The Power to Issue Stock

The following post comes to us from Mira Ganor of the School of Law at the University of Texas at Austin.

In the paper, The Power to Issue Stock, recently made publicly available on SSRN, I study the new but increasingly common practice of target management granting top-up options to bidders. The paper analyzes the mechanics and recent case law involving top-up options, as well as the more general implications of managers’ substantial power to issue stock.

A top-up option is given by a target to a bidder to reduce judicial scrutiny of the planned acquisition. Once the bidder succeeds in getting at least 51% of the shares, the bidder exercises the top-up option and is issued enough shares to bring its holdings up to 90%. At that point, the bidder can proceed with a short-form merger, freezing out dissenting shareholders. The bidder must offer all of the shareholders the same price at the tender offer, as required by federal regulations, and usually undertakes, as part of the top-up option agreement, to pay the same price also to the dissenters at the back-end squeeze-out to prevent judicial scrutiny for a potentially structurally coercive offer. The price that will convince holders of 51% of the shares to tender, however, may well be substantially lower than the price needed to cause the holders of 90% of the shares to sell. Dissenters’ only recourse is appraisal, which many believe is a weak form of protection.

The paper uses top-up options to highlight a broader problem in corporate governance: that managers’ power to issue stock can make public investors vulnerable to managerial opportunism. The issuance of shares has the effect of diluting existing shareholders. In some cases, the issuance of shares may have this very purpose. Managers might use their power to issue shares to dilute the voting rights of shareholders or the economic value of their shares in furtherance of the managers’ own interests. Using the power to issue shares to circumvent the voting power of the shareholders can take several forms. When managers seek to sell the firm over shareholders’ objections, they can use top-up options to dilute the voting power of dissenting shareholders. When managers seek to prevent the sale of a firm sought by shareholders, they can use the power to issue stock to adopt poison pills and other takeover defenses. Like the poison pill, a top-up option is granted to ensure the outcome the managers want to promote, regardless of the shareholders’ vote. Unlike a poison pill, a top-up option is used when the management prefers the acquisition; the top-up option is designed to force through an acquisition and a subsequent shareholder freeze-out despite the opposition from a large block of the minority shareholders. Like the poison pill the top-up option may involve agency costs and diminish shareholder wealth.

I explain that managers’ ability to use new stock issues to further their own objectives at shareholders’ expense can give rise to additional distortions. Notably, it may cause managers to “conserve” stock by replacing equity-based compensation and equity-based financing with less efficient arrangements. This is because tools such as the top-up option and the poison pill require the issuance of a significant amount of shares and managers’ ability to issue stock without obtaining the shareholder approval is limited.

Both a top-up option and a poison pill require the managers to be able to issue significant amounts of shares in order to have the desired dilutive effect on the issued and outstanding shares of the company. The top-up option, for example, gives the bidder the right to acquire ten times the difference between the percentage the bidder acquired and the desired 90%. For example, a bidder who obtains only 51% of the outstanding shares of the company following the tender offer, needs to acquire new shares from the company in the amount that equals to four times the number of outstanding shares of the company.

Thus, the paper explores the limitations on the managers’ ability to issue stock unilaterally, without securing a favorable shareholder vote. One limitation on managers’ power to issue stock in Delaware corporations is the amount of authorized capital of the corporation, which provides a ceiling for the total number of shares that can be issued. The ratio of authorized non-outstanding shares to the issued and outstanding shares, the “excess-ratio”, is an indicator of the magnitude of the managers’ power to issue stock in any given company. I find that corporations tend to go public with very high excess-ratios. On average, managers can more than quadruple the amount of issued shares without shareholder approval, which allows managers to use dilutive tools like top-up options and poison pills. However, given the substantial amount of new shares needed for the exercise of a top-up option and for the exercise of the rights under a poison pill, managers who wish to maintain their ability to use this type of tools may still need to issue stock for other business reasons only sparingly. In contrast, other jurisdictions such as Maryland allow managers to issue unlimited number of shares for any purpose. While this approach may address the concern that managers will refrain from using stock for more conventional business promoting purposes, it gives the managers substantial power and leaves the shareholders exposed to managerial opportunism.

Both the New York Stock Exchange and NASDAQ listing rules provide another limitation on managers’ power to issue stock and cap the maximum number of shares that managers can issue without going to the shareholders at 20% of the number of issued shares. It seems that the exchanges strictly enforce the cap and police attempts to coerce a favorable shareholder vote on issuances of shares. NASDAQ, for example, did not accept convertible financial instruments that stipulated a different outcome depending on the shareholder vote and provided that the company is penalized and the buyer rewarded if shareholders deny approval of additional issuances above the 20% cap. However, the listing requirements of US stock exchanges and the possible delisting penalty do not deter the grant of a top-up option to a bidder who is interested in freezing out all non-tendering shareholders.

In some countries, such as the UK and Germany, there is another statutory limitation on the managers’ power to issue stock: shareholders have pre-emptive rights which give them the right to participate pro-rata in any distribution of shares of the company. In the United States however, pre-emptive rights are no longer mandatory. Venture capitalists, for example, customarily negotiate for pre-emptive rights when they invest in a private company but these rights disappear following the initial public offering of the company. However, liquidity constraints as well as collective action problems may make pre-emptive rights in the case of public companies a weak defense for the shareholders and thus cannot alleviate the concerns of giving managers the extensive power to issue stock.

Thus, even though there are limitations on the managers’ power to issue stock, the paper shows that most of these limitations do not effectively restrict the managers’ power to issue stock and that managers can still take advantage of it to advance their own interests. Furthermore, the only restriction that can effectively prevent the managers from issuing substantial amounts of shares without receiving the shareholders’ approval— the ceiling set by the number of authorized shares— can distort managerial behavior. This limit on the power to issue stock may cause the managers to refrain from issuing stock for ordinary business purposes, such as equity-based financing and equity-based compensation, in order to retain their power.

The full paper is available for download here.

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