SEC Follow Up Exhibits Part C SEC_OEA_FCIC_001760-2501

and subsequent overvaluation of IPOs (Miller (1977), Derrien (2005), and Ljungqvist, Nanda,
and Singh (2006)). 11 Miller (1977) argues that if underwriters price issues according to their
own assessments of the “true” value of the security, then the offer price “will be below the
appraisals of the most optimistic investors who actually constitute the market for the security.”
Derrien (2005) and Ljungqvist, Nanda and Singh (2006) extend this argument with a theoretical
framework and rely on restrictions prohibiting short sales in the secondary market for IPOs. By
disallowing short sales, investor optimism drives the market price of IPOs far above the true
value resulting in overvaluation in the secondary market
Several papers find evidence consistent with the argument that divergence of opinion or
investor optimism is related to IPO pricing. Houge, Loughran, Suchanek and Yan (2001) present
evidence that measures of divergence of opinion have predictive power in explaining the poor
long-run returns documented by Ritter (1991) and they contend that regulatory rules place
constraints on short sales. When examining carve-out IPOs, Lamont and Thaler (2003) find
evidence of mispricing between the value of the 3Com and Palm and they argue that “the
demand for certain shares by irrational investors is too large relative to the ability of the market
to supply these shares via short sales, creating a price that is too high.” They argue that “the
short sale market works sluggishly.” However, they find there is substantial short interest in
carve-outs in the first month after the IPO. Mitchell, Pulvino, and Stafford (2002) provide
additional evidence that carve-outs are overpriced due to short sale constraints, but introduce the
risk of upward price movements as a significant impediment to the profitability of short sales.
Finally, Ofek and Richardson (2003) contend that short sale constraints after the IPO are
11
In this paper we will assume that divergence of opinion, investor sentiment and over-optimism generally refer to
the same general phenomenon.
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