Why are green shoe options used in initial public offerings (IPOs)? And why do underwriters usually short sell an issuer’s stock in connection with its IPO? Are underwriters permitted to profit from these trading positions?
Scholars have long argued that underwriters use green shoe options together with short sales to facilitate price stabilizing activities, and that U.S. securities laws prohibit underwriters from using green shoe options to profit from IPO underpricing. This Article finds the conventional wisdom lacking. I find that underwriters may permissibly profit from IPO underpricing by pairing purchases under a green shoe option with offshore short sales. I also find that underwriters may permissibly profit from IPO overpricing by short selling the issuer’s stock in the initial distribution.
The possession of a green shoe option and the ability to short sell IPOs effectively makes underwriters long a straddle at the IPO price. This position creates troubling incentivizes for underwriters to underprice or overprice IPOs, but not to price them accurately.
This new principal trading theory for green shoe options and underwriter short sales provides novel explanations for systematic IPO mispricing, the explosive initial return variability during the internet bubble, and the observation of “laddering” in severely underpriced IPOs.
This Article concludes by charting a new path for the regulatory scheme that applies to principal trading by underwriters in connection with securities offerings. Consistent with the purpose of preserving the integrity of securities markets, regulators should address the incentives of underwriters directly by prohibiting underwriters of an offering from enriching themselves through trading in the issuer’s securities.