LEGAL ENVIRONMENT OF BUSINESS

ASSIGNMENT

TOPIC: GREEN SHOE OPTION

(Provisions under Companies Act, SEBI Guidelines and examples of
companies coming with green shoe option)

SUBMITTED TO: PROF. SHIV NATH SINHA

SUBMITTED BY: MAHIMA DANGI
SECTION-C
ROLL NUMBER-2014149

GREEN SHOE OPTION

INTRODUCTION
Often known as an IPOs best friend, Green shoe option is a legal mechanism to bring stability in
all those kind of firms who wish to bring changes in their initial share prices when such firms
venture out and start selling their shares to the public.
A green shoe option allows underwriters to buy up to an additional 15% of company shares at
the offering price. It is a special provision in an IPO description, which lets underwriters to sell
investors more shares than originally planned by the issuer. This would normally be done if the
demand for a security issue proves higher than expected. The term "green shoe" came from the
Green Shoe Manufacturing Company (now called Stride Rite Corporation), founded in 1919. It
was the first company to implement the green shoe clause into their underwriting agreement.

FACTS
In most of the cases, it is experienced that IPO through Book Building method in India turns out
to be overpriced or underpriced after their listing of them and ultimately the small investors
become a net looser. If the IPO is overpriced it creates a bad feeling in investors mind as initial
returns to them may be negative at that point of time. On the other side, if the prices in the open
market fall below the issue price, small investors may start selling their securities to minimize
losses. Therefore, there was a vital need of a market stabilizer to smoothen the swings in the
open market price of a newly listed share, after an initial public offering.

EXAMPLE(S)
Facebook priced its initial public offering at $38.00 per share. Facebook stock began trading, and
the initial trade was at $42.05, a "pop" of over 11%. However, Facebook's stock price became
volatile, and soon fell to the IPO price of $38. It ended the day at $38.23 per share. Many press
accounts indicated that Morgan Stanley stepped in and purchased shares to stabilize the price.
Some press accounts stated that Morgan Stanley exercised the over-allotment option in the
process. This last statement is incorrect and demonstrates that many people in the press don't
fully understand post-IPO price stabilization and the use of the over-allotment option. This post
attempts to shed some light on the matter.
First, and importantly, the IPO price is a sacred thing. The company, investors and the lead IPO
underwriter all want to see the stock trade up in the after-market. When a stock trades up in the

aftermarket, everyone wins. However, when a stock price falls below the IPO price, the IPO is
considered "broken," the company and investors are disappointed and the lead underwriter
suffers reputational damage (with the company, with institutions buying the IPO, with future IPO
clients, etc.). In addition, it is common for lawsuits to occur when a stock falls below the IPO
price in the first days of trading (see today's news article about the first lawsuits filed in the
Facebook IPO). For these reasons (and more), it is customary for the lead underwriter to work to
"stabilize" the market and keep the stock price above the IPO price. This is called IPO price
stabilization and it works due to the existence of a misunderstood tool called the over-allotment
option (it's also known as a Green Shoe after the first company to use this mechanism).
As part of the IPO, the company will grant the underwriters an over-allotment option to buy
additional shares from the company that can be exercised for up to 30 days after the IPO. This
over-allotment option is typically for a number of shares equal to 15% of the shares offered in
the IPO, and has an exercise price equal to the IPO price. Then, armed with this over-allotment
option, the underwriters go and sell the IPO. But what they really do is sell more shares than are
indicated in the prospectus (yes this is legal), and oversell the IPO by 15% (equal to the number
of shares covered by the over-allotment option). Crazy, you say? Let's look at two scenarios: (1)
the stock price goes up; and (2) the stock price goes down.
If the stock price goes up, then the underwriters must deliver those oversold shares. Since the
number of oversold shares equals the number of shares subject to the over-allotment option, all
the underwriters do is exercise the over-allotment option and receive the shares from the option
to cover the over-selling. Note that the underwriters don't make a killing by doing this. They
over-sold the offering at the IPO price, and exercised the option at the IPO price, so there's no
huge profits made here, (however, the underwriters do get their underwriting fees and
commissions on these shares, so they do get an additional 15% commission).
If the stock price goes down, then it's a little more complicated. As mentioned above, the lead
underwriter will support the stock at the IPO price, with a view to not let it "break" the IPO and
fall below the IPO price. The lead underwriter accomplishes this by buying shares back from the
market at the IPO price, which helps to stabilize the price and also removes shares from the
market (reducing supply). Because the IPO was oversold, the lead underwriter can buy back
these oversold shares at the IPO price with no impact to its balance sheet. But, once all of the
oversold shares are bought back, then if the lead underwriter continues to stabilize and buy
shares at the IPO price, its balance sheet is at risk. If there's a lot of downward pressure on the
stock and the lead underwriter has already bought back all of the oversold shares, it will stop
stabilizing and the stock price will fall and 'break" the IPO. This is what happened in the
Facebook case.

Let's use an example. Let's say LattaCo goes public and sells 10 million shares in its IPO at $10
per share, raising $100 million. As part of the IPO, it grants its underwriters (Acme is the lead
underwriter) a 30-day over-allotment option equal to 15% of the IPO shares (1.5 million shares)
at the IPO price. LattaCo and Acme go on the IPO roadshow and Acme starts to build the IPO
order book. While doing so, Acme actually sells 11.5 million shares to buyers at $10 per share.
Once the stock starts trading, the initial trade is $12 per share and the price keeps going steadily
up from there, closing its first day of trading at $15 per share and closing at $20 per share a
couple days later. But Acme sold 11.5 million shares - how does it make good on those 1.5
million extra shares? This is where Acme exercises the over-allotment option to obtain those
extra shares. It exercises the option, obtains the 1.5 million shares, delivers the shares and
everyone wins.
But what if the stock doesn't perform well. Let's assume LattaCo starts trading at $11 per share,
but the price starts to drift down to the $10 IPO price. When the trades get to $10 per share, the
lead underwriter Acme will begin to support the stock price by buying shares at $10 per share.
Because the IPO was oversold by 1.5 million shares, Acme can buy back up to 1.5 million
shares at $10 per share with no impact to its balance sheet. In this case, there's no longer any
need to exercise the over-allotment option, and after 30 days it will expire.
The above is a simplified explanation of the mechanics of price stabilization and the use of the
over-allotment option. We could discuss how the process is like a protected short; we could
discuss how the over-allotment option can be from the company and selling shareholders; and we
could also discuss the mechanics of how the underwriter actually oversells the IPO by 15%
(essentially they borrow the shares from insiders). But why complicate things?

GSO WINDOW PERIOD: COMPARISON AND ITS ANALYSIS

GSO Window Period is a period of 30 days from the listing date. During this period, if the
closing price is below the offer price, then, the need for Price Stablisation arises. The Stabilising
Agent plays a role in stabilizing the price by using the amount from Escrow Account to purchase
the shares at the offer price or market price. Table 1 provides the number of days during which
the closing price was below the offer price and the number of trading days.
From the Table, it is clear that a majority of the companies (10) had more than 75% of days
when trading price was below the issue price during GSO window period, indicating the need for
Price Stabilization. In case of 4 companies, the percentage is 100. This shows that, GSO will be a
boon to the Companies to stabilize the price.

TABLE 2
GSO: COUNTRY-WISE COMPARISONS
Facets
Regulatory
Authority

GSO Window
Period

Naked
short
position
Penalty bids
Extent
of
Overallotment

US

UK
United
Kingdom
Financial
Services
14 Mandatorily, 30
calendar days
the from the listing
day

SEC

Around
calendar
days from
listing
day

Germany
German Federal
Financial
Supervisory
Authority (FSA)
Customarily,
one
month from the
listing day

India
Securities and
Exchange Board
of India (SEBI)
Mandatorily, 30
calendar days
from the listing
day

Widely used

Rarely used

Not allowed

Not allowed

Allowed

Not Allowed

Not Allowed

Not Allowed

Customarily, 15 15% of the issue

20% of the firm
size
commitment
of
the
underwriters
Allowed
Allowed

Retention of
Profits
Source: www.nseindia.com

15% of the issue 15% of the issue

size
size

Allowed

Not Allowed

TABLE 1
GSO WINDOW PERIOD: AN ANALYSIS

Issuer Company

Issue
Price

Listing Date

Days when
Closing
Price
was
below Issue

Trading
days
during
GSO

% of
Days
when Trading
Price
was
below

Price
during
GSO
Window
Period
1 Tata
Consultancy
Services Ltd.
2 Deccan
Chronicle
Holdings Ltd.
3 3I Infotech Ltd.
4 HT Media Ltd.
5 Shree Renuka Sugars
Ltd
6 Entertainment
Network (India) Ltd.
7 Jagran Prakashan Ltd.
8 B. L. Kashyap & Sons
Ltd.
9 Prime Focus Ltd.
10 Parsvnath Developers
Ltd.
11 Cairn India Ltd
12 House of Pearl
Fashions Ltd.
13 Idea Cellular Ltd
14 Housing Development
& Infrastructure Ltd.
15 Omaxe Ltd
16 Brigade Enterprises
Ltd
17 Indiabulls Power Ltd.
18 Electrosteel Steels Ltd
Source: www.nseindia.com

Window Issue
Period
during
Window
Period

Price
GSO

850 25 Aug 2004

23

162 22 Dec 2004

17

22

77.27

100 22 Apr 2005

530 1 Sep 2005
285 1 Sep 2005

20
19
0

21
21
21

95.24
90.48
0

162 15 Feb 2006

20

320 22 Feb 2006

685 17 Mar 2006

19
0

19
18

100.00
0

417 20 Jun 2006

300 30 Nov 2006

23
0

23
21

100.00
0

160 9 Jan 2007

550 19 Feb 2007

21
20

21
20

100.00
100.00

75 9 Mar 2007
500 24 Jul 2007

0
4

19
22

0
18.18

310 9 Aug 2007

390 31 Dec 2007

4
21

21
23

19.05
91.30

45 30 Oct 2009
11 8 Oct 2010

20
18

20
21

100.00
85.71

Greenshoe Option is similar to that of American call option. The underwriter has the right to buy
additional shares at the offering price anytime during a fixed time period (often +/- 30
days).Hansen, Fuller and Janjigian (1987) => value of the option using Black Scholes estimated
to be as much as 1% of the gross proceeds. Muscarella, Peavy III and Vestuypens (1992) =>
option exercise distinguishing close end funds and non-fund IPOs mean return of first day of

trade (offer price to closing price of first day) = 9.93% for non-fund IPOs, not 0 for funds IPOs
Underwriters on average exercised the option for 83.71% of the nonfund IPO shares available
thanks to the greenshoe option, whereas only 23.19% did so for the close end funds IPOS In
general, options are exercised rationally.

LIMITATIONS: Reasons for indifference towards GSOs

The data reveals that there is a case for issuer companies and merchant banks to avail the facility of GSOs
to reassure investors, especially RIIs, and to discourage them from exiting the capital markets. What then
is the reason for this indifference to GSOs on the part of issuer companies and merchant banks? From our
interaction with market participants and merchant banks, various reasons emerged, such as the
uncertainty about the effects of GSOs, the interference with market forces, the unfair advantage to
merchant banks, the merchant banks unwillingness to bear additional responsibility, the lack of
incentives, the absence of market discipline, and so on. These reasons are discussed in some detail in the
rest of this section.

A. Uncertainty about impact of GSOs

Our interviews with merchant bankers revealed that many issuer companies and quite a few merchant
banks were unsure of the effects of GSOs. There was a feeling that the GSOs facility was highly
constrained by the limit of 15% over-allotment and the 30-day stabilisation period. The general
opinion was that there was no guarantee that the stabilisation programme would in fact be successful.
In this scenario, these issuer companies and merchant banks felt that the panic and fear of the retail
individual investors (RIIs) would only increase.

B. Interference with free play of market forces

Some investors felt that the practice of GSOs was questionable as it artificially propped up share
prices, thereby interfering with the free play of market forces. It was suggested that starting from the
pre-SEBI days, RIIs were led to believe that investing in an IPO would guarantee them positive
initial returns. The GSO would merely reinforce these attitudes. Further, any aftermarket price
stabilisation would deprive value investors from purchasing shares from nave investors when the
price falls in the immediate aftermarket.

C.

Unfair advantage for merchant banks

Merchant banks that are designated as stabilising agents get high fees for availing of the GSOs. Such
high fees for merchant banks were felt to be unjust as they face limited risk in implementing GSOs
(Espinasse, 2010).

D.

Unwillingness of merchant banks to accept additional responsibility

The issuer companies and merchant banks that we interacted with felt that the legal and regulatory
compliances were cumbersome, and that the consequent risks had increased manifold. In this
scenario, they were not prepared to take any additional responsibility for a facility that was optional
to begin with.

E.

Lack of incentives

According to the GSO regulations, merchant bankers are not allowed to earn a profit from the
aftermarket price stabilising activity. This was one of the major concerns highlighted by merchant
bankers in a survey conducted by The Economic Times; a typical response was Unlike in the US,
SEBI does not permit merchant bankers to make money in trading. They will have to buy the stock if
the price falls below the offer price, but they are not allowed to sell even if the stock value goes up.
We are required to stabilise the price around the offer price for which we get a fixed fee (Anand,
2002).33
Any profits arising from the price stabilisation activity need to be transferred to the Investor
Protection and Education Fund (IPEF) established by the SEBI.34 In this scenario, issuer companies,
promoters and pre-listing shareholders, and merchant banks did not see any incentive to opt for
GSOs.

F.

Absence of market discipline

In a mature market, if the aftermarket price of the shares falls significantly, the investors would hold
the merchant banks responsible for the same. In such an event, the credibility of the merchant banks
would take a hit. This would adversely affect their chances of getting further business because
investors would keep away from the issues managed by them.

However, investors in India, especially the RIIs, appear to be indifferent to ascribing responsibility.
In the face of this lack of market discipline, merchant banks in India have no reason to shirk the
additional responsibilities associated with GSOs and talk about the lack of incentives.

GREEN SHOE OPTION denotes an option of allocation of shares, in excess of shares included
in the public issue. W.e.f 28.05.07, the concept of Green Shoe option has been extended to all
public issue in accordance with the provision of chapter VIII A of SEBI Guidelines. SEBI
introduced this option with a view to boost investors confidence by arresting the speculative
force, which work immediately after listing and thus result in short term votality in post listing
price. It ensures price stability.
According to SEBI guidelines, a company desirous of availing the GSO 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). The company shall appoint one of the
lead book runners, 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. The SA shall also enter into an agreement with the promoter(s)
who will lend their shares, specifying the maximum number of shares that may be borrowed
from the promoters, which shall not be in excess of 15% of the total issue size. 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).

There are some guidelines related to Green Shoe option by Security & Exchange
Board of India.

An issuer company making a public offer of equity shares can avail of green shoe option
for

--Stabilizing the post-listing price of its shares.

--Possibility of allotment for the shares to the stabilizing agent at the end of stabilizing period

A company shall appoint one of the merchant bankers from amongst the issue
management team, as a stabilizing agent who will be responsible for the price
stabilization process.

The stabilizing agent (SA) shall enter into an agreement with the promoters or pre-issue
shareholders who will be lend their shares specifying the max. no of shares shall not be in
excess of 15% of total issue size.

The details of the agreement shall be disclosed in the draft prospectus, draft red herring
prospectus, red herring prospectus and final prospectus.

Lead Merchant bankers by constitutions with stabilizing agent, shall determine the
amount of shares to overalloted with public issue.

The draft prospectus, draft red herring prospectus, red herring prospectus and final
prospectus shall contain following additional disclosures:--Name of Stability agent.
--The max. no of shares proposed to be overalloted by company.
--The period for which the company propose to avail of the stabilizing mechanism.

--The max. increase in capital of company and the shareholding pattern, post issue, is
required to allot for the shares to the extend of over allotment in the issue.
--The max amount of fund to be received by company in case of further allotment and the
use of these funds in final document to be filled with ROC.

In the case of initial public offer by the unlisted company, the promoter and the pre issue
share holders or incase of listed company having shareholding more than 5 % shares ,
may lend the shares subject to provision of SEBI. The Stabilizing Agent shall borrow
shares from the promoters or prs issue share holding to extend of proposed over
allotment.
The allocation of these shares shall be on pro rata basis.

The stabilization mechanism shall be available for the period, which shall not exceed 30
days from the date of trading permission, was given by exchange(s).

The SA shall open a special account with the bank to be called SPECIAL ACCOUNT
for GSO proceeds of ..Company. For the money received from applicants against
over-allotments in GSO shall be kept in GSO bank A/c for the purpose of buying shares
from market during stabilization period, credited to the GSO Demat A/c(shares brought
from markets by SA)

The share brought from market and lying in GSO Demat A/c shall be return to promoter
immediately in any case not later than 2 working days after the close of the stabilization
period.

The Prime-responsibility of SA shall be stabilizing post-listing price of share. The SA

shall determine the timing of buying the shares, quantity to be brought and the prices at
which the shares are to be brought.

On the expiry of stabilization period, in case of SA does not buy shares, the issuer
company shall allot shares to the extend of shortfalls in dematerialization form to GSO
Demat A/c with in 5 days of closer of Stabilization period.

The shares returned to promoter shall be subject to remaining lock in period as applicable
to promoters holding.

The SA shall remit an amount equal to Issuer Company from GSO Bank A/c. The
amount left in this account shall be transferred to investors protection fund.

The SA shall submit a report to stock exchange on daily basis during the stabilization
period. The SA shall also submit a final report to SEBI in specified format. The SA and
the company shall sign this report

The SA shall maintain the register in respect of each issue and must retained for the
period at least 3 years from the date of end of stabilization period. The register contains
1. Each transaction effective.
2. Details of Promoters from whom the shares are to be brought.
3. Details of allotments.

In most of the cases, it is experienced that IPO through Book Building method in India
turns out to be overpriced or underpriced after their listing of them and ultimately the
small investors become a net looser. If the IPO is overpriced it creates a bad feeling in
investors mind as initial returns to them may be negative at that point of time. On the
other side, if the prices in the open market fall below the issue price, small investors may
start selling their securities to minimize losses. Therefore, there was a vital need of a
market stabilizer to smoothen the swings in the open market price of a newly listed share,
after an initial public offering.

Market stabilization is the mechanism by which stabilizing agent acts on behalf of the
issuer company, buys a newly issued security for the limited purpose of preventing a
declining in the new securitys open market price in order to facilitate its distribution to
the public. It can prevent the IPO from huge price fluctuations and save investors from
potential loss. Such mechanism is known as Green Shoe Option (GSO) which is an
internationally recognized for market stabilization. So, GSO can rectify the demand and
supply imbalances and can stabilize the price of the stock. It owes its origin to the Green
Shoe Company which used this option for the first time throughout the World.

Suggestions
The GSOs provision was introduced by the SEBI in 2003 as a mechanism for reassuring RIIs
that the aftermarket price of the shares they were allotted in an IPO would be maintained at least
in the first month of listing. However, we found that most issuer companies and merchant banks
were indifferent to GSOs, and such options were rarely availed. Various reasons for this
indifference emerged, such as the uncertainty about the effects of GSOs, the unwillingness to
bear additional responsibility, the lack of incentives, the absence of market discipline, and so on.
Based on our findings, we propose the following suggestions: make GSOs mandatory; control
flipping by qualified institutional buyers (QIBs); disclose the track record of merchant banks;
and tighten IPO norms, especially for small IPOs.

A. Make green shoe options mandatory

On the face of it, the suggestion to make GSOs mandatory may sound preposterous to many
people. Currently, GSOs are not mandatory in any country. However, given the SEBIs objective
of increasing the participation of RIIs, and the peculiar nature of the capital markets in India, we
feel that the suggestion to make GSOs mandatory is reasonable.

B. Control QIB flips

When an issuer company is unable to satisfy the eligibility criteria related to past track records,
they are allowed to make an IPO if they are able to get qualified institutional buyers (QIBs) to
make a significant investment. The implicit assumption is that the QIBs are sophisticated
investors who would take a long-term investment view of the investment.

C. Disclose track record of merchant banks

Merchant banks seemed to be indifferent to the aftermarket price movement. They claimed this
indifference was justified because the compliance work of IPOs was already voluminous, and
they were not in any position to assume additional responsibilities and risks. Merchant banks in
India are able to get away with this attitude because the investors do not show any interest in
disciplining them, for instance, by boycotting the issues managed by them. In order to facilitate
such market discipline, the regulator may need to mandate an additional disclosures requirement
regarding the aftermarket returns for each merchant bank.

D. Tighten norms for small IPOs

The performance of small IPOs (with an issue size less than INR 100 crore) has been dismal.
There is a definite need to re-examine the IPO norms for such small issues. The implicit
assumptions and expectations from QIBs and project appraisal agencies in such small issues also
need to be re-examined. Further, this issue needs to be studied in detail by independent
researchers.

Conclusion
Based on the analysis of the aftermarket price performance of the companies that availed of the
GSO facility in their IPO programmes, it could be concluded that GSOs were not effective in
stabilising the prices in the period immediately following the listing date. However, broad
generalizations cannot be made due to the small size of the companies, both in absolute terms
and as a proportion of the companies making IPOs. Of the companies that did not include the
GSO facility in their IPO programmes, a disproportionately large number of companies
performed poorly. This led us to propose that GSOs be made mandatory; some penalties would
need to be imposed on QIBs who sell in the immediate aftermarket; merchant bankers would
need to disclose their track record; and the IPO norms would have to be tightened, especially for
small issues.

REFERENCES
1 Ravi Kapoor, senior vice-president, DSP Merrill Lynch, New IPO Norms To
Have GSO, www.financial express.com
www.investopedia.com
www.thehindubusinessline.in
www.financialexpress.com
www.moneycontrol.com

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