Greenshoe options

Author: | Published: 5 Jan 2004
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The continued development of the greenshoe option in the Japanese capital market will enable more efficient public offerings of securities by ensuring a better response to the market's supply and demand forces. It is hoped that the use of treasury stock will be permitted in the future so greenshoe options can be more widely and easily used.

What is a greenshoe option?

A greenshoe option is an option granted by an issuer and/or security holders to an underwriter in a public offering to purchase additional securities for a period of time on the same terms as the underwriter purchased the initial securities under the offering. The name comes from The Green Shoe Company, the first issuer to grant this type of option. It is also commonly referred to as an over-allotment option.

Rationale for a greenshoe option

Because public offerings may supply a large number of securities into a market, there is a risk that the price of the securities will be highly volatile immediately after the commencement of the offering. Price volatility is likely to be even greater in the case of an initial public offering (IPO) because there is no established secondary market for the securities.

The purpose of an issuer and/or a selling security holder providing an underwriter with an over-allotment is to allow the underwriter to stabilize the after-market for the issuer's securities in the period immediately after the public offering begins. By allowing an underwriter to obtain additional securities covering an over-allotment and to sell these securities to the public, an underwriter can maintain a balance between the demand for an issuer's securities and the supply of securities available to satisfy market demand.

Pre-payment and ex-payment greenshoe options

Before examining the greenshoe option in Japan we should note that a greenshoe option can be categorized into one of two types based on the timing of the exercise of the option. The first type is pre-payment, where the underwriter exercises the option before the payment date of the offering. The additional securities purchased under the greenshoe option are offered to investors together with the securities that were originally purchased by the underwriter under the offering. The underwriter exercises the option by giving notice to the issuer and/or selling security holders no later than the payment date.

The second type of greenshoe option is ex-payment, where the underwriter exercises the option after the payment date of the offering. In this case the underwriter acquires the additional securities purchased under the option after the payment date of the offering to cover the short positions created in connection with the over-allotment.

History of greenshoe options in Japan

It has been common in the US and European capital markets for issuers and/or selling security holders to grant a greenshoe option to an underwriter or the managing underwriter on behalf of an underwriting syndicate. But this is a relatively new concept in Japan.

A Japanese issuer granted the first pre-payment greenshoe option about 10 years ago. Since the late 1990s increasingly more have been granted in offerings by Japanese issuers in the US and European capital markets. NTT Corporation's international offering of common stock in November 2000 is one example. Pre-payment greenshoe options are also granted in public offerings in Japan of already-issued shares, such as the offering of common stock of Toyota Motor Corporation in October 1999.

The first ex-payment option, however, was granted only recently in a public offering in March 2002. Since these options are exercisable only after the payment date of the offering, it is common for an underwriter to take short positions in the securities created in connection with the over-allotment. To cover such short positions, the underwriter usually elects to either purchase additional securities from the issuer and/or security holders upon exercising the greenshoe option or in the open market in lieu of exercising all or part of the option. This latter purchase is called a syndicate covering transaction (SCT), which is a purchase of securities on behalf of an underwriter to reduce a short position created by the underwriter in connection with an over-allotment. The securities acquired by any permitted stabilizing transaction in connection with an offering are also available to cover short positions.

An ex-payment greenshoe option is advantageous for an underwriter for two main reasons. Firstly, when the market price of the securities is higher than the purchase price of securities under the greenshoe option (in most cases this is the same price as that which the underwriter paid to purchase the initial securities under the offering), the underwriter can purchase additional securities from the issuer and/or security holders for less than the market price. Secondly, when the market price is less than the purchase price of securities under the greenshoe option, the underwriter can purchase securities in the open market at a price less than the purchase price under the option. By entering into such transactions, an underwriter can probably reduce the amount of volatility in the price of the securities after the payment date. SCTs also serve as a supply and demand adjustment mechanism controlled by the underwriter.

What has prevented the development of greenshoe options?

Ambiguity regarding the regulations applicable to greenshoe options (in particular, ex-payment types) has limited their general use in Japan.

Under the Commercial Code of Japan, an issuer's board of directors in general must approve the number of shares or stock acquisition rights (including stock acquisition rights attached to bonds) to be issued. An issuer must also give public notice specifying the number of shares or stock acquisition rights to be issued at least two weeks before the payment date for the purpose of providing shareholders with an opportunity to exercise their injunctive rights to prevent the issue of such securities.

However, at the time of the board approval, the definitive number of securities to be issued in an over-allotment cannot be precisely determined. To avoid this potential issue, it is common for issuers to approve the maximum number of securities to be offered (including those to be issued additionally upon exercise in full of the greenshoe option). This issue is only relevant to an offering of new shares with a pre-payment greenshoe option. In the case of an offering of already-issued shares no board approval or public notice is required.

Under the Securities and Exchange Law of Japan, an issuer of a Japanese public offering must file a securities registration statement with the relevant finance bureau, disclosing the particulars of the offering and certain information about the issuer. In principle, an issuer is prohibited from selling any securities under an offering until 16 days after the filing of the registration statement. A filing can be only effective if the statement contains all required information, including the fixed number of securities to be sold in an offering. The number of securities to be purchased by an underwriter under any greenshoe option cannot be determined until some time after the pricing of the securities. Because of this, it practically prevents the registration statement from coming into effect. To avoid this, an issuer of a public offering with pre-payment greenshoe options commonly files the statement on the basis that the underwriter will purchase the maximum number of securities eligible on the exercise in full of the option. If the number of securities offered and purchased under the over-allotment is less than such maximum number, the right to subscribe for the remaining securities is considered forfeited.

Because of this framework, pre-payment greenshoe options were previously known in the Japanese capital market as "under-allotment" options. For ex-payment options, however, only recently has it been clarified how to describe the option and the relevant over-allotment in the securities registration statement. Underwriters have also been hesitant to engage in SCTs because of the risk that such transactions may constitute a market manipulation and/or proscribed stabilizing transaction, each of which are violations under the Securities and Exchange Law. Securities companies, in their capacity as underwriters, have refrained from engaging in any SCTs because no safe harbour rules or guidelines have been issued in relation to these types of transactions.

There are also practical limitations to the use of ex-payment greenshoe options, in addition to the constraints under the Commercial Code and Securities and Exchange Law. Since ex-payment greenshoe options are exercisable only after the payment date of the offering, on the delivery date of the offering, securities to be purchased on exercise of the option cannot be used in the settlement of the over-allotted securities. To cover the over-allotment and deliver the required number of securities to investors at the time of settlement of the offering, underwriters must borrow the relevant number of securities from existing security holders. However, it may be difficult for underwriters to obtain the necessary cooperation of the sponsor or other security holders to borrow the required number of securities on commercially reasonable terms.

Market developments

Because of the increasing number of IPOs in the past 10 years, there has been a growing need to clarify and modernize the regulations concerning greenshoe options to make them a useful tool in lowering the volatility of security prices after an offering. In January 2002, the Japan Securities Dealers Association (JSDA) and the Tokyo Stock Exchange (TSE) established rules concerning ex-payment greenshoe options, SCTs and over-allotments. These regulatory clarifications and improvements are expected to result in the increased use of ex-payment options in offerings in Japan.

A public offering of already-issued shares of Hitachi Mobile in March 2002 was the first offering in Japan where the selling security holder granted an ex-payment greenshoe option to an underwriter. Softfront was the first issuer to grant an ex-payment greenshoe option in its IPO in September 2002 of new shares.

As a result of the amendments to the JSDA regulations that became effective in December 2002, Japanese real estate investment trusts (JREITs) are now permitted to grant ex-payment greenshoe options in offerings of investment units. Japan Retail Fund Investment Corporation was the first JREIT to grant an ex-payment greenshoe option in the public offering of its units in March 2003. In the past two years, there have been nearly 200 offerings of ex-payment greenshoe option transactions in Japan. In the March 2003 global offering of its common stock, Mitsubishi Tokyo Financial Group granted a greenshoe option in each of its offerings in the US, Europe and Japan.

It should be noted the current accepted practice of the Financial Services Agency of Japan is that a securities registration statement involving an ex-payment greenshoe option will be effective if the underwriter is presumed to purchase the maximum number of securities eligible to be purchased on exercise in full of the ex-payment option. If the number of securities purchased on exercise of the ex-payment option is less than such maximum number due to SCTs covering the short positions created in connection with the over-allotment, the right to subscribe for the remaining securities is considered forfeited.

Regulations concerning ex-payment greenshoe options

There is a risk that transactions involving greenshoe options may result in market manipulation and/or proscribed stabilizing transactions. To prevent this, the JSDA has established regulations concerning greenshoe options that provide, among other things, that: the number of securities to be purchased in an over-allotment must be no greater than 15% of the offering in Japan; the number of securities that can be purchased upon exercise in full of the greenshoe option must be the same as the maximum number of the over-allotment; and the exercise period of the greenshoe option and the period during which SCTs may be performed must be no longer than 30 days from the last day of the subscription period of the securities.

The TSE has also established rules to prevent market manipulation or stabilizing transactions. These rules provide, among other things, that any underwriter performing a SCT must report to the TSE the number of securities purchased, the purchase price and other relevant information on each day the underwriter performs a SCT. The underwriter must also file a completion report upon the conclusion of the SCTs that sets out all SCTs engaged in during the period and the consequences of such transactions. The completion reports are available to the public. The TSE rules also set out guidelines regarding how underwriters should perform a SCT. The TSE also requests issuers to issue press releases setting out the details of any over-allotment, greenshoe option and/or SCT if such are to be used in connection with a public offering of their securities.

Types of ex-payment greenshoe options

Ex-payment greenshoe options may be further categorized into two types, based on the method of acquiring the securities to be used to cover the short positions that resulted in connection with the over-allotment.

The first type is the "allotment greenshoe option", where an underwriter may request the issuer to additionally allot new securities to the underwriter to cover its short positions. The benefit of this is that issuers may issue new securities and increase their capital upon an exercise of the option. However, issuing new shares can lead to a further dilution of ownership interest of existing security holders.

The second type is the "purchase greenshoe option", where an underwriter may purchase securities from sponsors or other security holders whose securities were previously borrowed from the same sponsors or other security holders for covering the over-allotted securities. The advantage of this is that no dilution of ownership of existing security holders occurs. But it may be practically difficult to obtain the cooperation of sponsors or other security holders because any purchase of securities from them as a result of the underwriter exercising the option would lead to a reduction in their ownership interest in the securities.

If not enough securities are available to be borrowed to satisfy an over-allotment, the underwriter may use a certain number of securities for sale to a sponsor designated by the issuer and that has a special relationship with the issuer, in certain circumstances permitted by the JSDA regulations. In such case, the securities newly issued by the issuer to the sponsor on the delivery date are immediately borrowed by the underwriter and then delivered by the underwriter to investors on the delivery date to perform the underwriter's obligations under the over-allotment.

Daido Life Insurance Company was the first Japanese issuer to adopt this type of scheme in its IPO in March 2002. TOKYU REIT was the first JREIT to adopt this type of scheme in its IPO in September 2003.

Future issues

It is still unclear under Japanese law the extent to which treasury stock can be generally used in a greenshoe option. In Nomura Holdings' offering of common stock in September 2003, treasury stock was allotted to the underwriter upon the exercise of an allotment greenshoe option. Notices and guidelines of the JSDA permitted this. Borrowing of securities by underwriters is required in many cases and underwriters may not be able to obtain the necessary cooperation of the sponsor or other security holders to borrow the required number of securities. If treasury stock were available for the purpose of over-allotments, in place of borrowed securities, ex-payment greenshoe options would be easier to include in public offerings. But such use of treasury stock for over-allotments is presently problematic because of the provisions relating to acquisition and disposal of treasury stock under the Commercial Code.

It is hoped that legislation will be introduced to resolve this issue so that ex-payment greenshoe options can be put into practice more easily.

Author biographies

Miyuki Ishiguro

Nagashima Ohno & Tsunematsu

Miyuki Ishiguro is a partner of Nagashima Ohno & Tsunematsu. She mainly advises Japanese issuers on public offerings and private placements of debt and equity securities in the Japanese domestic and overseas capital markets. She also provides continuous disclosure advice to Japanese issuers whose shares or American Depositary Receipts are listed on the Japanese, US and/or European stock exchanges. She obtained her LLB from Hitotsubashi University in 1989 and has been admitted to practice law in Japan since 1991.


Shinichi Araki

Nagashima Ohno & Tsunematsu

Shinichi Araki is an associate of Nagashima Ohno & Tsunematsu. He practises in the area of capital markets with an emphasis on equity transactions involving Japan and overseas issuers. He also advises Japanese companies in corporate restructurings including corporate splits and share exchanges. He is a graduate of the University of Tokyo (LLB 1999) and has been admitted to the bar in Japan since 2001.



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