One of the tools available to promote investor confidence in an initial public offering is post-offer market stabilisation, or, as it is colloquially described, a “greenshoe”.
Greenshoes have been used in a large number of significant IPOs in Australia since first being used in Australia on the Telstra I float in 1997. Whilst their use in Australia has been more limited than in the United States, the United Kingdom and Hong Kong (where post-offer stabilisation is standard market practice for IPOs and is also sometimes used for other significant offerings), anyone contemplating a significant offering should understand what greenshoes are and why they are used, as well as the legal and regulatory issues associated with them.
Why are “greenshoes” used?
As the recent IPO of Facebook demonstrated, the offer price determined by way of a bookbuild process may not always be sustained once the security begins to trade upon listing.
It is critical to obtaining investor support for an IPO that investors have confidence that the offer price will be a fair reflection of the market price. In addition, an adverse difference between the market price and the offer price is bad for the issuer and the underwriter/lead manager, since there will be a perception that the offer was over-priced, which may have reputational issues, and, from an underwriter’s perspective, may also lead to economic loss (as any shortfall cannot be disposed of at or above the offer price if the trading price is lower than the offer price).
There are many possible reasons why the market price of a newly listed security may fall to a level below the offer price shortly after listing. For example, there may have been a number of investors who participated in the offer with a view to realising profits quickly by selling down soon after listing, or investors may have received higher allocations than they had expected and sold down to a lower level. Or, it may just turn out that the general market is experiencing volatile trading conditions at the time quotation commences.
In order to mitigate the risk of the price of newly listed securities falling below the offer price in the period immediately following listing, and to help provide confidence to potential investors about the sustainability of the offer price, the underwriter (or lead manager) may seek to undertake post-offer market stabilisation.
What is a “greenshoe” and how does market stabilisation work?
The term “greenshoe” does not actually refer to market stabilisation. Market stabilisation involves the acquisition, following listing, of securities by the lead manager (when acting in this capacity, referred to as the “stabilisation manager”) at prices at or below the offer price with the intention of “stabilising” the market price of those shares at the offer price (or retarding a further decline in the price).
The greenshoe is a call option that is used for hedging purposes, and not for stabilisation, as described in more detail below. The entry into and exercise of the greenshoe is not what constitutes market stabilisation (and in fact, when a greenshoe is exercised in full, this indicates that no market stabilisation has taken place at all). As a result of the regulatory history of market stabilisation in Australia (see section 4), the greenshoe has necessarily been a feature of stabilisation transactions in Australia.
The traditional transaction structure of a stabilisation arrangement in Australia is as follows:
- the stabilisation manager allocates to institutional investors a number of securities (the “Over Allotment Securities”) greater than the amount of the issue ( “up-sizing”) by up to 15% more;;
- in order to settle those “over-allocations” at settlement of the IPO, the stabilisation manager borrows the Over Allotment Securities from one or more existing securityholders (“Stock Loan”). The stabilisation manager must repay the Stock Loan by re-delivering an equivalent number of securities to that securityholder at the end of the “stabilisation period” (up to 30 days after trading of the securities begins);
- the stabilisation manager takes a greenshoe option over the same number of securities as the Over Allotment Securities. The “greenshoe” option is traditionally granted to the stabilisation manager by either a vendor securityholder or by the issuer which gives the stabilisation manager the right to buy (from the vendor) or to subscribe for (from the issuer) additional securities at the offer price1. The benefit of the greenshoe for the stabilisation manager is that it prevents it from being “squeezed” (ie there is no need to buy securities on market to settle the Stock Loan);
- the IPO settles. The proceeds of the offer are provided to the issuer (if a primary offer) or to the vending securityholders (if a secondary offer) except for the proceeds of sale of the Over Allotment Securities, which are retained by the stabilisation manager in a special purpose account to fund stabilisation bids;
- if, during the stabilisation period, the market price of the securities falls below the offer price, the stabilisation manager may acquire securities on market at the prevailing price up to the number of Over-Allotment Securities. The stabilisation manager may either use the securities in repayment of the Stock Loan or sell those securities again (but only if the market price exceeds the offer price);
- if by the end of the stabilisation period the stabilisation manager holds less securities than are required to repay the Stock Loan (either because no stabilisation bids have been made, or any securities acquired have been resold), the stabilisation manager will exercise the greenshoe option. The proceeds remaining in the special purpose account are used to fund the exercise price. The securities acquired by the stabilisation manager upon exercise of the greenshoe go towards repaying the Stock Loan;
- the Stock Loan may be “repaid” by a combination of securities acquired through stabilisation bids and exercise of the greenshoe.
The optimal outcome from an issuer’s and a lead manager’s point of view is where the greenshoe option is exercised in full. This would indicate that:
- there have not been any stabilisation bids made by the stabilisation manager (and therefore that the market price of the securities has not fallen below the offer price during the stabilisation period); and
- the size of the offer has been maximised (this is because the vendor shareholder, or the issuer, get to retain the full proceeds of the Over Allotment Securities). The fact that the offer price was sustained with the Over Allotment Securities “in the market” meant that there was genuinely sufficient demand for those securities at the offer price.
Conversely, to the extent that the greenshoe option is not exercised (and instead securities acquired on market are used to repay the Stock Loan), this indicates that the market could not genuinely support all of the Over Allotment Securities at the offer price.
What are the legal issues associated with market stabilisation?
Using a greenshoe will result either in a larger offer size (if the option is exercised in full) or, if it is not, a higher market price for the securities on ASX than would have subsisted in the absence of the stabilisation bids (as a result of stabilisation bids being made).
As a consequence, the Australian Securities and Investments Commission states in its draft policy statement on market stabilisation2 that stabilisation activity may contravene certain sections of the Corporations Act 2001 (Cth) relating to market manipulation, such as s 1041A, which prohibits a person from taking part in a transaction that creates an artificial price for trading in financial products on a financial market in Australia (or which maintains a price at a level that is artificial). Unlike the United States, the United Kingdom, Hong Kong and other foreign jurisdictions, there is no formal legislative safe harbour in Australia which sanctions market stabilisation activity.
What is ASIC’s policy in relation to market stabilisation?
ASIC is prepared to facilitate market stabilisation in certain circumstances by issuing a “no action letter” to those involved in market stabilisation. Such letters are a statement of ASIC’s present intention not to take regulatory action against those persons for that activity. Although they do not bind third parties (or even ASIC), in practice, stabilisation managers, issuers and vending securityholders have been comfortable facilitating or carrying out stabilisation activity after fully disclosing this in the prospectus and ensuring that any stabilisation is conducted in accordance with the standard terms and conditions expressed by ASIC in its draft policy.
ASIC sought (and obtained) industry feedback on its draft policy and the conditions in 2005, however, it has never published a final policy. Whilst ASIC states that it is prepared to consider departures from its draft policy, in practice this is difficult and time consuming. This has had the effect of standardising the stabilisation transaction structure along the lines summarised in the What is a “greenshoe” and how does market stabilisation work? section above and limiting its use to large IPOs. A “standard” application for a no action letter requires the following:
- the offer must be an IPO (although the draft policy states that stabilisation is not confined to IPOs, an application for a no action letter for a secondary offer or sale will require detailed consideration by ASIC)
- the total value of securities offered (excluding the over-allotment) must be at least $50 million
- the stabilisation manager must have the benefit of a greenshoe option (this means that alternative structures which may not necessarily require the use of a greenshoe option require case by case consideration by ASIC)
- the greenshoe may be for at most 15% of the offer size.
In addition, ASIC imposes conditions on market stabilisation activities to reduce the risk of the stabilisation giving rise to a false, misled or uninformed market, including:
- conditions mandating the disclosure that needs to be made about stabilisation in the prospectus as well as a requirement that stabilisation bids be tagged and disclosed daily on the ASX company announcements platform (although tagging bids may undermine the impact of stabilisation bidding, to date ASIC has considered this necessary to ensure the market is informed)
- conditions regulating the price of stabilisation bids. Bids may not be higher than the offer price and can only be at the highest current independent bid on ASX (this contrasts with the position in the UK and Europe, which doesn’t set a floor price, and the US, which allows bids at lower than the highest independent price)
- a restriction on having more than 2 stabilisation bids in the market at any one time and a condition requiring that bids be made on market during the open session (that is, no off market bids)
- a condition limiting the stabilisation period to 30 days.
In framing these conditions, ASIC drew heavily upon offshore legislative provisions (particularly the US Securities Exchange Commission’s Regulation M) but has been more restrictive in some respects as indicated above.
In light of the generally more volatile nature of equity capital markets since the GFC, it is likely that issuers and lead managers will look to adopt stabilisation in significant IPOs and even in larger secondary offers to make those transactions more appealing to institutional investors. At present, there are only limited circumstances where a no action letter will be available from ASIC without a lengthy consultation process. For that reason, it would be beneficial for ASIC to conclude its consideration of feedback received in relation to its draft policy and consider, in light of that feedback and more recent regulatory developments abroad, whether its draft policy places too many limitations on the way in which stabilisation activities may be carried out.