The Greenshoe Option in Action

Green Shoe Option in India

General: Companies that want to venture out and start selling their shares to the public have ways to stabilize their initial share prices. One of these ways is through a legal mechanism called the greenshoe option. A greenshoe is a clause contained in the underwriting agreement of an initial public offering (IPO) that allows underwriters to buy up to an additional 15% of company shares at the offering price. The investment banks and brokerage agencies (the underwriters) that take part in the greenshoe process have the ability to exercise this option if public demand for the shares exceeds expectations and the stock trades above the offering price. (Read more about IPO ownership in IPO Lock-Ups Stop Insider Selling.)

The Origin of the Greenshoe
The term "greenshoe" came from the Green Shoe Manufacturing Company (now called Stride Rite Corporation), founded in 1919. It was the first company to implement the greenshoe clause into their underwriting agreement.

In a company prospectus, the legal term for the greenshoe is "over-allotment option", because in addition to the shares originally offered, shares are set aside for underwriters. This type of option is the only means permitted by the Securities and Exchange Commission (SEC) for an underwriter to legally stabilize the price of a new issue after the offering price has been determined. The SEC introduced this option in order to enhance the efficiency and competitiveness of the fundraising process for IPOs.

Stabilisation Process
The greenshoe option provides stability and liquidity to a public offering. As an example, a company intends to sell one million shares of its stock in a public offering through an investment banking firm (or group of firms, known as the syndicate) which the company has chosen to be the offering's underwriters. Stock offered for public trading for the first time is called an initial public offering (IPO). Stock that is already trading publicly, when a company is selling more of its non-publicly traded stock, is called a follow-on or secondary offering.
The underwriters function as the brokers of these shares and find buyers among their clients. A price for the shares is determined by agreement between the company and the buyers. When shares begin trading in a public market, the lead underwriter is responsible for helping to ensure that the shares trade at or above the offering price.
When a public offering trades below its offering price, the offering is said to have "broke issue" or "broke syndicate bid". This creates the perception of an unstable or undesirable offering, which can lead to further selling and hesitant buying of the shares. To manage this situation, the underwriters initially oversell ("short") the offering to clients by an additional 15% of the offering size (in this example, 1.15 million shares). When the offering is priced and those 1.15 million shares are "effective" (become eligible for public trading), the underwriters are able to support and stabilize the offering price bid (also known as the "syndicate bid") by buying back the extra 15% of shares (150,000 shares in this example) in the market at or below the offer price. The underwriters can do this without the market risk of being "long" this extra 15% of shares in their own account, as they are simply "covering" (closing out) their short position.
When the offering is successful, demand for shares causes the price of the stock to rise and remain above the offering price. If the underwriters were to close their short position by purchasing shares in the open market, they would incur a loss by purchasing shares at a higher price than the price at which they sold them short.
The greenshoe (over-allotment) option would now come into play. The company had initially granted the underwriters the option to purchase from the company up to 15% more shares than the original offering size at the original offering price. By exercising their greenshoe option, the underwriters are able to close their short position by purchasing shares at the same price for which they short-sold the shares, so the underwriters do not lose money.
If the underwriters are able to buy back all of the oversold shares at or below the offering price (to support the stock price), then they would not need to exercise any portion of their greenshoe option. If they are able to buy back only some of the shares at or below the offer price (because the stock eventually rises higher than the offer price), then the underwriters would exercise a portion of greenshoe option to cover their remaining short position. If the underwriters were not able to buy back any portion of the oversold shares at or below the offering price ("syndicate bid") because the stock immediately rose and stayed up, then they would completely cover their 15% short position by exercising 100% of their greenshoe option.

SEBI norms for Green Shoe Options
Securities law panning the world is in principle based on the U.S. model in India GREEN SHOE OPTION is as:
Provision under SECURITIES AND EXCHANGE BOARD OF INDIA (DISCLOSURE AND INVESTOR PROTECTION) GUIDELINES, 2000 -CHAPTER VIII-A GREEN SHOE OPTION
8A.1
(a) An issuer company making a public offer of equity shares can avail of the Green Shoe Option (GSO) for stabilizing the post listing price of its shares, subject to the provisions of this Chapter.
(b) A company desirous of availing the option granted by this Chapter, shall in the resolution of the general meeting authorizing the public issue, seek authorization also for the possibility of allotment of further shares to the 'stabilizing agent' (SA) at the end of the stabilization period in terms of clause 8A.15.

8A.2 The company shall appoint one of the merchant bankers or Book Runners, as the case may be, from amongst the issue management team, as the "stabilizing agent" (SA), who will be responsible for the price stabilization process, if required. The SA shall enter into an agreement with the issuer company, prior to filing of offer document with SEBI, clearly stating all the terms and conditions relating to this option including fees charged / expenses to be incurred by SA for this purpose.

8A.3 (a) The SA shall also enter into an agreement with the promoter(s) or pre-issue shareholders who will lend their shares under the provisions of this Chapter, specifying the maximum number of shares that may be borrowed from the promoters or the shareholders, which shall not be in excess of 15% of the total issue size.)

8A.4 The details of the agreements mentioned in clause 8A.2 and 8A.3 shall be disclosed in 342(the draft prospectus,) the draft Red Herring prospectus, Red Herring prospectus and the final prospectus. The agreements shall also be included as material documents for public inspection in terms of 343(clause 6.15.1).

8A.5 344(Lead merchant banker or the) Lead Book Runner, in consultation with the SA, shall determine the amount of shares to be overallotted with the public issue, subject to the maximum number specified in clause 8A.3.

8A.6 The 345(draft prospectus,) draft Red Herring prospectus, the Red Herring prospectus and the final prospectus shall contain the following additional disclosures:
a. Name of the SA
b. The maximum number of shares (as also the percentage vis a vis the proposed issue size) proposed to be over-allotted by the company.
c. The period, for which the company proposes to avail of the stabilization mechanism,
d. The maximum increase in the capital of the company and the shareholding pattern post issue, in case the company is required to allot further shares to the extent of over-allotment in the issue.
e. The maximum amount of funds to be received by the company in case of further allotment and the use of these additional funds, in final document to be filed with RoC
f. Details of the agreement/ arrangement entered in to by SA with the promoters to borrow shares from the latter which inter-alia shall include name of the promoters, their existing shareholding, number & percentage of shares to be lent by them and other important terms and conditions including the rights and obligations of each party.
g. The final prospectus shall additionally disclose the exact number of shares to be allotted pursuant to the public issue, stating separately therein the number of shares to be borrowed from the promoters and overallotted by the SA, and the percentage of such shares in relation to the total issue size.

8A.7
(a) In case of an initial public offer by a unlisted company, the promotersand pre-issue shareholders and in case of public issue by a listed company, the promoters and pre- issue shareholders holding more than 5% shares, may lend the shares subject to the provisions of this Chapter.
(b) The SA shall borrow shares from the promoters or the pre-issue shareholders of the issuer company or both, to the extent of the proposed over-allotment. Provided that the shares referred to in this clause shall be in dematerialized form only.

8A.8 The allocation of these shares shall be pro-rata to all the applicants.

8A.9 The stabilization mechanism shall be available for the period disclosed by the company in the prospectus, which shall not exceed 30 days from the date when trading permission was given by the exchange(s).

8A.10 The SA shall open a special account with a bank to be called the"Special Account for GSO proceeds of company" (hereinafter referred to as the GSO Bank account) and a special account for securities with a depository participant to be called the "Special Account for GSO shares of company" (hereinafter referred to as the GSO Demat Account).

8A.11 The money received from the applicants against the overallotment in the green shoe option shall be kept in the GSO Bank Account, distinct from the issue account and shall be used for the purpose of buying shares from the market, during the stabilization period.

8A.12 The shares bought from the market by the SA, if any during the stabilization period, shall be credited to the GSO Demat Account.

8A.13 The shares bought from the market and lying in the GSO Demat Account shall be returned to the promoters immediately, in any case not later than 2 working days after the close of the stabilization period.

8A.14 The prime responsibility of the SA shall be to stabilize post listing price of the shares. To this end, the SA shall determine the timing of buying the shares, the quantity to be bought, the price at which the shares are to be bought etc.

8A.15 On expiry of the stabilization period, in case the SA does not buy shares to the extent of shares over-allotted by the company from the market, the issuer company shall allot shares to the extent of the shortfall in dematerialized form to the GSO Demat Account, within five days of the closure of the stabilization period. These shares shall be returned to the promoters by the SA in lieu of the shares borrowed from them and the GSO Demat Account shall be closed thereafter. The company shall make a final listing application in respect of these shares to all the Exchanges where the shares allotted in the public issue are listed. The provisions of Chapter XIII shall not be applicable to such allotment.

8A.16 The shares returned to the promoters under clause 8A.13 or 8A.15, as the case may be, shall be subject to the remaining lock in period as provided in the proviso the clause 4.14.1.

8A.17 The SA shall remit an amount equal to further shares allotted by the issuer company to the GSO Demat Account (issue price) to the issuer company from the GSO Bank Account. The amount left in this account, if any, after this remittance and deduction of expenses incurred by the SA for the stabilization mechanism, shall be transferred to the investor protection fund(s) of the stock exchange(s) where the shares of issuer company are listed, in equal parts if the shares are listed in more than one exchanges. The GSO Bank Account shall be closed soon thereafter.

8A.18 The SA shall submit a report to the stock exchange(s) on a daily basis during the stabilization period. The SA shall also submit a final report to SEBI in the format specified in Schedule XXIX. This report shall be signed by the SA and the company. This report shall be accompanied with a depository statement for the "GSO Demat Account" for the stabilization period, indicating the flow of the shares into and from the account. The report shall also be accompanied by an undertaking given by the SA and countersigned by the depository(ies) regarding confirmation of lock-in on the shares returned to the promoters in lieu of the shares borrowed from them for the purpose of the stabilization, as per the requirement specified in 8A.16.

8A.19 The SA shall maintain a register in respect of each issue having the green shoe option in which he acts as a SA. The register shall contain the following details of:
(a) in respect of each transaction effected in the course of the stabilizing action, the price, date and time
(b) the details of the promoters from whom the shares are borrowed and the number of shares borrowed from each; and
(c) details of allotments made under clause 8A. 15.

8A.20 The register must be retained for a period of at least three years from the date of the end of the stabilizing period."

8A.21 For the purpose of the Chapter VIII-A,
(a) promoter means a promoter as defined in Explanation I to clause 6.4.2.1 of these guidelines."
(b) Over allotment shall mean as an allotment or allocation of shares in excess of the size of a public issue, made by the SA out of shares borrowed from the promoters or the pre-issue shareholders or both, in pursuance of a green shoe option exercised by the company in accordance with the provisions of this Chapter.

Full, Partial and Reverse Greenshoes
The number of shares the underwriter buys back determines if they will exercise a partial greenshoe or a full greenshoe. A partial greenshoe is when underwriters are only able to buy back some shares before the price of the shares increases. A full greenshoe occurs when they are unable to buy back any shares before the price goes higher. At this point, the underwriter needs to exercise the full option and buy at the offering price. The option can be exercised any time throughout the first 30 days of IPO trading.
There is also the reverse greenshoe option. This option has the same effect on the price of the shares as the regular greenshoe option, but instead of buying the shares, the underwriter is allowed to sell shares back to the issuer. If the share price falls below the offering price, the underwriter can buy shares in the open market and sell them back to the issuer. (Learn about the factors affecting stock prices in Breaking Down The Fed Model and Forces That Move Stock Prices.)

It is very common for companies to offer the greenshoe option in their underwriting agreement. For example, the Esso unit of Exxon Mobil Corporation (NYSE:XOM) sold an additional 84.58 million shares during its initial public offering, because investors placed orders to buy 475.5 million shares when Esso had initially offered only 161.9 million shares. The company took this step because the demand surpassed their share supply by two-times the initial amount.
Another example is the Tata Steel Company, which was able to raise $150 million by selling additional securities through the greenshoe option.

Conclusion
One of the benefits of using the greenshoe is its ability to reduce risk for the company issuing the shares. It allows the underwriter to have buying power in order to cover their short position when a stock price falls, without the risk of having to buy stock if the price rises. In return, this helps keep the share price stable, which positively affects both the issuers and investors.