Penalty Bid: What It Means, How It Works

What Is a Penalty Bid?

A penalty bid is an offer to take part in an initial public offering (IPO), in which the buyer is disincentivized from selling their shares shortly after the purchase.

Specifically, penalty bids specify that if the investor "flips" the shares within a specified period of time, the broker who processed their purchase order will be penalized. The broker then has the option to pass on that penalty to their client.

Understanding Penalty Bids

When the demand for an IPO exceeds its supply, the price of the newly issued shares often rises shortly after the shares begin trading. Given this fact, it can be tempting for investors to seek allocations from their brokers to participate in upcoming IPOs, not because they are enthusiastic about the long-term prospects of the stock, but simply because they wish to sell the shares shortly after the IPO in order to secure a quick gain.

If a sufficient number of early investors were to act in this manner, it could force the lead underwriter of the IPO to buy back the recently-allocated shares during the initial stabilization period of the IPO to prevent the share price from declining too severely from the increased selling pressure from early investors. In order to mitigate this risk, the underwriters impose penalties on investors who sell their shares within a specified period of time following the IPO. 

Technically, these penalties are levied against the investors' brokers, who then have the option of passing on the cost to the investor. In practice, however, it is more common for the broker to pay the penalty themselves. Specifically, brokers typically pay this penalty by returning some or all of the commission income they earned from the IPO back to the underwriting syndicate. At the very least, a broker whose client insists on selling their IPO shares within the proscribed time frame would not be pleased with that client, and they may exclude that client from future allocations to IPOs that are in high demand.

Real World Example of a Penalty Bid

Sandra is an investor who enjoys participating in highly anticipated IPOs. She has found that the shares of these companies often increase in value shortly following the IPO, and she is eager to profit from this fact by investing in the upcoming IPO of XYZ Enterprises.

When expressing this interest to her broker, Sandra was informed that if she is given an allocation to the IPO of XYZ Enterprises, her investment would be considered a penalty bid. The broker explained to her that, because of this, she should refrain from selling the shares within a specified period of time. If she fails to do so, the broker would be penalized and the cost of this penalty may be passed on to her.

Sandra understood that, although she may not be forced to pay the direct financial cost of the penalty, there is a good chance that she would be excluded by her broker from future IPOs if she sells her shares prematurely.