During an initial public offering (IPO) transaction the companies shares are sold for the first time to the investor community. Although severe efforts are made by the participating investment service providers (investment banks), it is highly complicated to estimate the real value of a company going public. And not only the proper estimation of the companies own value presents a demanding challenge. Market trends, industry changes, investor fads and many other factors may also have a strong impact on the market value of companies. The role of legal regulation has to be emphasised which imposes a significant liability on the issuing companies' management and potentially on the experts organising the transaction. This liability occurs when the transaction's basic document, which contains all necessary data to assess the investment opportunity, - called the prospectus, - is misleading or omitting substantial information. As no liability would arise if there was no damage, such as a drop in the share price, overpricing IPO shares may not be a good idea in this regard. The psychological aspects of introducing new shares to the market should not be downplayed either. If the price of a recently introduced paper drops significantly, investors may become more reserved and cautious towards to it. These are the reasons why pricing IPOs is not just simply science and knowledge, but an art in itself.[1] It is also not surprising, that after the offering took place, price fluctuations may occur. This could be traced back to several reasons which makes it important to note the above-mentioned difficulties of proper price determination. Another significant factor is the fluctuations of initial investor interest which makes it important to establish a temporary mechanism in (major) initial public offering transactions to keep the price of newly issued shares between reasonable barriers during the first days of trading. The establishment of this temporary stabilising mechanism is the role of the leading investment bank, and since 1963 it is called the "greenshoe option". Because this stabilising mechanism obviously means some kind of "intervention" into the functioning of the market and into the price of a security, it is - not surprisingly - subject of strict legal regulation. The aim of the article is to dicuss the theoretical background of secondary market stabilisation and to showcase the regulatory framework both in the European Union and in Hungary.
In an initial public offering transaction, the marketing and listing of shares is followed by stabilisation.[2] The agreement concluded with the underwriter often stipulates the underwriter carries out transactions that stabilise or maintain the price of the shares on the open market, above the price that would otherwise prevail.[3] By such activities, the price of the newly issued securities can be kept within limits and thus it will not drop below a certain level. It is essential from the perspective of issuers and underwriters to keep the price above the offer price.
The Securities and Exchange Commission (SEC) defines stabilisation as "the buying of a security for the limited purpose of preventing or retarding a decline in its open market price in order to facilitate its distribution to the public".[4] Stabilisation therefore aims at maintaining the share price during the first days of trading and is generally only permitted within a short period (usually 30 days) after the allocation of the shares. Trading activities following the initial public offering are quite intense which makes price fluctuations more probable. Stabilisation helps to prevent, slow down or retard the decline of newly issued share prices. Basically, only one member of the underwriting syndicate is entitled to perform stabilisation activities on behalf of the other members too. The members of the underwriting syndicate get the profits and bear the loss originating in stabilisation, in accordance with the terms of each member's underwriting commitment.[5]
In the United States, SEC has also recognized that stabilization is a form of manipulation. However, it has historically allowed underwriters to buy IPO shares at the offering price during the distribution, even if that price is above the market price. The purpose of this permission is preventing or slowing down a decline in price. The underwriters can also stabilise prices by intentionally selling shares over the original IPO allotment and then buy those over-allotted shares
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back from the market if it is considered necessary. In this case of course the market price will be the buy-back price.[6]
Usually it is the lead manager that is entitled to perform stabilisation on behalf of the underwriting syndicate. A suitable stabilising method for example is to reserve a purchase offer at offer price during the distribution of the shares. This could prevent the price from decreasing below the offer price, even if demand is weak; also motivating further purchases by making the security look more attractive then the real market reception. This is of course a certain manipulation of the price[7], but it can prevent a strong selling pressure and a drop in the share price.[8]
In order to ensure a stable market, the lead manager often over-allocates the shares (i.e. it sells more shares than are being offered) to the investors and thereby assuming short position[9] on the market[10] (by selling shares that it does not own). The lead manager does that by entering into a stock lending agreement with the current shareholders of the company or by acquiring options with regard to the shares. In order to ensure the maximum flexibility in price stabilisation on the secondary market, the issuer often grants an option to acquire shares to the syndicate which is called over-allotment or greenshoe option. Its name originates in the name of Green Shoe Manufacturing Company of Lexington, whose offering in February 1963 had a pioneer role in this regard. The solution that was used in this transaction for the first time enabled the underwriting syndicate to purchase additional shares (generally up to 15% of the offering)[11] from the issuer or from a current shareholder at the price and under the terms and conditions applied during the offering, within a certain period (usually 30 days) following the transaction. If the share price increased within the respective period (stabilisation period), the lead manager would exercise the greenshoe option, purchasing the shares at the offer price and covering its short position. If the share price dropped, the greenshoe option would not be exercised and the lead manager would purchase the shares back from the market[12] in order to " fill" its short position. Thereby the lead manager generates demand, which may slow or reverse any share price fall. If the greenshoe option is exercised, the number of sold shares and the value of the funds raised by the issuer shall grow - consequently the commission of the participating investment banks will also grow.[13]
The lead manager faces an important time-related problem when closing its short position: when the deal is priced and the shares are allocated to the investors, the lead manager is yet not aware of how the secondary market would turn out. It cannot know if it will close its short position by purchasing back shares from the market, or by exercising the greenshoe option. Nonetheless it has to pass the shares to the investors by the closing of the transaction. Besides the agreement on option, the above-mentioned stock lending agreement plays an important role as well as a solution for this problem.
In order to pass the shares to the investors, the lead manager often borrows shares from an existing shareholder of the issuer. It can return these shares either from the ones purchased on the secondary market during the stabilisation[14] or by exercising the greenshoe option. In some cases - especially in cases of secondary public offerings - the syndicate takes an uncovered (naked) short position, when the lead manager sells more shares than the company is issuing, but without the application of a greenshoe option.[15]
The Hungarian legislation prescribes with regard to stock lending agreements (securities lending agreements) if the borrower is unable to return the securities upon the expiration of the lending agreement, the minimum amount of damages payable to the lender shall be based upon the price in effect on the date of lending or on the date of expiration, whichever is higher.[16]
Greenshoe option increases the investors' trust and contributes to maximising the incomes of the offering.[17]
Taking into account that initial public offerings are considered to be overpriced in the long term (and consequently shares are sold for a higher price than their market value), stabilisation is not an altogether harmless transaction[18]; therefore, it is regulated by strict rules.
In the European Union, Directive 2003/6/EC on insider dealing and market manipulation aims to prevent insider dealings and market abuse, manifesting itself as manipulation. It stipulates that all Member States shall prohibit any person from engaging in market manipulation.[19]
Commission Regulation 2273/2003/EC however sets forth exceptions.[20] Pursuant to Article 8 of Directive 2003/6/EC the prohibitions provided for therein shall not apply to trading own shares in 'buy-back' programmes or to the stabilisation of a financial instrument provided such trading is
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carried out in accordance with implementing measures. Those measures, designed to amend non-essential elements of this Directive by supplementing it, shall be adopted in accordance with the regulatory procedure with scrutiny referred to in Article 17(2a).[21] So - in this regard - the 'buy-back' programmes of own shares and the stabilisation of financial instruments falls under a pretty similar regulation.
Exceptions set forth by the provisions of 2273/2003/EC apply only for conducts directly related to the purpose of the buy-back and stabilisation activities. All other conducts not relating directly to the purpose of the buy-back and stabilisation activities shall therefore be considered as any other action within the scope of Directive 2003/6/EC, which may be subject to administrative measures or sanctions, if in the view of the competent authority they qualify as market abuse.
Pursuant to Regulation 2273/2003/EC stabilisation means any purchase or offer to purchase relevant securities[22], or any transaction in associated instruments[23] equivalent thereto, by investment firms or credit institutions, which is undertaken in the context of a significant distribution[24] of such relevant securities exclusively for supporting the market price of these relevant securities for a predetermined period of time, due to a selling pressure in such securities.[25]
Stabilisation may only be carried out for a limited time period in the European Union.[26] In respect of shares and other securities equivalent to shares, this time period shall, in the case of an initial offer publicly announced, start on the date of commencement of trading of the relevant securities on the regulated market and end no later than 30 calendar days thereafter.[27]
Where the publicly announced initial offer takes place in a Member State that permits trading prior to the commencement of trading on a regulated market, the above time period shall start on the date of adequate public disclosure of the final price of the relevant securities and end no later than 30 calendar days thereafter, provided that any such trading is carried out in compliance with the rules, if any, of the regulated market on which the relevant securities are to be admitted to trading, including any rules concerning public disclosure and trade reporting.[28]
With regard to stabilisation, the issuers, offerors or entities undertaking the stabilisation acting on their behalf or independently from them shall adequately publicly disclose the information prior to the commencement of the offer period of the relevant securities as stipulated by Article 9 paragraph (1) of the Regulation.[29] Basically the related information can be found in the prospectus (share securities note).[30]
All stabilisation orders and transactions thereof shall be recorded.[31] Within a week after the end of the stabilisation period, the following information shall be adequately disclosed: whether or not stabilisation was undertaken; the date at which stabilisation started; the date at which stabilisation occurred for the last time; the price range within which stabilisation was carried out, for each of the dates during which stabilisation transactions were carried out.[32]
The details of all stabilisation transactions must be notified by issuers, offerors, or entities undertaking the stabilisation acting, or not, on behalf of such persons, to the competent authority of the relevant market no later than the end of the seventh daily market session following the date of execution of such transaction.[33]
In the case of an offer of shares or other securities equivalent to shares, stabilisation of the relevant securities shall not in any circumstances be executed above the offering price.[34]
In order to exempt the ancillary stabilisation from under the scope of the directive 2003/6/EC on insider dealing and market manipulation, other requirements must be fulfilled as well. For instance the relevant securities may be overallotted only during the subscription period and at the offer price.[35] A position resulting from the exercise of an overallotment facility by an investment firm or credit institution which is not covered by the option to buy the shares at their original price (greenshoe option) may not exceed 5 % of the original offer.[36] The greenshoe option may be exercised by the beneficiaries of such an option only where relevant securities have been overallotted.[37] The greenshoe option may not amount to more than 15 % of the original offer (therefore the maximum amount of the greenshoe option with regard to securities issued in an initial public offering is 15% in the European Union).[38] The exercise period of the greenshoe option must be the same as the stabilisation period required under Article 8 of Regulation 2273/2003/EC (so in respect of shares 30 days, as presented above).[39] The exercise of the greenshoe option must be disclosed to the public promptly, together with all appropriate details, including in particular the date of exercise and the number and nature of relevant securities involved.[40]
In Hungary, pursuant to Article 202 of Act on Capital Markets, market manipulation means entering into transactions or giving an assignment to enter into a transaction that provides or may provide false or misleading indications regarding the supply, demand or price of a given financial instrument.[41] It is also market manipulation to enter into a transaction or to give an assignment to enter into a transaction that sets the price of a financial
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instrument on an artificial or irregular level.[42] Additionally entering into a transaction or giving an assignment to enter into a transaction that is false or in which any kind of deceit or manipulation takes place, qualifies as market manipulation.[43] Disclosing, spreading, publishing or announcing unfounded, misleading or false information counts as market manipulation as well, if the person providing the information is aware of the false or misleading nature of the information, or should have been aware if he had acted with due care.[44]
Nevertheless, Hungarian regulation sets exceptions from under the prohibition of market manipulation: it is not deemed to be insider trading or market manipulation if the transaction is part of a buy-back programme or if it aims at the stabilisation of a financial instrument, provided that it is carried out in the above-mentioned manner set forth in Regulation 2273/2003/EC.[45]
In order to ensure the adequate transparency of stabilisation activities - where an issuer or a selling shareholder has granted an over-allotment option or it is otherwise proposed that price stabilising activities may be entered into in connection with an offer- Regulation 809/2004/EC prescribes that the prospectus (share securities note) must indicate that stabilisation may be undertaken, that there is no assurance that it will be undertaken and that it may be stopped at any time. The prospectus (share securities note) shall also indicate the beginning and the end of the period during which stabilisation may occur and the identity of the stabilisation manager for each relevant jurisdiction (unless this is not known at the time of publication). The investors must be informed that stabilisation transactions may result in a market price that is higher than would otherwise prevail.[46]
There are many reasons why underwriters stabilise the price of newly issued shares on the secondary market. On one hand, the higher the price of the shares are, the greater is the probability of further offerings by the issuer in the future. So if the underwriter properly stabilised the latest public offering and could reach a high price, the chances for another issuing are increased, as well as the chances of the underwriter to participate in the deal and to obtain the related commission. Furthermore, stabilisation facilitates the preservation of the participating investment service providers' reputation among the clients. The investors purchasing the shares can see that their investment performs well, at least in the short term. On the other hand, underwriters bear or may bear liability for the contents of the prospectus. As long as the share price stays above the offering price, the question of liability may not even emerge as the investors have suffered no loss. Therefore, stabilisation can be a tool to avoid liability for the prospectus.[47]
The expectable success of stabilisation on the secondary market is an important aspect of the selection of underwriters. For instance, a prestigious underwriter is usually more suited to provide an orderly market for the company's shares after the issuance.[48] It is quite usual that transactions carried out with the participation of less prestigious underwriters get lesser support on the secondary market, so the shares might become less liquid. This could make future equity issues less attractive to investors and increase the costs of capital.[49]
Two contradictons in the secondary market performance of shares sold in an initial public offering should be discussed which also indicate the frequent inaccuracy of the price set in the initial public offering. One of the features of newly issued shares is that they are - usually - underpriced in the short term. On an average, the price of shares sold in an initial public offering increases by more than 10% compared to the issue price by the end of the first day of trading. It is the general opinion among both academics and business professionals that the price evolving on the secondary market shows the real value of the share. This leads to the conclusion that in initial public offerings, securities are underpriced.[50] In the United States initial public offerings were underpriced by 22% on average between 1980 and 2001, although this figure was greatly influenced by the dot-com bubble[51] as well. Jay R. Ritter,[52] demonstrated that between 1999 and 2000 the degree of underpricing[53] culminated, as it reached 70-80%[54]. Also an interesting observation, that in this period the share price doubled in the first day in 182 IPOs out of a total of 803 offerings.[55]
This phenomenon has been well documented for about 50 years not only in the United States[56] but in other capital markets of the world as well.[57] Accordingly the price of an initial public offering would be about 15-20%[58] higher at the end of the first day of trading than the one set during the pricing of the transaction. This figure however varies from time to time on each market and with regard to each industry.[59]
In their joint research Roger G. Ibbotson and Jay R. Ritter reported the results of studies documenting the phenomenon of underpricing in nineteen countries. Underpricing was quite low in the case
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of France, with only a 4.2% difference in between the initial price and the closing price at the end of the first day.[60] The difference was 9.7% in the United Kingdom, 21.5% in Germany, 31.9% in Japan, 40,5 % in Sweden, 79% in South Korea, and 149.3% in Malaysia. Pursuant to the above study, the weighted average degree of underpricing outside of the United States is 14.1%, whereas in the United States it is 16.4%.[61]
The facts above mean that the issuer or the selling shareholders of the company are leaving significant amount of money on the table during an initial public offering. This amount can be calculated by subtracting the issue price from the closing price of the first day of trading and multiply the result by the number of the issued shares. Leaving the effects of the greenshoe option out of consideration, we can get a more or less reliable image.[62] For instance, in the United States between 1980 and 2001, when IPO's were underpriced by 22% on average, issuers left on the table approximately more than 100 billion dollars on the first day of trading due to underpricing.[63]
Underpricing is also present in these days. An interesting example can be the case of LinkedIn Corporation, whose IPO showed a particularly robust first-day share price increase. LinkedIn, the professional social networking company was introduced to New York Stock Exchange on 19 May 2011. The transaction was priced at $45 a share, and 7.84 million shares were involved in the offering. On the first day of trading the stock opened at $83, which already represented an 84% rise compared with the IPO price. However, the price quickly rose above $90, and hit a high of $122.70. Though the price fell back to $94.25 on closure, this still meant it closed more than 109 percent above the $45 IPO price.[64] LinkedIn's shares today are traded for $127 at the NYSE (although it hit $250 height in autumn 2013 and also between 2015 February and April).[65]
Up until the recent fall of corporate giants and also the financial and economic crisis, economists unequivocally held that capital markets are efficient in a sense they reflect all publicly accessible information promptly (efficient capital market hypothesis). Taking the above statement as a starting point, and also considering that IPOs had been continuously underpriced for decades,[66] it is reasonable to conclude that it all had been intentional.[67] A reason for underpricing may be that underwriters try to compensate[68] the investors for revealing their opinions to them regarding the value of the company (and its shares).[69] Obviously only those investors can provide well-founded information that have an adequate background of analysts, sufficient experience, and previously receive the important data relating to the company. As shares are usually sold for the same price to everyone during the initial public offering, those investors also can make use of the "benefits" of underpricing that could not provide any relevant information.[70]
Viewing from another aspect, underpricing reduces the risks of the participating investment service providers (and the risk of the issuer). For instance, in case of a firm commitment[71] if the shares are not subscribed to the underwriter would incur loss. The price for an undersubscribed IPO can also collapse easily. Thus it is reasonable to assume that the price is set lower in order to sell all of the shares rapidly.[72]
Underpricing can also reduce the liability for the contents of the prospectus;[73] if the price does not fall under the offering price, it is hard to ascertain any kind of loss with the investors and initiate a well-founded lawsuit. Therefore, on the secondary market underwriters aim at maintaining the share price with by stabilisation. Obviously, the higher the offering price is, the greater effort it takes to do that. It is worth taking prospectus liability seriously, as in a document of such size one could usually find a false statement or a concealment.[74] Furthermore the share price can change often and for to various reasons. For example, market movements have a great impact on the share price, which can be even more dangerous in case of a newly listed share. For that reason underpricing provides defence against prospectus liability[75] at times of external market changes as well.[76] This theory is however contradicted by the fact that most of these risks (even 50-80% of the typical settlement[77]) are covered by insurances. Such risks are covered partially by the so-called D&O (directors and officers) liability insurances (a liability insurance protecting executives).[78] Additionally the company may take out an insurance that covers risks originating in the prospectus liability as well. Firms dealing with initial public offerings have a lot higher rating at several insurance companies due to the scale of risks related to the transaction.[79]
The aforementioned theory seems to downplay that securities law basically prescribes disclosure obligations and not substantive provisions regarding the value and pricing of investments. Legal liability may only occur if during the sale of shares the important facts, circumstances and perspectives of the company have been materially misrepresented or kept back. This is what is unlawful, not overpricing. If the issuer and the underwriter participating in the transaction reveal
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all relevant pieces of information, they should have no fear of the consequences of overpricing.[80]
The sentiments of investors has a great role in the field of initial public offerings.[81] Many companies that perform an initial public offering has gone through a major development; however, their future performance is sometimes hard to predict which may make an investor overly optimistic. The evaluation of the newly issued shares is inevitably vaguer, and the lack of share price history casts investors' optimism loose. Consequently it is generally the optimistic investors that define the aftermarket price.[82]
Another similar explanation for why investors are willing to pay a higher price for the newly issued shares on the secondary market is, because their decisions do not rest upon the rational analysis, but on emotions, rumours, whims[83] or the actual trends. Moreover small investors are more likely to buy "rousing" shares.[84] Christine Hurt[85] also remarks, although retail investors have access to massive amounts of information, some studies show that these investors may make investment decisions not based on accurate processing of information but on trends or hype. Those investors, who tend to make "irrational" investment decisions (based on such trends or hype) usually are called "sentiment investors". [86]
Underpricing may even be a rational conduct of the underwriter, aiming at maximising profits.[87] Underwriters are the main controllers of the pricing, their beneficial position stems from their contact with the investors who supposedly have a better understanding of the market. Underwriters are, however, constant players in public offerings, so maintaining their reputation is important for them.[88] Therefore, issuers might wish to reach a higher price, but the underwriters by all means aim at ensuring the sale of all shares and thereby maintaining their reputation.[89]
Another possible explanation for underpricing is that underwriters try to maximise their immediate economic and reputational gains during the course of pricing and therefore, they ignore the optimal market price. They rather choose the highest price which can hopefully avoid the price decrease on the aftermarket.[90] By setting the asking price low, the marketing costs can be reduced as well. If an offering enters the market with a price decrease, it would severely damage the reputation of the participating investment service provider (underwriter), who would later on have a hard time finding investors for their transactions, as the investors would be concerned of the possibility of an initial price decrease.[91]
With regard to the stability of the price, one should note the possibility that underwriters often try to allocate the shares to those investors, who would keep them for a certain period of time. Those who immediately sell the acquired shares in the hope of a short-term profit, might drop out of the allocation of the future share offerings managed by the same investment service provider. However, the underwriter obviously cannot require investors to comply with this informal expectation, if they are to suffer a loss thereof. So underpricing might be a compensation for the investors in order to restrict the selling of their shares.[92]
It is important to highlight that pricing problems should not be blamed entirely on the underwriters. They are urged to maximise the offering price, and to a certain extent there is a competition between them for successful transactions and high prices.[93] Furthermore, there is a great uncertainty in connection with the future growth and perspectives of the issuer at the time of pricing.[94] As the company only starts its public operation, it is hard to find a benchmark. So pricing securities is not at all an easy task.[95]
Furthermore, it is important to emphasise that underpricing is necessary for creating a market that would appreciate the securities deriving of an initial public offering. If initial offerings were not underpriced and if the investors could not count on a significantly positive average initial return[96], that offering prices would be possibly fixed on a lower level. The current system, however, is sustainable: initial public offerings of a high yield on the first trading day can persuade many investors to take part in the transaction. It can also contribute to the optimism of the investors, who would appreciate the newly issued shares.[97] It is also an argument for underpricing that if the price of the newly issued shares grows on the secondary market, the investors would draw positive conclusions about the issuer,[98] - or for instance that the underwriter is qualified and well-informed.[99]
Tim Loughran and Jay Ritter identified a lesser-known parallel problem: the long-term overpricing of initial public offerings.[100] This indicates that newly issued shares underperform[101] compared to the shares of companies that previously got listed, if both investment possibilities are monitored for a period of a few years (for example for five years).[102] From an investment point of view this can be even more significant than short-term underpricing, as it results in a continuous transfer of wealth from buyers to sellers.[103] Therefore, the investment in an initial public offering as opposed to other shares is an inappropriate choice in the long term. The above statement seems correct for two reasons. Firstly, initial public offerings are generally carried out during a market upswing in an optimal
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environment, so they basically reflect the price developed under these circumstances. Secondly, the newly issued shares underperform compared to the securities of seasoned companies already present at the market. Loughran and Ritter compared two different hypotetical investment strategies over the period 1970 to 1990 in the United States. They concluded that in the periods when initial public offerings were made, general stock market was 22.7 percent overvalued, relative to the market's normal value.[104] This is not the only conclusion, however, that one can draw from the observations of Loughran and Ritter. They also indicated that in the long term, shares issued in an initial public offering underperform compared to the securities of seasoned companies.[105] During this research, companies that had operated as public corporations for at least five years and had not issued new shares since then were considered as seasoned companies. All data originated from the United States from the period between 1970 and 1990. Loughran and Ritter monitored the securities for a five-year long period from the closing of the first day of trading after the initial public offering. Their research shows that total 117.6 billion dollars that were invested in initial public offerings only grew to 157.4 billion dollars during the relevant periods, while the same amount of money at the same time invested in seasoned securities, have increased to 196.4 billion dollars. The above amounts should be calculated at the exchange rate of the dollar in 1991.[106] From the study of Jonathan A Shayne and Larry D. Soderquist one can conclude that having bought securities in the relevant period for the price prevailing at the closing of the first day of trading, their securities would have been overvalued by 24.8% compared to the seasoned securities available at that time. Jay Ritter came up with a similar figure in his research extended until 2002.[107] One can refine the above 24.8% overvaluation by the fact that those who purchased the shares of the initial public offering at the offering price, following the first day of trading could acquire a significant yield. The average such initial return is 10.9% according to the research. When this initial return is factored into the above results, it turns out that the scope of overvaluation was in fact only approximately 12,5%, as opposed to 24.8%.[108] However we can most certainly conclude that regarding their long-term performance, the securities of initial public offerings are overpriced.[109] These transactions are generally carried out when the market exceeds its average performance by 22.7% (relative to its historical norm). So to the already significantly high-priced market the overpricing of the shares adds another 12,5%. The second element completes the first one, and based on the sample we can observe that the issue price of securities issued in initial public offerings exceeds their long-term market value by approximately 38%. Evidently there are other studies engaged in this matter, however, none other followed the changes of the performance for a period of five years. In case of studies based on shorter periods of time, newly issued shares seem to be underpriced still. This however does not reflect the real degree of inefficiency.[110] Therefore one should act with due care when purchasing newly issued shares.[111] As Benjamin Graham, the former teacher and employer of Warren Buffett remarked: "...most new issues are sold under 'favorable market conditions' - which means favorable for the seller and consequently less favorable for the buyer."[112]
In case of initial public offerings, companies often define a lock-up period for current shareholders (insiders).[113] During this period they are not allowed to sell their shares, and they undertake to comply in the agreement concluded with the lead manager.[114]
With lock-up agreements underwriters exercise a certain degree of control on the supply of IPO shares after the initial public offering transaction was carried out. With these agreements insiders (for example, existing shareholders or the participants of so-called friends and family programs) undertake to hold their shares for a certain time after the IPO. This creates a restricted supply during a short period (usually 90 - 180 days) after the initial public offering.[115]
Investors find it attractive if the offering does not provide an immediate way out of the company for pre-IPO shareholders, therefore lock-up is a usual phenomenon.[116] Its advantage is that some shareholders (for example venture capital funds) cannot sell their securities immediately after the initial public offering, as it is an important indicator that persons having well-founded information about the company are not leaving because of the negative perspective. Lock-up also contributes to a successful stabilisation, as it temporarily narrows down the supply of shares and reduces the selling pressure on the price.[117] If the current shareholders wished to sell their shares (or a part thereof) right away, it would clearly be a difficult task for the underwriter (lead manager) to keep the secondary market price above the offering price in the first days of trading, by using tools of stabilisation.[118] For this reason exactly, only the lead manager may permit the shortening of the lock-up period or the release from the lock-up.[119] However, empirical analysis shows that if the lock-up period is reduced following the transaction, the share price drops by
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23% within 10 days of the announcement. It can be observed that in the 1990s the average length of the lock-up period was 180 days in the United States[120], and the transfer restraint covered approximately 95% of the unsold previously issued shares as well.[121] Lock-up periods of 90, 270 or 365 days were quite frequent as well.[122] Generally share prices fall significantly at the end of lock-up periods.[123]
Basically a lock-up period of 180 days is adequate. It is possible to stipulate a different lock-up period for the management of the company or for other shareholders.[124] However in case of lock-up agreements there are plenty of techniques at the disposal of the concerned shareholders by which they can shift the risks. For instance they can use the shares as cover for credit transactions or transfer the risks to others by derivative deals (over the counter forwards).[125]
The few days of trading provide a remarkable (and sometimes long-lasting) impression towards the investor community about the company which just entered into the stock market. So in case of a company intending to go public, it is inevitable to examine the driving factors and trends of newly issued share prices. The price of newly issued shares can be volatile, as the extraordinary investor interest drives the demand, which however sometimes can be remittent. This is why it is important to apply a stabilising mechanism, which helps smoothing the initial price fluctuations. Because this stabilising mechanism represents an intentional intervention into the demand - and through this into the share price -, it constitutes as manipulation of the market, albeit a permitted one with strict legal rules applicable.
Investors should also be aware of common phenomenons, which may occur in case of newly issued shares in order to ensure proper understanding of the market signs. For example, subscribing IPO shares directly from the issuing company/the participating investment service providers can be a lucrative business. The reason is, that the shares issued by companies going public are commonly offered below their market-clearing price, thus winning bidders are rewarded with a handsome return. This return can be measured by the difference between the offer price and the higher price attained in early trading.[126] However, to buy the shares on the secondary market on the first day(s) of trading requires significant foresight and care. Because on the first day(s) of trading a significant increase in the newly issued share's price is quite common; however, the long term performance is less clear. Of course, in every case an individual assessment is needed, but long-term empirical observations can provide useful background information. During the first day of an IPO, shares generally flow from institutional investors to retail investors in the aftermarket (because mainly institutional investors are only allowed to buy original IPO shares from the underwriter). Definitely some new issues will see price increases for longer times (for example weeks or even months). But the average IPO share price will decrease over the first three years.[127] It is also important to take into account the so-called lock-up period, which can affect the supply of (newly issued) shares, and so, the market price. Namely, the lock-up agreement forestalls that some major shareholders sell their holdings right after the initial public offering took place. However, at the end of this period, the supply of shares may increase suddenly. ■
NOTES
* This paper has been supported by the János Bolyai Research Scholarship of the Hungarian Academy of Sciences.
[1] See Geddes, Ross: IPOs and Equity Offerings. Butterworth-Heinemann 2008
[2] See Sher, Noam: Underwriter's Civil Liability for IPO's: An Economic Analysis, University of Pennsylvania Journal of International Economic Law, Vol. 27. Issue 2. (2006) pp. 429430.
[3] See Drahon: The IPO Decision - Why and How Companies Go Public. Edward Elgar Publishing, Northampton 2005. p. 254.
[4] Geddes: op. cit. p. 205; Shayne, Jonathan A., Soderquist, Larry D., Inefficiency in the Market of Initial Public Offerings, Vanderbilt Law Review, Vol. 48. Issue 4. (1995) p. 978.
[5] See Geddes: op. cit. p. 205; Kecskés András - Halász Vendel: Stock Corporations - A Guide to Initial Public Offerings, Corporate Governance and Hostile Takeovers, HVG-Orac & LexisNexis, translated by Anna Tolnai and the Authors, Budapest - Wien 2013. p. 155.
[6] See Hurt, Christine: Moral Hazard and the Initial Public Offering, Cardozo Law Review, Vol. 26. Issue 2. (2005) pp. 752-753.
[7] See Shayne - Soderquist: op. cit. p. 978.
[8] See Draho: op. cit. pp. 254-255; Kecskés - Halász: Stock op. cit. p. 155-156.
[9] See Article 5 paragraph (1) point 112 of Act CXX of 2001 on capital markets. Pursuant to this rule short position shall mean all positions where any decrease in the price of the underlying instrument results in future gains in terms of value.
[10] See Sher, Noam: Negligence versus Strict Liability: The Case of Underwriter Liability of IPO's, DePaul Business & Commercial Law Journal, Vol. 4. Issue 3. (2006) p. 479.
[11] See Rueda, Andres: The Hot IPO Phenomenon and the Great Internet Bust, Fordham Journal of Corporate & Financial Law Vol. 7. Issue 1. (2001) pp. 32-33.
[12] See Sher: Underwriter's... p. 445.
[13] See Geddes: op. cit. pp. 205-206; Kecskés - Halász: Stock op. cit. p. 156.
[14] See Sher, Noam: Underwriter's. p. 445;
[15] See Geddes: op. cit. pp. 206-207.; Kecskés - Halász: op. cit. p. 156-157.
[16] Act CXX of 2001 on capital markets Article 169.
[17] See Kecskés - Halász: op. cit.p. 157.
[18] See Shayne - Soderquist: op. cit. p. 979.
[19] Directive 2003/6/EC Article 5
[20] Commission Regulation (EC) No 2273/2003 (22 December 2003) implementing Directive 2003/6/EC of the European Parliament and of the Council as regards exemptions for buy-back programmes and stabilisation of financial instruments
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[21] See Kecskés - Halász: op. cit. p. 157.
[22] Under Article 2 paragraph (6) "relevant securities" mean transferable securities as defined in Directive 93/22/EEC, which are admitted to trading on a regulated market or for which a request for admission to trading on such a market has been made, and which are the subject of a significant distribution.
[23] Under Article 2 paragraph (8) "associated instruments" mean the following financial instruments (including those which are not admitted to trading on a regulated market, or for which a request for admission to trading on such a market has not been made, provided that the relevant competent authorities have agreed to standards of transparency for transactions in such financial instruments): contracts or rights to subscribe for, acquire or dispose of relevant securities; financial derivatives on relevant securities; where the relevant securities are convertible or exchangeable debt instruments, the securities into which such convertible or exchangeable debt instruments may be converted or exchanged; instruments which are issued or guaranteed by the issuer or guarantor of the relevant securities and whose market price is likely to materially influence the price of the relevant securities, or vice versa; where the relevant securities are securities equivalent to shares, the shares represented by those securities (and any other securities equivalent to those shares).
[24] Under Article 2 paragraph (9) "significant distribution" means an initial or secondary offer of relevant securities, publicly announced and distinct from ordinary trading both in terms of the amount in value of the securities offered and the selling methods employed.
[25] Fn. 25. Article 2 paragraph (7); Kecskés - Halász: op. cit. 157-158.
[26] Fn. 25. Article 8 paragraph (1)
[27] Fn. 25. Article 8 paragraph (2)
[28] Fn. 25. Article 8 paragraph (2); Kecskés András - Halász Vendel: Stock Corporations - A Guide to Initial Public Offerings, Corporate Governance and Hostile Takeovers, HVG-Orac & LexisNexis, translated by Anna Tolnai and the Authors, Budapest - Wien 2013. p. 158.
[29] Fn. 25. Article 9 paragraph (1)
[30] Kecskés - Halász: op. cit. p. 158-159.
[31] Fn. 25. Article 9 paragraph (4)
[32] Fn. 25. Article 9 paragraph (3)
[33] Fn. 25. Article 9 paragraph (2); Kecskés - Halász: op. cit. p. 158-159.
[34] Fn. 25. Article 10 paragraph (1)
[35] Fn. 25. Article 11 point a
[36] Fn. 25. Article 11 point b
[37] Fn. 25. Article 11 point c
[38] Fn. 25. Article 11 point d
[39] Fn. 25. Article 11 point e
[40] Fn. 25. Article 11 point f; Kecskés - Halász: op. cit. p. 159.
[41] Act CXX of 2001 on capital markets Article 202 point a
[42] Fn. 41. point b
[43] Fn. 41. point c
[44] Fn. 41. point d; Kecskés - Halász: op. cit. p. 159-160.
[45] Act CXX of 2001 on capital markets Article 203 paragraph (3)
[46] Regulation 809/2004/EC Annex III point 6.5; Fn. 25. Article 9 paragraph (1); Kecskés - Halász: op. cit. p. 160.
[47] Shayne - Soderquist: op. cit. p. 980; Draho: op. cit. pp. 254255.
[48] See Ferris, Stephen P., Hiller, Janine S., Wolfe, Glenn A., Cooperman, Elizabeth S.: An Analysis and Recommendation for Prestigious Underwriter Participation in IPO's, The Journal of Corporation Law, Vol. 17. Issue 3. (1992) p. 588.
[49] See Ferris - Hiller - Wolfe - Cooperman: op. cit. p. 588; 602; Kecskés - Halász: op. cit. p. 160-161.
[50] See Spindler, James C.: IPO Liability and Entrepreneurial Response, University of Pennsylvania Law Review, Vol. 155. Issue 5. (2007) pp. 1210-1212.
[51] See Anand, Anita Indira: Is the Dutch Auction IPO a Good Idea?, Stanford Journal of Law, Business and Finance, Vol. 11. Issue 2. (2006) p. 251.
[52] Professor of the University of Florida
[53] See Rueda: op. cit. p. 23, 46; Barondes, Royce de R.: NASD Regulation of IPO Conflicts of Interest - Does Gatekeeping Work?, Tulane Law Review, Vol. 79. Issue 4. (2005) pp. 867868.; 898.
[54] See Hurt, Christine: What Google Can't Tell Us About Internet Auctions (And What It Can), University of Toledo Law Review, Vol. 37. Issue 2. (2006) p. 404; Geddes: op. cit. p. 27; Griffith, Sean J.: Spinning and Underpricing - A Legal and Economic Analysis of the Preferential Allocation of Shares in Initial Public Offerings, Brooklyn Law Review, Vol. 69. Issue 2. (2004) p. 617.; Kecskés - Halász: op. cit. p. 161.
[55] See Hurt: Moral Hazard... p. 715.
[56] See Sher: op. cit. p. 409.
[57] See Alexander, Janet Cooper: The Lawsuit Avoidance Theory of Why Initial Public Offerings are Underpriced, University of California Los Angeles Law Review, Vol. 41. Issue 1. (1993) p. 18
[58] See Barondes: NASD Regulation. p. 867
[59] See Geddes: op. cit. p. 27
[60] See Turki, Adel L., Barry, Christopher B.: Initial Public Offerings by Development Stage Companies, The Journal of Small & Emerging Business Law, Vol. 2. Issue 1. (1998) pp. 103-104.
[61] See Alexander: op. cit. p. 62.
[62] See Geddes: op. cit. p. 27.
[63] See Anand: op. cit. p. 251; Kecskés - Halász: op. cit. pp. 161-162.
[64] See Reuters by Clare Baldwin and Alina Selyukh Thu May 19, 2011 7:52pm EDT at http://www.reuters.com/article/us-linkedin-ipo-risks-idUSTRE74H0TL20110519; CNN By Julianne Pepitone May 19, 2011: 4:10 PM ET at http://money.cnn.com/2011/05/19/technology/linkedin_IPO/; and Wall Street Journal By Stu Woo And Lynn Cowan Updated May 19, 2011 12:01 a.m. ET at http://www.wsj.com/articles/SB10001424052748703421204576331610501421954
[65] See http://finance.yahoo.com/echarts?s=LNKD+Interactive#("range":"5y","allowChartStacking":true)
[66] See Alexander: op. cit.p. 18-19.
[67] See Barondes, Royce de R.: Adequacy of Disclosure of Restrictions on Flipping IPO Securities, Tulane Law Review, Vol. 74. Issue 3. (2000) p. 891.
[68] See Griffith: op. cit. pp. 615-618.; Barondes: NASD Regulation. p. 867
[69] See Barondes: Adequacy of. pp. 891-893; Draho: op. cit. p. 242, pp. 243-244.
[70] See Barondes: Adequacy of. pp. 892- 893; Kecskés - Halász: op. cit. pp. 162-163.
[71] When underwriters act as dealers and are responsible for any unsold inventory. The dealer makes profit from the spread between the purchase price and the IPO price.
[72] See Rueda: op. cit. p. 49; Booth, Richard A.: Going Public, Selling Stock, and Buying Liquidity, Entrepreneurial Business Law Journal, Vol. 2. Issue 2. (2008) pp. 650-651; Kecskés - Halász: op. cit. pp. 162-163.
[73] See Spindler: op. cit. pp. 1210-1214.
[74] See Booth: op. cit. p. 651.
[75] See Griffith: op. cit. pp. 606-608.; Booth: op. cit. p. 651.
[76] See Booth: op. cit. p. 651.
[77] Alexander: op. cit. p. 46.
[78] See Spindler: op. cit. pp. 1222-1223.
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[79] See Alexander: op. cit. pp. 46-47.; Kecskés - Halász: op. cit. pp. 163-164.
[80] Alexander: op. cit. pp. 35-36.
[81] Alexander: op. cit. pp. 22.
[82] Alexander: op. cit. p. 22
[83] See Alexander: op. cit. p. 22
[84] See Draho: op. cit. p. 248; Kecskés - Halász: op. cit. pp. 164.
[85] Christine Hurt is the Professor of Law at Brigham Young University Faculty of Law
[86] See Hurt: Moral Hazard... p. 731.
[87] See Alexander: op. cit. p. 66.
[88] See Sher: Underwriter's... pp. 411-412.; 422.
[89] See Alexander: op. cit. p. 67
[90] See Alexander: op. cit. pp. 71-72.
[91] See Alexander: op. cit. p. 67-69.; Kecskés - Halász: op. cit. pp. 164-165.
[92] See Alexander: op. cit.p. 69.
[93] See Booth: op. cit. pp. 653-654.
[94] See Turki - Barry: op. cit. p. 104
[95] Kecskés - Halász: op. cit. p. 165.
[96] See Griffith: op. cit. p. 602.
[97] See Alexander: op. cit. p. 71.
[98] See Rueda: op. cit. pp. 50-51.; Griffith: op. cit. p. 601.
[99] See Spindler: op. cit. p. 1211; Kecskés - Halász: op. cit. pp. 165-166.
[100] See Shayne - Soderquist: op. cit. pp. 965-966; Griffith: op. cit. pp. 603-604.
[101] This is supported by another research that examined the performance of initial public offerings in the United States between 1968 and 1987. The research demonstrated that average newly issued shares provided an average annual return of 2% in the first five years, compared to the value at the closing of the first day of trading. See Alexander: op. cit. p. 23.
[102] See Spindler: op. cit. p. 1214.
[103] See Shayne - Soderquist: op. cit. pp. 965-966.
[104] See Shayne - Soderquist: op. cit. pp. 967-968.; Kecskés -Halász: op. cit. pp. 166-167.
[105] See Turki - Barry: op. cit. pp. 105-106.
[106] See Shayne - Soderquist: op. cit. p. 970
[107] See Spindler: op. cit. pp. 1216-1217.
[108] See Shayne - Soderquist: op. cit. pp. 970-971.; Kecskés - Halász: op. cit. pp. 166-167.
[109] See Spindler: op. cit. pp. 1216-1217.
[110] See Shayne - Soderquist: op. cit. pp. 970-972.
[111] See Spindler: op. cit. p. 1214.
[112] See Shayne - Soderquist: op. cit. p. 975; Kecskés - Halász: op. cit. pp. 167-168.
[113] See Hurt: What Google... p. 418.
[114] See Rueda: op. cit. p. 53.
[115] See Hurt: Moral Hazard... pp. 754-755.
[116] See Geddes: op. cit. p. 48.
[117] See Draho: op. cit. pp. 278-279.
[118] See Geddes: op. cit. p. 208-209.
[119] See Hurt: What Google... p. 418.
[120] See Geddes: op. cit.pp. 209-210.; Hurt: What Google... p. 418-419.
[121] See Draho: op. cit. p. 277.
[122] See Geddes: op. cit.p. 209.; Kecskés - Halász: op. cit. p. 170.
[123] See Hurt: Moral Hazard... p. 755.
[124] See Geddes: op. cit.p. 58.
[125] See Kecskés - Halász: op. cit. p. 170.
[126] See Hauser, Shmuel, Yaari, Uzi, Tanchuma, Yael, Baker, Harold, Initial Public Offering Discount and Competition, Journal of Law and Economics, Vol. 49. Issue 1 (2006) p. 331.
[127] See Hurt: Moral Hazard... p. 715.
Lábjegyzetek:
[1] A szerző habilitált egyetemi docens, tanszékvezető PTE ÁJK Gazdasági és Kereskedelmi Jogi Tanszék. University of Pécs, Faculty of Law Department of Business & Commercial Law.
Visszaugrás
