The Capital Markets Cooperative Research Centre (CMCRC) has discovered abnormal trading activity by underwriters of dividend re-investment plans (DRPs) which push prices downward in the pricing period and result in a lower issue price.

Companies use these underwriters (typically investment banks) to ensure they have sufficient funds to pay out dividends. They do this by offering the underwriters new shares of the stock equivalent to the amount of dividend to be paid out.

While the underwriters have a legitimate interest in hedging their exposure by going short, CMCRC’s research found that the underwriting brokers engaged in significant selling during the pricing period. On average, brokers sold 200 – 400% more shares in each of the 10 days of the pricing period compared to a benchmark period. Across the 115 DRPs in the five year sample period CMCRC examined, this resulted in an average price reduction of 5.5% during the pricing period. Consequently, more shares were issued under the DRP at a lower price.

CMCRC Researcher and Lecturer at University of Sydney, Sean Foley said, “We can’t definitively say whether this trading behavior is motivated by a desire to manipulate the issue price downward, or by a desire to hedge the price risk from underwriting.”

“What’s clear is that it benefits the interest of the underwriters, depresses the issue price and transfers wealth from non-participating shareholders to the underwriters. Moreover, this abnormal selling behavior is not observed in non-underwritten DRPs.”

These results support the need to flag trades as principal or agent, which will be required post October 2014, as this will ensure any selling pressure during the pricing period is attributable to clients and not proprietary order flow.