
280 J. R. Booth and R. L. Smith, II, Underwriting and certification

accurately certify the issue price as would tend to be the case with competitive
underwriting.

5. Summary and conclusions


This paper advances the certification hypothesis to explain the role of the
underwriter in the capital raising process. Due to potential opportunistic
behavior by insiders, underwriters can be employed to certify that issue price is
consistent with inside information. Testable hypotheses are developed regard-
ing the decision to use an underwriter, the type of contract that will be utilized,
the amount charged for certification, and the pricing of financial claims. These
hypotheses are evaluated in light of previous literature on underwriting and
new tests were undertaken to explain the cost of using underwriters, the choice
of competitive or negotiated underwriting arrangement, and the relationship of
issue cost to risk. The analysis indicates that firm value can be increased if
bonding investments are made to certify the new issue price, and that the net
benefit from certification can be greater if issuing firms are able to utilize a
specialist (investment banker) who has made the requisite bonding investment.
Based on the results of previous studies as well as new evidence presented here,
the certification hypothesis is supported.

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