Selection Bias and the Underwriter Certification of the Largest Shareholders in Seasoned Equity Offerings

• Published date: 01 June 2018
• DOI: http://doi.org/10.1111/irfi.12145
• Author: Jothee Sinnakkannu,Wai‐Ching Poon,Chin‐Chong Lee
• Date: 01 June 2018

Selection Bias and the Underwriter

Certification of the Largest

Shareholders in Seasoned Equity

Offerings*

CHIN-CHONG LEE

†

,WAI-CHING POON

‡

AND JOTHEE SINNAKKANNU

‡

†

Faculty of Business, Communications and Law, INTI International University, Nilai,

Negeri Sembilan, Malaysia and

‡

School of Business, Monash University Malaysia, Bandar Sunway, Selangor, Malaysia

ABSTRACT

The largest shareholders of issuing firms in Hong Kong are eligible to

underwrite rights issues and open offers. We hypothesize that the largest

shareholders as underwriters who possess more information are better than

investment banks in certifying firm value. Our analyses show that the largest

shareholders self-select into their preferred issuing firms, and a selection bias

in the choice of underwriters arises. After controlling for firm and issue

characteristics and addressing the selection bias, our findings support our

hypothesis. We also find that investment banks with greater access to

information through prior underwriting relationship provide better

certification than investment banks without such relationship.

JEL Codes: G14; G24; G38

Accepted: 11 July 2017

I. INTRODUCTION

Rights issues and open offers are the two types of rights-preserving seasoned

equity offerings (SEOs) used by public firms in Hong Kong to raise funds. Both

rights offerings allow the existing shareholders of a firm to purchase new

common stock on a pro rata basis. The existing shareholders who do not wish

to take up their entitlements of new shares are allowed to sell their rights in rights

issues, but their entitlements in open offers cannot be sold. As required by the

local listing rules in Hong Kong, these two issuance methods must be fully

* We would like to thank Sudipto Dasgupta, the managing editor, and the anonymous referee for

constructive recommendations. We have also benefited from Chee-Ghee Teh and Gary John Rangel

for the comments and suggestions on previous versions of this paper. All the remaining errors are our

own.

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12145

International Review of Finance, 18:2, 2018: pp. 217–251

DOI:10.1111/irfi .12145

© 2017 International Review of Finance Ltd. 2017

underwritten and the underwriters of these SEOs can be investment banks, the

largest shareholder of an issuing firm, blockholders or directors of an issuing firm,

or others. The unique feature of rights issues and open offers in Hong Kong gives

an opportunity to compare the underwriter certification provided by the largest

shareholders and by investment banks.

1

The negative announcement effect of rights issues is tremendously large, and

it is more crucial for issuing firms in Hong Kong to alleviate the substantial price

decline.

2

The large negative announcement effect could be due to the

asymmetric information between issuers and investors as pointed out by Myers

and Majluf (1984) and Eckbo and Masulis (1992). To reduce the information

gap, current literature suggests that reputable underwriters, either commercial

banks or investment banks, can be employed as information intermediaries to

certify that the offer price is consistent with inside information about future

earnings prospects of issuing firms and not mispriced.

3

The largest shareholders of issuing firms as SEO underwriters, similar to

commercial banks and affiliated investment banks, have information advantages

about their firms. Commercial banks and affiliated investment banks with prior

access and superior information acquired through credit evaluation and loan

monitoring are found to have information advantages about issuing firms in

securities underwriting activities (Puri 1996; Gompers and Lerner 1999; Benzoni

and Schenone 2010). Chemmanur and Fulghieri (1994) also argue that

investment banks as middlemen do not have as much information as

entrepreneurs. This is especially true to those largest shareholders of

family-controlled firms in Hong Kong because these largest shareholders have

deep involvements in the operation of these firms (Claessens et al. 2000). As

largest shareholders possess more valuable firm-specific information than

investment banks, we thus posit that the largest shareholders as underwriters

could better certify firm value and reduce the negative SEO announcement

effects more than investment banks.

A number of studies, however, find that conflicts of interest and expropriation

of minority shareholders are the main concerns in equity offerings. For example,

Fong and Lam (2014) and Cheung et al. (2006) provide evidence that controlling

1 Chapter 7 of the listing rules in Hong Kong requires that all rights issues and open offers must

be fully underwritten in normal circumstances. In this study,the offers underwritten by both

investment banks and securities brokerage companies are grouped under the category of in-

vestment banks. On the other hand, the offers underwritten by the largestshareholders of is-

suing firms and their associates are grouped under the category of the largest shareholders.

2 Lee et al. (2014), Ching et al. (2006), and Wu and Wang (2005b) find that the 3-day cumulative

average abnormal return from day 1 to day 1 is more than 7.5%, but the average announce-

ment return of the corresponding rights issues for industrial firms in the US and in the UK is

only about 2.09% (Hansen 1988; Eckbo and Masulis 1992; Slovin et al. 2000).

3 See Booth and Smith (1986), Blackwell et al. (1990), Denis (1991), Hansen and Torregrosa

(1992), Eckbo and Masulis (1992), Kumar and Tsetsekos (1993), Puri (1996), and Pandes

(2010) for more details.

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shareholders of the companies with high ownership concentration expropriate

the interests of minority shareholders in Hong Kong SEOs. The potential

conflicts of interest also arise in the process of the securities underwriting when

commercial banks and affiliated investment banks are the underwriters

(Puri 1996; Gompers and Lerner 1999). As a result, investors might question

the credibility of the due diligence process conducted by commercial banks and

affiliated investment banks.

Taken together, given significant evidence that the substantial shareholders or

managers might pursue their own private benefits of control and expropriate

wealth from minority shareholders in equity offerings, to examine whether the

underwriter certification provided by the largest shareholders could outweigh

potential conflicts of interest is of our interest. While the largest shareholder of

an issuing firm in Hong Kong, the UK, and Australia is eligible to be the SEO

underwriter, currently, there is limited research in this area, and this study aims

to fill the gap in the literature.

4

The direct comparison between the largest

shareholder-underwritten offers and the investment bank-underwritten offers

helps sharpen the test of the conflict of interest effect versus the underwriter

certification effect.

Our study differs from the previous literature with respect to the type of un-

derwriters we test. Unlike commercial banks and affiliated investment banks,

the largest shareholders hold a significant portion of outstanding shares. Their

large shareholdings might further exacerbate the potential conflicts of interest

and entrenchment effects in SEO underwriting activities.

5

While the largest

shareholders who have great influences over firm decisions are eligible to be

the underwriters for Hong Kong SEOs, the mutual choice pointed out by

Fernando et al. (2005) between investment banks as underwriters and an

issuing firm might not be applicable. In a nutshell, the significant equity

ownership of the largest shareholders provides a sharper test of the two

trade-off effects.

4 Fong and Lam (2014) provide the mixed results for the underwriter certification roles of the

controlling shareholders. Specifically, they document the finding of the conflicts of interest

in rights issues, but they do not find such evidence in open offers and in the pooled sam-

ple. There are at least three differences between this study and Fong and Lam (2014): (i)

The controlling shareholders of public firms might self-select to underwrite the SEOs of

their preferred firms. We address this endogeneity problem of the underwriter choice in

studying the determinants of SEO announcement returns, but Fong and Lam (2014) do

not address this endogeneity problem; (ii) the criteria for sample selection are different.

The offers not underwritten specifically by the largest shareholders might be part of the

sample of Fong and Lam (2014), but these offers are not chosen by this study; and (iii)

the study period is different.

5 A number of studies in Hong Kong SEOs report that the average proportion of shares held by

the largest shareholders is nearly 38% (Wu et al. 2005; Fong and Lam 2014; Lee et al. 2014).

This significant portion of outstanding shares might lead to a greater likelihood of wealth ex-

propriation by the largest shareholders from minority shareholders (La Porta et al. 1999;

Claessens et al. 2002; Cheung et al. 2006).

Certification of the Largest Shareholders in SEOs

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Certifi cation of the Largest Shareholders in SEOs

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