Reflecting On Corporate Finance
Rights and Wrongs for 2017
17 Mar 2017

The SFC and HKEx warned through a December 2016 press release that they were monitoring the possible abuse of rights issues and open offers. However, in an ideal world, rights issues are the ‘gold standard’ for the issue of further shares by listed companies. What are the wrongs and ‘rights’ of the situation?

The terms ‘rights’ itself suggests something valuable to shareholders, which they should protect. Note to Listing Rule 13.36(1)(a) reinforces this: “Importance is attached to the principle that a shareholder should be able to protect his proportion of the total equity by having the opportunity to subscribe for any new issue of equity securities. Accordingly, unless shareholders permit, all issues of equity securities must be offered to the existing shareholders…’.

In practice, it has become standard for shareholders to pass annually a ‘general mandate’, permitting the directors to issue 20% of the company’s shares to third parties without significant further checks. In practice also, it is quicker and cheaper to use the general mandate to issue new shares than to make a rights issue or open offer. Rights issues and open offers already labour under the need for greater documentation and procedures, a longer timetable and greater risks and expenses. Do they need any further discouragement?

An open offer is in effect the same as a rights issue with the (important) distinction that the application form issued to shareholders in an open offer is not tradable, whereas in a rights issue shareholders can trade their rights ‘nil paid’. Despite the apparent protection against dilution, large rights issues or open offers can be abusive. Some warning signs are set out below, but there may be mitigating circumstances and there are no easy answers. The warning signs are:

  • A pattern of repeated rights issues or open offers, particularly when combined with a lack of dividends – money is flowing just one way!

    A degree of protection against this abuse already exists through Listing Rules 7.19(6) and 7.24(5) which require an independent shareholder vote if rights issues or open offers increase the share capital by over 50% in any 12-month period. However, a company could still make a 1-for-2 issue each year without the need for shareholder approval, and with independent shareholder approval in theory a company can make as many issues as it likes.
  • No compelling or urgent specific use for the proceeds is disclosed.

    This is often a “giveaway” that a share issue made for other reasons than raising money. However, it may prove risky to wait to raise new equity until it is urgently needed. What happens if the market is difficult at that time or the company’s own performance is not ideal for a fund raising? The time to buy an umbrella is when it is not raining.
  • No genuine review of other means of raising funds seems to have been made or perfunctory reasons given for rejecting other possibilities.

    Any issue of shares is an engrossing process and management may have difficulty giving full consideration to other alternatives when they are trying to get an issue away.
  • The underwriter is the controlling shareholder or other insider.

    No commercial underwriter is involved.To be fair, it is often difficult to secure commercial underwriting on reasonable terms for the relatively long exposure period of a rights issue or open offer.
  • A typical Hong Kong 1-for-2 rights issue may be priced at about a 20-40% discount to the ‘ex rights’ price, depending on the circumstances. Lower pricing results in high dilution if shares are not taken up by shareholders; higher pricing may not give shareholders much incentive to subscribe.

    A low price is not a bad thing for shareholders if they can and do take up their rights. The feature of a rights issue whereby shareholders can sell their nil paid rights in the market instead of having to put up money is one of the key distinctions of a rights issue. A reasonable discount is needed to promote nil paid trading.A price which is close to market (or even occasionally at a premium) may seem advantageous to shareholders but could be designed to discourage take-up. Shareholders can more conveniently buy in the market in such a case.

These potential abuses are real and in our view it is fair for the authorities to draw attention to them. However, it would be a pity if the market treated rights issues or open offers with too much caution. In our view, this method of raising further capital should be considered as one of the main equity fund-raising options, even if it is in the end concluded that it is not practical or appropriate in the particular circumstances. Indeed, consideration of how to make rights issues quicker and cheaper and to encourage “clawback” for other shareholders where shares are issued to controlling shareholders would in our view promote fair and equal treatment of shareholders.

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