Question 1

What is the over-allotment (greenshoe) option?

Accepted Answer

An over-allotment option is an arrangement with the issuer under which the underwriters may purchase additional shares in connection with the offering, at the public offering price, on top of the shares in the base deal. Regulation S-K Item 508(e) requires the prospectus to indicate that the arrangement exists and to state the amount of additional shares the underwriters may purchase under it. Market participants commonly call this the 'greenshoe' option. Under Instruction 3 to Item 508(e) (17 CFR 229.508(e)), where the underwriter has an arrangement with the issuer such as an over-allotment option, the registrant must indicate that the arrangement exists, state the amount of additional shares the underwriter may purchase, present maximum-minimum information in a separate column of the underwriter's-compensation table based on the purchase of all or none of the shares subject to the arrangement, and describe the key terms of the arrangement in the narrative. The additional shares are typically bought from the issuer, and in some offerings a portion is bought from selling security holders. 'Greenshoe' is a widely used colloquial name for the arrangement.

Question 2

How large can the over-allotment option be?

Accepted Answer

FINRA Rule 5110(g)(9) — part of the Corporate Financing Rule's list of arrangements deemed unfair and unreasonable — treats an over-allotment option that allows the underwriters to over-allot more than 15% of the amount of securities being offered as an unreasonable underwriting term. In practice, over-allotment options are therefore sized at up to 15% of the base offering. FINRA reviews the underwriting terms and arrangements of most public offerings under Rule 5110 (the Corporate Financing Rule) and identifies specific terms it deems unreasonable when proposed in a public offering. Among those terms is an over-allotment option covering more than 15% of the amount of securities being offered. FINRA rulebook text is copyrighted self-regulatory-organization material and is described here, not reproduced; the numeric limit is stated with attribution. The 15% cap is separate from, and applies alongside, the SEC's disclosure requirements for the option under Regulation S-K Item 508.

Question 3

Where is the over-allotment option disclosed in the offering documents?

Accepted Answer

In the prospectus's plan of distribution. Regulation S-K Item 508 governs the plan-of-distribution disclosure, and Item 508(e) requires the underwriter's-compensation table and its instructions — including the instruction that an over-allotment arrangement with the issuer be disclosed, with the amount of additional shares stated and maximum-minimum figures presented in a separate column of the table. Item 508 (17 CFR 229.508) is the Regulation S-K item that a registration statement's plan-of-distribution section (Form S-1 Item 8) implements. Item 508(a) requires naming the principal underwriters and the amounts underwritten and stating the nature of the underwriters' obligation (for example, whether they are committed to take and pay for all the securities if any are taken — a firm-commitment underwriting). Item 508(e) requires a table setting out the nature of the underwriters' compensation, and its Instruction 3 requires the over-allotment arrangement, the additional-share amount, the separate maximum-minimum column, and a narrative description of the arrangement's key terms.

Question 4

How does over-allotting create a syndicate short position?

Accepted Answer

To distribute an offering that includes an over-allotment option, the underwriters can sell more shares than the base deal — they 'over-allot' — which leaves the syndicate short the extra shares it has sold but not yet delivered. Regulation M defines a 'syndicate covering transaction' as placing a bid or effecting a purchase on behalf of the sole distributor or the underwriting syndicate to reduce a short position created in connection with the offering. The syndicate short position is the number of shares sold in excess of the base offering. The over-allotment option is what lets the underwriters cover that short without going to the open market: exercising the option delivers additional shares from the issuer at the offering price. Regulation M (17 CFR part 242) is the SEC's anti-manipulation framework for securities offerings; its definition section, 17 CFR 242.100, defines 'syndicate covering transaction,' 'stabilize,' 'penalty bid,' and 'distribution,' and Rule 104 (17 CFR 242.104) sets the conditions for stabilizing, syndicate covering transactions, and penalty bids in connection with an offering.

Question 5

What is the difference between a covered short and a naked short?

Accepted Answer

The terms describe a syndicate short position by reference to the over-allotment option. A short position within the size of the over-allotment option is a 'covered' short, because the underwriters can close it either by exercising the option or by buying shares in the open market. A short position larger than the over-allotment option is a 'naked' short, because the excess cannot be sourced from the option and can be closed only by open-market purchases. 'Covered' and 'naked' are market descriptors used in the plan-of-distribution disclosure of SEC-filed prospectuses; the underlying mechanics rest on primary rules. The over-allotment option is a fixed number of additional shares (capped at 15% of the offering under FINRA Rule 5110(g)(9)), so a short up to that number can be matched by exercising the option, while a short beyond it cannot. Under Regulation M's definition (17 CFR 242.100), a purchase in the open market to reduce a short position created in connection with the offering is a syndicate covering transaction — the mechanism available for both the covered and the naked portions — whereas exercising the over-allotment option is a purchase from the issuer at the offering price and is not itself a syndicate covering transaction.

Question 6

Is exercising the greenshoe a syndicate covering transaction under Regulation M?

Accepted Answer

No. In its Staff Legal Bulletin No. 9 (Frequently Asked Questions About Regulation M), the SEC's Division of Trading and Markets states that the exercise of an over-allotment option is not considered a syndicate covering transaction. Exercising the option is a purchase of additional shares from the issuer at the offering price, whereas a syndicate covering transaction under 17 CFR 242.100 is an open-market bid or purchase that reduces the offering-related short position. The distinction matters for when a distribution is treated as completed. The bulletin explains that a syndicate member's participation in the distribution is completed when all the securities have been distributed and after stabilization arrangements and trading restrictions in connection with the distribution have been terminated, and that a later exercise of an over-allotment option does not affect that termination — unless the option is exercised for an amount exceeding the syndicate short position at the time of exercise, in which case the distribution is deemed to continue until all the excess shares are sold. Staff Legal Bulletin No. 9 was issued October 27, 1999 and reflects staff interpretive views, not a rule.

Question 7

How does the over-allotment option relate to supporting the aftermarket price?

Accepted Answer

The over-allotment option gives the underwriters two ways to close the syndicate short, and which one is cheaper depends on where the stock trades after the offering. If the market price falls below the offering price, the underwriters can reduce the short by buying shares in the open market — a syndicate covering transaction under Regulation M, a purchase that adds buying demand. If the market price is at or above the offering price, the underwriters can instead exercise the over-allotment option, obtaining shares from the issuer at the offering price rather than buying at the higher market price. Regulation S-K Item 508(l) requires the prospectus to briefly describe any transaction the underwriter intends to conduct that stabilizes, maintains, or otherwise affects the market price of the offered securities — including stabilizing transactions, syndicate short covering transactions, and penalty bids — to explain how the transactions affect the price, to identify the market where they may occur, and, if true, to disclose that the underwriter may discontinue them at any time. The description here is of the mechanics and the required disclosure; it is not a prediction that any particular transaction will occur or will move the price.

Question 8

What is a penalty bid, and how does it relate to the greenshoe?

Accepted Answer

Regulation M (17 CFR 242.100) defines a penalty bid as an arrangement that permits the managing underwriter to reclaim a selling concession from a syndicate member when the securities the member originally sold are purchased in syndicate covering transactions. A penalty bid works with the covering of a syndicate short: when the syndicate buys back in the open market shares a member had placed, the managing underwriter can recoup that member's concession. The penalty bid is one of the three post-offering activities Rule 104 addresses, alongside stabilizing and syndicate covering transactions. Under 17 CFR 242.104(h)(2), any person imposing a penalty bid or effecting a syndicate covering transaction must give prior notice to the self-regulatory organization with direct authority over the principal market in the United States for the security. Penalty bids and syndicate covering transactions are also among the transactions a prospectus must describe under Regulation S-K Item 508(l).

Question 9

What is stabilizing, and how is it different from covering a short with the greenshoe?

Accepted Answer

Regulation M defines 'stabilize' as placing a bid, or effecting a purchase, for the purpose of pegging, fixing, or maintaining the price of a security. Stabilizing is a distinct activity from covering a syndicate short: Rule 104 permits stabilizing only to prevent or retard a decline in the market price, caps a stabilizing bid at no higher than the lower of the offering price or the stabilizing bid for the security in the principal market, and prohibits stabilizing in an at-the-market offering. Under 17 CFR 242.104, stabilizing is unlawful except for the purpose of preventing or retarding a decline in the market price (paragraph (b)); a person stabilizing must grant priority to independent bids at the same price (paragraph (c)); no syndicate may maintain more than one stabilizing bid in one market at the same price at the same time (paragraph (d)); and the maximum stabilizing bid is limited under paragraph (f). Covering a short by exercising the over-allotment option or by a syndicate covering transaction is a separate mechanism aimed at the syndicate's short position, not a bid placed to peg or fix the price. Stabilizing bids, syndicate covering transactions, and penalty bids are treated together in the stabilization and syndicate-activity stage of the IPO process and are disclosed together under Regulation S-K Item 508(l).

Question 10

What notice must the underwriters give when they cover a short or impose a penalty bid?

Accepted Answer

Under Regulation M Rule 104's disclosure-and-notification provision (17 CFR 242.104(h)), any person effecting a syndicate covering transaction or imposing a penalty bid must give prior notice to the self-regulatory organization with direct authority over the principal U.S. market for the security. A person displaying or transmitting a bid known to be for the purpose of stabilizing must give prior notice to the market where the stabilizing will be effected and disclose the bid's purpose to the person with whom it is entered. Rule 104(h)(3) also requires that a person who sells to, or purchases for the account of, any person a security whose price may be or has been stabilized send the purchaser, at or before the completion of the transaction, a prospectus, offering circular, confirmation, or other document containing a stabilization statement of the kind the rule specifies by its cross-reference to Item 502(d) of Regulation S-K; the current plan-of-distribution disclosure of stabilizing, syndicate-covering, and penalty-bid activity is set out in Regulation S-K Item 508(l) (17 CFR 229.508(l)). These notification duties apply to the covering and penalty-bid activity associated with the over-allotment option and run to the relevant market and self-regulatory organization, not to the SEC.

Question 11

Who grants and who exercises the over-allotment option?

Accepted Answer

The issuer grants the over-allotment option to the underwriters as a term of the underwriting agreement, and in some offerings selling security holders grant a portion of it; the underwriters hold the option and may exercise it to buy the additional shares at the public offering price. An 'underwriter' is defined in Section 2(a)(11) of the Securities Act of 1933 as, in general, any person who buys from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of a security. Regulation S-K Item 508(e) frames the option as an arrangement 'with the issuer,' under which the underwriter may purchase additional shares in connection with the offering. The option is exercisable for a limited period fixed by the underwriting agreement and disclosed in the prospectus; its size is capped at 15% of the securities being offered by FINRA Rule 5110(g)(9). The option is one of the terms and arrangements FINRA reviews under the Corporate Financing Rule, and it is one of the plan-of-distribution items the SEC's disclosure rules require in the registration statement.

Transaction	What the underwriters do	Price condition / when used	Primary authority
Exercise the over-allotment (greenshoe) option	Buy the additional shares from the issuer (and, where applicable, selling security holders) at the public offering price to deliver against the covered portion of the short	Used when the aftermarket price is at or above the offering price, so that sourcing shares at the offering price is cheaper than buying in the open market; the exercise is not a syndicate covering transaction under Regulation M	17 CFR 229.508(e); SEC Staff Legal Bulletin No. 9 · source
Syndicate covering transaction (open-market purchase)	Place a bid or effect a purchase on behalf of the syndicate in the open market to reduce the short position created in connection with the offering; the only way to close a naked short	Used when the aftermarket price is below the offering price; the open-market purchase adds buying demand and reduces the syndicate short position	17 CFR 242.100 (definition); 17 CFR 242.104 · source
Penalty bid (related mechanism)	Managing underwriter reclaims the selling concession from a syndicate member when the shares that member originally sold are bought back in syndicate covering transactions	Imposed in connection with syndicate covering; prior notice to the self-regulatory organization with direct authority over the principal U.S. market is required	17 CFR 242.100 (definition); 17 CFR 242.104(h)(2) · source
Stabilizing bid (distinct activity)	Place a bid to peg, fix, or maintain the price; not a purchase to reduce the syndicate short	Permitted only to prevent or retard a price decline, capped at no higher than the lower of the offering price or the stabilizing bid for the security in the principal market, and prohibited in an at-the-market offering	17 CFR 242.100 (definition); 17 CFR 242.104(b), (f) · source

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Over-Allotment (Greenshoe) Option