Penalty bid provisions may be included in underwriting contracts for initial public offerings (IPOs) in order to complement price stabilization mechanisms such as stabilizing bids and short covering in the aftermarket. They are intended to discourage flipping, that is, immediate reselling, of the allocated shares when the share price declines due to weak demand in the secondary market.
The rationale behind penalty bids is to create an incentive for the members of the distribution team, that is, syndicate members, to allocate the shares to investors who will hold onto the shares or who can easily be discouraged from flipping.
Penalty bids typically result either in forfeiture of the selling concession, that is, the distributing firm’s compensation for the distributed shares, or in exclusion of distributing firms or of investors from future allocations. the force of the threat of exclusion, however, is very limited for large institutional investors who are indispensable for successful future placements.
The assessment of the penalty bid is not fixed in advance. In contrast, the lead underwriter may assess the penalty bid ex post. Typically, the penalty bid will not be assessed when market liquidity is low in order to avoid further deterioration of market liquidity or when considerable trading revenues at practically no risk of a price decrease can be generated from high turnover together with an increasing price in the secondary market. The effectiveness of penalty bids crucially depends on a tracking system for the allocated shares.