Judging from the Facebook activity around the newly launched CFA Institute report Non-Preemptive Share Issues in Asia: Role of Regulation in Investor Protection, it is relatively safe to conclude that interest — or rather a lack of knowledge about share placement and non-preemptive share issues — are respectively strong and rampant. If you do not fully understand the concept of share placement and its twin sister — rights issues — rest assured that you are not alone.
On a personal note, my maiden encounter with share placement and rights issues dates back nine years. It involved a dot-com company whose stock price reached an all-time high during the 1999–2000 Internet bubble, and later crashed to less than 10% of its IPO pricing. (A fantastic story from an interesting era for another day; for now, let’s get back to the main story.)
The market share price of that company was 53 cents. Concurrently, there was a one-for-four rights issue, with each issue priced at 16 cents each. Being a minority shareholder and having some spare cash at hand, I dutifully applied for my allotment at the ATM machine. While navigating through the menu, I came across an option called “excess rights issue subscription.” Out of curiosity, I clicked it. Up came a long narrative list that roughly explained that this option allowed one to bid for any right issues that were not taken up by existing shareholders. Given the steep discount from the then-current market share price, there was only a small probability that the post-rights issue share price would go underwater within the window period — barring, of course, a dramatic corporate or catastrophic event.
I applied for the “excess rights” and was subsequently filled at 20%, a much higher figure than the usual fulfillment rate for even IPO issues. The share price remained fairly constant during the first day of post-rights-issue trading. I immediately cashed in all my shareholdings and was handsomely rewarded a return of more than 200% on a per-annum basis for the entire episode. Not too bad for an undergraduate student.
Besides feeling very happy for my lucky streak, I began to wonder how it all happened. And why are there so many “excess rights” floating around? At such a steep discount, who in their right mind would give them up?
To answer the above questions, I have developed the following theories:
- Some investors might have changed their mailing address and forgotten they owned the shares.
- Investors wanted to invest but did not have the spare cash to do so.
- Investors received physical mailings that informed them of the pending rights issue, but they had no clue what it was all about and chose to ignore it.
The first scenario is plausible but relatively unlikely; very few investors would forget about the stock they own, and among this small group, even fewer would have lost their mailing contacts with the stock exchange. Let’s move on to the second scenario.
At first glance, the second scenario sounds intuitively logical given that it is quite common for people to be short on cash from time to time. But at such a steep discount, it makes no sense to ignore the rights issue. This group of investors could either borrow from friends and relatives or receive margin financing from their stockbrokers.
Indeed, the third scenario would most likely explain the bulk of the “excess rights.” It is quite natural for humans to refrain from taking any action when faced with ambiguity; they want to prevent behavior they may later regret. For companies who dish out a normal rights issue, there is at least a first right of refusal given to all existing shareholders. What would be more contentious would be a private placement to outside investors that directly dilutes the value of all existing shareholders, and more so when the issue price is way below the current market share price.
Is there anything in regulation that could potentially limit management from indefinitely dishing out private placements? It varies by jurisdiction. Some do and others do not.
Some jurisdictions have safety features in place, including:
- No dilution of share value beyond that of par value; the par value of a share is typically very low, so this safety feature is not really useful at all in practice.
- Prior to issuance of private placement, top management must gain approval from the majority of the shareholders; what differs among jurisdictions is the required percentage threshold.
- During the special general meeting with shareholders, top management must substantiate the proposed share placement based on concrete reasons.
But even when such safety features are in place, top management can still seek shareholder approval to grant them the pre-emptive right to dish out private-share placements. In other words, top management can appeal to shareholders to give up their entitlement to the last two safety features mentioned above.
The reason top management may give for doing so often revolves around the need for flexibility in fund raising to improve their responsiveness towards profitable investment opportunities. We are not here to argue the validity of this statement. However, we need to highlight that when shareholders surrender these rights, there are very few mechanisms to keep check on potential share-dilution corporate activities.
During the voting process, minority investors typically refrain from taking any action; again, most probably do so because they do not understand what is being voted on. Add to that the presence of a majority shareholder who (for some reason) is highly favorable of the change, and it becomes relatively easy for the motion to get approved among those who voted.
In order for the current situation to improve, it might eventually boil down to appropriate investor education. Unfortunately, most investor education forums nowadays revolve around a panel of experts to voice their opinions on where the market is heading or what stocks to buy. That is not what we are looking at.
Rather, appropriate investor education should be a genuine attempt to empower stakeholders with the right knowledge and tools so that the capital market has enough depth to be truly caveat emptor (or “buyer beware”). But given the typical preference towards short-term punting and lack of tenacity to gain investing knowledge among the general public, it will definitely be a hard nut to crack in practice.
I will be looking at the appropriate types of investor education in my next blog post. Please stay tuned.
Photo credit: iStockphoto.com/erhui1979