What is a Penalty Bid
A penalty bid is an offer to purchase securities by a lead underwriter or other member of a syndicate as part of early IPO trading, but this bid comes with consequences for the broker that wants to sell back shares to the underwriter, or book runner, for quick profits. The penalty will be assessed to the broker selling the shares back to the underwriter; the penalty typically takes the form of a reduction in the commission payable to the broker for its role in marketing and distributing shares to its clients. A penalty bid exists to deter "flipping" IPO shares shortly after trading begins.
BREAKING DOWN Penalty Bid
When demand for a new issue far exceeds supply, it is very likely that the shares will pop when they are released to trade in the secondary market. This creates the temptation for investors to seek allocations from their brokers for the IPO, not because they are believers in the long-term prospects of the stock, but because they are interested in flipping the shares for a quick gain. If this is the case and a stock opens to trade at a much higher level, investors would instruct their brokers to sell the stock. The underwriter is then placed in a position to buy back the recently-allocated shares during the initial stabilization period. However, it would apply a penalty bid to the broker.
This penalty may be passed on from the broker to the client selling the IPO shares, but usually, it involves the broker returning some or all of the internal commission income back to the underwriting syndicate. At the very least, a broker whose client insists on selling shares back, thus incurring a penalty bid, will not be pleased with the client, and would not be inclined to include that client in future allocations of IPOs that are in high demand.
Watching Penalty Bids
The Securities and Exchange Commission issued Regulation M Rule 104 to regulate stabilizing and other activities related to a distribution of shares in an IPO. Rule 104 requires "any person effecting a syndicate covering transaction, or placing or transmitting a penalty bid, to disclose that fact to the SRO [self-regulatory organization] that has direct oversight authority over the principal market in the United States for the security for which the syndicate covering transaction is effected, or the penalty bid is imposed. This information will assist the exchanges and the NASD in carrying out their surveillance responsibilities."