Footloose with Green Shoes: Can Underwriters Profit from IPO Underpricing?

Patrick M. Corrigan is Associate Professor of Law at Notre Dame Law School. This post is based on his recent paper, forthcoming in the Yale Journal on Regulation.

Initial public offerings (IPOs) are set to rocket out of the gates again in 2021. Recently, we have witnessed some big pops (for example, Airbnb, 113 percent first-day return) and some steep drops (Wish, negative 16 percent).

With all this pricing variability following IPOs, what role is underwriter price stabilization playing? Relatedly, what role do overallotments and green shoe options play?

Overallotments are sales by the underwriting syndicate in excess of the number of shares the syndicate is obligated to purchase to underwrite the offering. A green shoe option is the right of the underwriters to purchase an amount of shares in addition to and at the same price as the base shares in the IPO.

Leading academic theories claim that underwriters use overallotments and green shoe options to help stabilize an issuer’s stock price following an IPO.

Puzzlingly, the purported “stabilizing” mechanism—short sales followed by repurchases—constitutes a wash trade that is unlikely to inject lasting or substantial net demand into the aftermarket

There’s also an empirical problem with this leading theory. In the universe of 911 U.S. commercial IPOs between 2010 and 2017, only 6 (1) percent of IPOs finished the first (tenth) day of trading with exactly a 0 percent return.

Contrary to the price stabilization theory’s predictions, a surprisingly high number of IPOs break issue very rapidly. More than 23 (28) percent of IPOs in my sample traded below the initial offering price by the end of the first (tenth) day, with an average return of negative 8.1 (negative 10.7) percent. More than 16 percent of IPOs traded below the initial offering price in the very first trade on exchange, with an average decline of negative 6.2 percent.

In my recent paper, I set forth a more satisfactory explanation for the use of green shoe options and overallotments in IPOs: they are used to maximize the principal trading payoffs of underwriters.

Green shoe options and overallotments constitute, fundamentally, trading positions. A green shoe option is a call option on the issuer’s stock. Overallotments create a short position in an issuer’s stock. The option of realizing either trading position effectively makes underwriters long a straddle at the initial offering price in IPOs.

A straddle position is a long gamma position. Accordingly, underwriters have incentives to operate the bookbuilding process and the IPO pricing negotiation with an aim of underpricing or overpricing IPOs, but not pricing them accurately.

The prediction is precisely the opposite of the price stabilization theory: IPO initial returns should exhibit variability, not stability. Consistent with this prediction, we observe that IPOs with negative initial returns have mean first day returns of 8.1 percent, while IPOs with positive initial returns have mean first day returns of 25.5 percent.

Thus, the blowouts in the Airbnb IPO and the flop in the Wish IPO are two sides of the same coin. In the former, underwriters monetize a very valuable call option. In the latter, underwriters monetize a valuable short position.

You may be thinking: don’t the U.S. securities laws categorically prohibit underwriters from using green shoe options to profit from IPO underpricing? Indeed, this conclusion about the securities laws is widely believed.

However, this belief is incorrect as a matter of law. I show that underwriters may permissibly pair offshore short sales of an issuer’s securities at prices about the initial offering price with subsequent purchases under a green shoe option. This strategy exploits narrowly crafted FINRA and SEC rules, as well as the limited extraterritorial reach of the securities laws.

Issuers may fail to bargain for optimal contractual protections if they hold the mistaken belief that the securities laws protect them against opportunistic use of green shoe options. Only slightly more than 54% of IPO issuers in my sample restrict the use of the green shoe option solely for the purpose of covering overallotments. The remaining 46% of IPO issuers grant their underwriters a plain vanilla call option on their stock. As predicted, IPOs with “overallotment options” are associated with first day returns that are, on average, 7 percentage points less than IPOs that use green shoe options without any contractual restrictions—an economically and statistically significant difference in group means.

Reputational forces undoubtedly constrain IPO pricing to at least some degree, but reputation may not be sufficient to prevent opportunistic trading by underwriters that is undetectable by issuers or the market.

The payoffs of my new principal trading theory are substantial.

First, the theory suggests that issuers should jettison the use of green shoe options entirely, like DoorDash did in its recent IPO. If using options remains desirable, issuers should restrict their use solely for the purpose of covering overallotments.

Second, lock-up agreements should be thought of merely as trading restrictions designed to ensure compliance with Regulation M. Accordingly, issuers may negotiate to reduce the traditional six-month lock-up period and to release employees and other pre-IPO stockholders who are not “affiliated purchasers” under Regulation M from onerous lock-up restrictions. Lock-up agreements are not necessary at all in direct listings where Regulation M does not apply.

Third, my principal trading theory undermines the core pillar of the Second Circuit’s anti-textual, public policy activism in Lowinger v. Morgan Stanley in granting underwriters a shield against litigating claims of “good faith” transactions by underwriters under the short swing trading prohibitions of Section 16(b) of the Exchange Act.

Fourth, the theory provides the first explanation in the academic literature for laddering practices observed in the internet bubble. Under my theory, laddering occurred when underwriters conditioned initial allocations in IPOs on commitments to purchase in the aftermarket precisely to maximize the trading value of their green shoe options.

Fifth, by identifying the implementation of Regulation M in 1997 as a little-noted deregulatory event, the theory may also provide a new explanation for why mean IPO underpricing increased so dramatically during the internet bubble years.

Finally, the principal trading theory illuminates a new path for the regulatory scheme that applies to the aftermarket trading activities of underwriters. Underwriters should be required to publicly disclose the timing and prices of any syndicate short sales and short covering transactions that are not made at the initial offering price. FINRA should end its practice of effectively ignoring the trading value of green shoe options and overallotments when determining fair and reasonable underwriting compensation. And, finally, the SEC should enhance the prophylactic purpose of Regulation M by directly prohibiting the outcome of underwriter enrichment due to principal trading in connection with a securities offering.

The complete paper is available for download here.

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