Rights offerings are a relatively common method of raising capital. In a rights offering, existing shareholders of the company have the option to purchase newly issued shares in proportion to the number of shares they already own (pro rata) for a specific subscription price per share. Typically, rights offerings are made at a discount to the price of the underlying stock.
Since rights offerings allow all shareholders to participate in the issue pro rata to their existing shareholding and under the same conditions, the traditional view used to be that rights offerings were fair to all shareholders. Previous academic work, however, has shown that rights offerings cannot fully protect outsiders from insider expropriation. Specifically, company insiders can sell shares cheaply – a scenario called a “cheap stock tunnel” – even when the issue is made in the form of a rights offering. First, when some shareholders are limited in their ability to participate in attractive rights offerings, for example due to a lack of sufficient funds, the formal right to participate does little to protect those shareholders. Second, Fried and Spamann recently showed that corporate insiders can leverage their informational advantage to engage in a cheap stock tunnel via rights offerings. Namely, company insiders may intentionally set the subscription price in a “zone of uncertainty” – a price range for which outsiders cannot tell with certainty whether the price is too high or too low. When the subscription price is set within this range, foreigners who participate risk buying overvalued stocks, while foreigners who refrain from participating risk creating a tunnel of cheap stocks. To balance these two risks, foreigners exercise only part of their subscription rights, and some cheap stock tunnels are facilitated.
My article complements previous research by revealing a different form of expropriation via rights offerings, which can take place even in the absence of any barriers to participation or informational asymmetry. Specifically, my article shows that dominant and non-controlling shareholders (“insiders”) can use an overvalued rights offering to expropriate control. In an overpriced rights offering, the subscription price is intentionally set outside (above) the “zone of uncertainty”, so that all shareholders are equally aware that the price is too high. Although there are no obstacles for foreigners to participate in the rights offering, they are deterred by the high subscription price and refrain from participating. This paves the way for insiders to acquire a disproportionate number of shares and cement control. Once control changes, the new controller is able to extract private benefits from the business at the expense of outsiders. In addition, the new controller would be the sole beneficiary of a future control bonus. These expected benefits of control make the high subscription price worth paying from the perspective of insiders, so the rights offering is effectively cheap for insiders but too expensive for other shareholders.
It is important to note that in the vast majority of contexts, outsiders cannot coordinate effectively to thwart insider takeover efforts, or hope to gain control themselves through the offer. Thus, foreigners resort to non-participation. Essentially, since insiders and outsiders are in different situations, their equal treatment (through an offer of rights) has an unequal effect.
If overpriced rights offerings were just a change in value, that’s to say would only transfer value from outsiders to insiders without cutting the corporate pie, rational parties could anticipate future expropriation and adjust their transactions accordingly. However, as is often the case with insider trading, overvalued rights offerings can also be value-destroying, with costs resulting from both ex post And ex ante. Possible ex ante costs include transaction costs involved in executing a rights offering, making issues when the business cannot grow efficiently, and performing costly manipulations to drive prices down to reduce the price short-term actions and facilitate a less costly takeover. Another potential cost is the creation of inefficient control blocks. Once in control, insiders could run the business inefficiently to create opportunities for value diversion. However, insiders will not fully internalize the full cost of their mismanagement, as it will be partially borne by outsiders as a negative externality. For insiders, the change in control and subsequent write-down is desirable, as long as the insiders’ private benefits outweigh the insiders’ share of the write-down and the premium paid for control. Importantly, the lower the premium paid by insiders to cement control, the wider the range of transfers of control likely to be sought by insiders, including ineffective transfers. In overvalued rights offerings, insiders can set a modest premium to discourage outside participation and force a change of control, thus compounding the potential for inefficient transfers.
ex-post, overvalued rights offerings could further reduce the corporate pie by adding to the lemons problem in capital markets. Where opportunistic insider tendencies go unchecked, investors are expected to respond by discounting the shares of any companies that may experience abusive issuances. While such a discount will indeed reward well-diversified shareholders, it will nevertheless increase the cost of capital borne by all companies. In addition, the prospect of future control theft could lead parties to overinvest in costly contractual protections, such as the right to block future broadcasts, or to underuse otherwise advantageous agreements such as “shared control”. “, whereby founders share control with VCs in exchange for VCs. funding.
As a general rule, under current Delaware law, rights offerings are subject to lenient treatment. They are often seen as treating all shareholders equally and are therefore reviewed under the rule of deferential business judgment. However, my analysis shows that rights offerings do not always level the playing field between insiders and outsiders. Company insiders could craft an overpriced rights offering to cement control, rather than using traditional takeover methods such as a takeover bid, to circumvent court-created obligations to change of control transactions. Allowing insiders to evade judicial review by disguising a takeover bid as a rights offering could create a loophole in takeover law. Thus, courts should subject rights offerings to a case-by-case analysis that carefully considers the dynamic and underlying circumstances of each offering. If a rights offering is used by insiders as a takeover tool, courts should subject the offering to scrutiny, as with any other change of control transaction. In particular, the board must demonstrate that it acted to maximize the premium paid by insiders.
I further suggest that stock exchanges adopt a mandatory rights offering price adjustment mechanism, which will mechanically guarantee that the subscription price of an offering will be less than or equal to the price of the underlying stock. If adopted, this mechanism will prevent insiders from deliberately engineering out-of-the-money rights offerings in public companies. In addition, the proposed mechanism will eliminate the risk of unintentional offers of premium rights caused by fluctuating prices. As such, this mechanism can help maximize shareholder participation in rights offerings and reduce the cost to companies of protecting themselves against failure of the rights offering.
A link to the full document is available here.