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Green Shoe Option Concept in Indonesian IPOs

March 2013 - Corporate & Commercial. Legal Developments by Melli Darsa & Co..

More articles by this firm.

A. Introduction

The securities market where public offerings are conducted contributes an important role in the economic development of a country, including Indonesia, in terms of moving the financial resources from public to corporate sector which allows companies to undertake various projects in favor of the economy development as well as general corporate purposes. On the other hand it also enables the public ("Investors") to invest their assets (i.e. savings) in gainful investments which allow them to participate directly in the profits of the corporate sector.

Public offerings may supply a large number of securities into securities market, both the primary and secondary market. As a result of which, there is a risk that the price of the securities offered in public offerings may be highly volatile after the commencement of the offerings. Price volatility is likely to be even greater in the case of shares offered in an Initial Public Offering ("IPO") since there is no secondary market has been established for those particular shares prior to the IPO.

 

A company basically conducts an IPO in the hope that it will obtain financial resources in a successful manner, as measured by a large amount of demand for the shares. On the other hand Investors purchase the shares of companies in the hope that the shares would trade in the secondary market (aftermarket) at a higher price than the original offering price. However, the increase of the shares price in the aftermarket may not turn out as expected; even an IPO of well-known companies may lose steam on the first day of trading. Some people may truly believe that companies which have good potential and performance eventually make a comeback in the long run. However, Investors generally become anxious if the shares price in the aftermarket falls significantly below the offering price in the immediate period following the first day of trading. This condition may result in the loss of investors' confidence which in turn would adversely impact the reputation of the issuers as well as the underwriters. In anticipation of this condition, some sort of price support mechanism for an IPO are generally taken by the issuers by way of providing the underwriters an over-allotment option that enables them to stabilize the aftermarket price for the issuer's shares in the immediate period after the IPO commences. The price support mechanism of which is the ‚ÄėGreen Shoe Option' which is also known in legal parlance as an ‚ÄėOver-Allotment Option', which may potentially assist the underwriting of an IPO in going better. 

 

This article will mainly discuss (i) how the Indonesian regulations regulate the Green Shoe Option concept in Indonesian IPOs; and (ii) whether the implementation of Green Shoe Option in providing some sort of price support can be construed to be a market manipulation under Indonesian capital market laws. 

 

B.             Definition and Background

 

‚ÄėGreen Shoe' is a well-known term in the world of capital markets which derived from a company named Green Shoe Manufacturing Company founded in 1919 in the United States of America (now called as Stride Rite Corp) which exercised this mechanism for the first time. 

 

Generally the Green Shoe Option which is also known as an Over-Allotment Option, is a type of option granted to the underwriters to purchase additional shares of an offering on the same terms as the original shares offered to the public. The Green Shoe Option allows the underwriters the right to sell to investors more shares than originally planned by the issuer [1]. This would normally be done if the demand for a security issue proves higher than expected [2]. 

 

The Green Shoe Option can vary in size and it typically allows underwriters to sell up to 15% more shares than the original number set by the issuer, provided that, the public demand for the shares exceeds the original expectations and where the shares trade above the offering price. When there is a large amount of demand for shares in an IPO, the exercise of the Green Shoe Option would also enable the underwriters to maintain a balance between the demand and supply of the shares available to satisfy the market demand of an IPO. As the underwriters has the ability to increase supply if demand is higher than expected, the Green Shoe Option can create price stability during an IPO [3]. 

 

As a tool which can be used by a company (issuer) in creating price support when the shares price falls below the offering price, the Green Shoe Option is closely related to a price stabilization mechanism whereby a company over-allots shares to investors with a view to have the underwriters buy the shares back from the open market after listing in order to prevent any fall in the shares price below the offering price. 

 

The price stabilization in an IPO is typically carried out by a stabilizing agent who typically acts on behalf of all the underwriters. The standard approach to stabilization is for the stabilizing agent to start the stabilization period with negative inventory and that reduce the short position when the stabilizing agent makes stabilization purchases. The short position is created by over-allotting shares where the stabilizing agent allots to investors more shares it received from the company than the original shares. If the shares price declines below the offering price and the stabilizing agent makes stabilization purchases, the profits accrue to the underwriters as the short position is reduced. On the other hand, if the shares price rises above the offering price, the underwriters are exposed to losses on the short position. With the Green Shoe Option, it provides the underwriters the buying power to cover their short position in order to stem a falling shares price, without the risk of having to buy shares at higher prices to cover their short position if the shares price increases. This mechanism allows the stabilizing agent to purchase a given number of additional shares from the company (issuer) during the stabilization period at the original offering price. As a result, this mechanism helps the underwriters to maintain the shares price at a certain level and in return provides positive benefits to the company, underwriters and investors including avoiding any panic shares selling by the investors following the first day of trading. 

 

C.             Indonesian Legal Frameworks

 

1.            Green Shoe Option and Price Stabilization

 

(a)           The prevailing regulation

 

The "Green Shoe" was first implemented during the mid-1990's and generally its implementation must observe Bapepam4 Regulation No.Kep-88/PM/1996 dated 24 January 1996 concerning Price Stabilization for Initial Public Offering ("Indonesian Price Stabilization Regulation"). Since then, the Green Shoe Options are common features of high profile IPOs. 

 

The Indonesian Price Stabilization Regulation allows the underwriters of an IPO to offer or purchase securities in order to be able to maintain the aftermarket price of the securities (price stabilization) under certain conditions as follow: 

 

¬∑         The stabilization price may not be set differently from the offering price

 

¬∑         The stabilization, if implemented, must continue at all time during the offering period and may not be extended

 

¬∑         The stabilization plan must be disclosed in the prospectus

 

¬∑         The underwriters must ensure that all investors has received or given the chance to read a written disclosure that purchases of shares for the purpose of price stabilization will be, is being, or has been conducted

 

¬∑         The underwriters must notify the OJK, the selling agents and investors on the timing of the price stabilization including the end of the stabilization and offering period. 

 

The Indonesian Price Stabilization Regulation does not specifically regulate some important features of a Green Shoe Option such as the maximum size of the Green Shoe Option, the maximum period of time during which the price stabilization can be conducted as well as to what level of disclosures required to be made to public. 

 

Based on the lack of comprehensive provisions, a question may rise on does this limit the implementation of the Green Shoe Option and price stabilization in Indonesian IPOs? Although the Indonesian Price Stabilization Regulation does not specifically regulate some important features of Green Shoe Option as mentioned above, however, the concept of Green Shoe Option and price stabilization have been implemented in a number of Indonesian IPOs. Such IPOs were conducted based on the common practice, the limited Indonesian rules on this subject and the Indonesian concept of freedom of contract. As stipulated under Article 1330 jo. 1320 of the Indonesian Civil Code, every person has the right to enter into any agreements with any person, provided that such person has the capability to enter into such agreements and which does not constitutes an unlawful act under Indonesian laws.  Moreover, Article 1338 of the Indonesian Civil Code provides a concept of ‚Äėfreedom of contract' stating that all agreements that are validly entered into by any person shall be valid as the law for those entering into such agreements. In this respect, the concept of Green Shoe Option and price stabilization can be implemented in Indonesian IPOs without being construed as violating the Indonesian laws although the prevailing regulation does not specifically regulate some features as mentioned above. 

 

(b)          Draft new regulation

 

Until the date of this article is being prepared, the Indonesian Financial Services Authority (Otoritas Jasa Keuangan / "OJK") is still in the process of drafting a new Indonesian Price Stabilization Regulation to provide the more comprehensive legal basis for the implementation of Green Shoe Option and price stabilization in Indonesian IPOs. Below are the salient features of the draft new Indonesian Price Stabilization Regulation that is currently still in the process of being drafted by the OJK [4]: 

 

Salient features with respect to over-allotment option:

 

¬∑         The over-allotment option may only be granted for the purpose of price stabilization

 

¬∑         The shares alloted in the over-allotment option can be originated from the issuer and/or the shareholders' shares

 

¬∑         The over-allotment option may only be exercised where there is oversubscription on the shares being offered

 

¬∑         The maximum number of the over-alloted shares that can be granted is 15% of the offering size

 

¬∑         The over-allotment option may only be exercised 1 day after the end of the price stabilization period 

 

Salient features with respect  to price stabilization:

 

¬∑         The price stabilization may only be conducted after the offered shares are listed on the stock exchange

 

¬∑         The price stabilization may only be conducted if the shares price falls below or equal to the offering price

 

¬∑         The maximum period for the price stabilization is 30 days after the listing date

 

¬∑         For the purpose of price stabilization, the stabilization agent may only conduct the purchase of shares and is prohibited to re-sell the shares which were previously purchased from the open market. 

 

Disclosures required to be made in respect of the Green Shoe Option and price stabilization in the prospectus should cover among others

 

¬∑         The purpose and reason of the proposed Green Shoe Option and price stabilization

 

¬∑         The number of the Green Shoe Option

 

¬∑         The exercise price of the Green Shoe Option

 

¬∑         The underlying shares used for the purpose of the Green Shoe Option and price stabilization

 

¬∑         The period of price stabilization

 

¬∑         The exercise schedule of the Green Shoe Option

 

¬∑         Name and address of the stabilization agent

 

¬∑         Summary of agreements related to the price stabilization and Green Shoe Option 

 

Although it is still in the process of being drafted and no guarantee that the salient features above will be enacted in the exact manner, the new Indonesian Price Stabilization Regulation, when enacted, may provide the more comprehensive legal basis to the involving parties in respect of the implementation of Green Shoe Option in Indonesian IPOs. In addition, it is also expected to provide more protection to the investors in terms of level of disclosures provided to them in the prospectus. 

 

2.            Market Manipulation

 

Before examining whether or not the use of Green Shoe Option and price stabilization constitute a market manipulation in Indonesia, one must know how a "market manipulation" is defined under Indonesian laws. Law No. 8 of 1995 on Capital Market ("Indonesian Capital Market Law"), Article 91 in particular, stipulates that every Person [5] is prohibited from, directly or indirectly, taking any actions for the purpose of creating a false or misleading appearance of a trading activity, market conditions or the price of securities on the stock exchange. The elucidation of such Article 91 further explains that certain actions that are prohibited under this provision include (i) conducting securities transaction which does not involve any change of ownership, or (ii) offer to sell or buy securities at certain price, which is made by a Person in conspiracy with others offering to sell or buy the same securities at around the same price.

 

Article 92 of the Indonesian Capital Market Law also stipulates that every Person, either by themselves or together with other Person, is prohibited from, directly or indirectly, entering into two or more transactions resulting in the price of securities on the stock exchange to rise, fall, or remain steady with the purpose of influencing others to buy, sell or keep their securities. Based on the elucidation of such Article 92, this provision prohibits the conduct of series of transactions that create a deceptive pattern of prices on the stock exchange as a result of trades that are not legitimate for the purpose of self-benefit or others. Based on the above, it can be inferred that any actions that fall under Article 91 and 92 as mentioned above will constitute a market manipulation which is an unlawful act under Indonesian Capital Market Law. 

 

But what about the use of Green Shoe Option and price stabilization as the mechanism of a price support in Indonesian IPOs? Article 94 of the Indonesian Capital Market Law and its elucidation basically provides an exemption for the price stabilization in Indonesian IPOs for so long it is disclosed in the prospectus where the conduct of price stabilization in Indonesian IPOs is excluded from a market manipulation prohibition provided under Article 91 and 92 of the Indonesian Capital Market Law. In this respect, the use of Green Shoe Option and price stabilization constitutes the only actions permitted by the Indonesian capital market authority for an underwriter to legally implement a price support of newly issued shares in an IPO starting from the first day of trading. 

 

D.        Green Shoe Option and Price Stabilization common practice in Indonesia 

 

The implementation of Green Shoe Option in Indonesian common practice may slightly differ from those commonly conducted in other countries. Before implementing the price stabilization, the issuer must appoint a stabilizing agent who will conduct the stabilization on behalf of the underwriters, which shall be an Indonesian securities company registered at the OJK. Further, the implementation of Green Shoe Option and price stabilization in Indonesian IPOs will typically require two key agreements to be entered into by the involving parties to effect the Green Shoe Option and price stabilization. 

 

First, the parties involved will enter into an agreement pursuant to which the shareholder of the issuer will grant to the stabilizing agent an over-allotment option to purchase from the shareholder up to certain number of shares at the offering price for the purpose of covering over-allotments which may be made in connection with the IPO. In addition, the parties involved will also enter into another agreement, pursuant to which the stabilizing agent may borrow shares of up to certain amount of shares from the shareholder of the issuer for the purpose of facilitating settlement of the over-allotment of shares in connection with the IPO. 

 

There are two basic scenarios foreseeable during the stabilization period, that are: (i) if the market price falls below the offering price, the stabilizing agent will buy the shares from the open market to cover the short position and that the Green Shoe Option need not be exercised; or (ii) if the market price rises up, the stabilizing agent may opt to exercise the Green Shoe Option granted to it, under which it has the option to buy the shares it borrowed from the shareholder at the offering price to cover the short position. By exercising the Green Shoe Option, the stabilizing agent will have no risk to buy the shares at higher price than the offering price. 

 

The shares underlying the Over-Allotment Option are typically originated from the shareholders' existing shares in the issuers and not the new shares issued by the issuers. Furthermore, although the draft of the new Indonesian Price Stabilization Regulation indicates that the underlying shares could be originated from the issuer's shares, legally, it is not that simple to use the issuer's shares as the underlying shares in the Green Shoe concept. Several legal issues must be considered carefully by OJK, such as to what extent an Indonesian issuer can issue shares in an IPO to the stabilization agent, or how the issuer can attend the issue under Article 33 of the Indonesian Company Law which provides a concept of a ‚Äėpayment versus issuance'. In Article 33, it is stipulated that every issuance of additional shares must be fully paid-up, while on the other hand, in the common practice, the Stabilization Agent only "borrow" the shares (never really pay the shares), and the Stabilization Agent will then need to "return" the shares either in the form of cash or shares upon the expiration of the stabilization period. Despite the foregoing, one may argue that theoretically there is a possibility of the treasury stock to be used as the underlying shares, but this gives risk to certain issues to the issuers such as a potential loss if the aftermarket price increases significantly above the offering price. 

 

E.        Downside of the Green Shoe Option

 

Despite its positive benefits, there are also downsides of the Green Shoe Option in trying to keep the aftermarket price steady or even higher than the offering price. Generally, there is no guarantee that the Green Shoe Option would be successful in keeping the aftermarket price stays above or at the offering price and that it may not always works in preventing the falling of share prices since its first day of trading. While the stabilizing agent will act as a ready purchaser for the offered shares pursuant to its underwriting commitment, the purchase of the shares by the stabilizing agent alone may not be sufficient to increase the share prices significantly high in order to at least matching the offering price, especially for a company that does not show good performance in the eyes of investors. In addition, based on the common international practice and the draft of new Indonesian Price Stabilization Regulation, when enacted, the period of price stabilization is typically limited at 30 days only and that may not be a sufficient time to keep the aftermarket price steady as expected in the long run.  

 

As for the shareholder of the issuers that lent its existing shares in the issuer to the stabilizing agent, a potential loss may also be suffered by it in particular when the aftermarket price increases significantly above the offering price during the stabilization period. In this condition, the stabilizing agent, in trying to return the shares to the shareholders it borrowed from, will typically opt to exercise the Green Shoe Option where it will only purchase the shareholder's shares at the offering price and not at the market price which is already increased higher than the offering price. As a result, the shareholder will only receive the payment consideration for its shares at the offering price since the stabilizing agent will not be able to return the shares by buying back the shares it already sold to market at the market price since the market price will have been higher than the offering price at that time. 

 

Although there are risks of the Green Shoe Option as described above, it has still been widely implemented by Indonesian issuers in their IPOs given the positive benefit it has in providing price support to investors in anticipation of some detrimental conditions that may impact the reputation images of the issuer as well as the underwriters in the aftermarket. 

 

F.          Conclusion

 

Despite risks of the Green Shoe Option, it would be fair to say that the Green Shoe Option still provide wide benefits in terms of its ability to reduce the risk for the issuers in IPOs which enables the underwriting of an IPO in going better. The exercise of the Green Shoe Option enables the underwriters to maintain a balance between the demand and supply of the shares available to satisfy the market demand of an IPO. As the underwriters has the ability to increase supply if demand is higher than expected, the Green Shoe Option can create price stability during an IPO.

 

Although the concept of Green Shoe Option has long been recognized in practice, the regulatory framework with respect to the mechanism of the Green Shoe Option and price stabilization have not been comprehensively regulated in Indonesia. It is hoped therefore that the Indonesian capital market authority will issue the new Indonesian Price Stabilization Regulation as currently being drafted so that the use of Green Shoe Option including the price stabilization can be implemented in a more certain manner in terms of its legal basis in Indonesian IPOs. 

 

Lastly, the implementation of Green Shoe Option and price stabilization does not constitute a market manipulation and it is the only actions permitted under Indonesian laws for an underwriter to legally implement a price support of newly issued shares in an IPO starting from the first day of trading. 

 

Author                  : Danar Respati

Co-Author           : David Siahaan

 


[1]Greenshoe Option Law & Legal Definition, http://definitions.uslegal.com/g/greenshoe-option/.

 

[2] Ibid.

[3] Ibid.

[4] Draft Awal Keputusan Ketua Badan Pengawas Pasal Modal dan Lembaga Keuangan Tentang Stabilisasi Harga Saham, http://www.bapepam.go.id/pasar_modal/regulasi_pm/draft_peraturan_pm/draft/Draft_Peraturan_Greenshoe.pdf

[5] A "Person" is defined, under the Indonesian Capital Market Law, as individual, company, joint venture, association, or organized group.