The ‘greenshoe’ option is included in almost all US IPOs, although is less common in New Zealand.
It is intended to provide price stabilisation in the aftermarket for an IPO so that investors have some degree of protection against short-term price weakness caused, for example, by weaker than expected demand or by negative market sentiment.
But while it can provide a measure of comfort, it cannot guarantee against a fall in share price – as the Facebook IPO demonstrated.
This Brief Counsel looks at the greenshoe in the context of the Facebook IPO and briefly summarises New Zealand market practice and equivalent regulation.
What is a ‘greenshoe’
A greenshoe, legally referred to as an over-allotment option, is a clause contained in an underwriting agreement that allows the issuer to authorise additional shares for distribution by underwriters in the event of exceptional public demand in a securities offering.
The term comes from Green Shoe Manufacturing (now called Stride Rite Corporation), the first company to use the mechanism. The greenshoe is an extremely common feature of large IPOs globally (more common in Asian, U.S. and U.K. offerings than New Zealand), and can allow for an additional amount of shares of up to 15% of the original number offered.
The ‘greenshoe’ and the Facebook IPO
The underwriting syndicate (comprising a number of banks, including Morgan Stanley) agreed with Facebook to buy 421 million shares at $38 a share less the 1.1% underwriting commission. But when the IPO was priced and allocated, the banks sold at least 484 million shares at $38 – 15% above the initial allocation. That left them ‘short’ around 63 million shares.
Had the IPO been successful and there been a ‘pop’ in the share price, the underwriters would have exercised the greenshoe option to go back to Facebook and buy those 63 million shares at $38 (less their commission), in order to cover their short position. Without the greenshoe option, they would have had to buy at the new increased market price shares which they’d agreed to sell for $38, thereby incurring a loss.
In this case, there was no ‘pop’ and, rather than rise, the share price fell. In such circumstances, the ‘greenshoe’ option is not taken up but the underwriters still need to cover their short position, which they do by buying those 63 million shares in the aftermarket at or around the issue price of $38 to “defend” or “stabilise” the IPO price.
Over the first few days following the IPO, these price stabilisation efforts were moderately effective in reducing downwards price pressure. But, a greenshoe does not provide a guarantee against an issuer’s share price falling below the offer price. Importantly, where an IPO is overpriced to begin with and demand does not match supply, a greenshoe cannot (and is not intended to) provide a solution.
The New Zealand context
In the Australasian markets over the last decade or so, greenshoes have typically been used in higher-value IPOs ($300 million+) and have ranged in size from around 5% to 15% of the offer size. In New Zealand, although a handful of larger-value deals over the last decade or so have featured greenshoes, including Auckland International Airport and Contact Energy, price stabilisation has not been required.
Section 11B of the Securities Markets Act 1988 prohibits the knowing creation of a false or misleading appearance of active trading in the securities of a public issuer, including in relation to the supply, demand, price or value of those securities. Without an exemption, therefore, the greenshoe would be illegal as it is a form of market manipulation.
That exemption is provided in Securities Markets (Market Manipulation) Regulations 2007. The key requirements of any permitted market stabilisation under the relevant regulations are:
- market stabilisation is permitted for a maximum of 30 days, beginning with the first day of trading (in practice, this tends to occur in the first week after the IPO, when trading is typically at its heaviest)
- the over-allotment must not exceed 15% of the total value of the IPO
- the issuer must enter into a stabilisation agreement with NZX and the “stabilisation manager” (e.g. the lead manager or organising participant for the offer), which gets included with the offer document
- the stabilisation manager must notify NZX and the FMA that stabilisation is to begin at least three trading hours in advance (or, if the stabilisation begins at the start of a trading day, before the market closes on the previous trading day) and NZX must release the notification to the market as soon as practicable
- stabilisation bids must in general terms be the lower of the highest current independent bid/last trade and the offer price, and must be notified to the NZX at the time of the bid.
Chapman Tripp comments
The greenshoe option, and the role it plays in facilitating price stabilisation in the immediate aftermarket, is an important mechanism from an investor’s perspective in defending against the risk of a falling share price following an IPO. However, as Facebook has demonstrated, price stabilisation can only go so far and ultimately cannot guarantee against an issuer’s share price falling below the offer price.