Initial public offerings by companies are beset with the aspect of what is known as ‘underpricing’. This is when companies accessing the capital markets for the first time experience a significant jump in the stock price on the first day of trading. This works to the advantage of investors who have been allocated shares in the IPO, as they benefit from selling the shares on the first day of trading and making a quick profit from the IPO.

In order to curtail such activities, in a proposal announced yesterday, SEC is considering the imposition of a 25% price band on the issue price on the first day of trading of an IPO stock.
The price band applies only to issuances up to Rs. 250 crores (Rs. 2.5 billion), as studies (by way of back testing) have revealed that first day fluctuations are rampant in such small offerings, and not when it come to large offerings.

SEC’s proposal is laudable as it introduces a further level of orderliness in the IPO process, including its possible impact on price discovery and allocation to investors. However, questions such as whether this should be limited to offerings of only up to Rs. 250 crores and whether the method of fixing this number (based on evidence from recent IPOs) is appropriate remain open, and these will likely be the subject of comments on the proposal.

Comments are invited by SEC until January 31, 2008.

(Update – January 21, 2008: Here is an editorial in the Economic Times on SEC’s proposal)