Powering Preemptive Rights with Presubscription Disclosure

Jesse Fried is the Dane Professor of Law at Harvard Law School. This post is based on his recent paper. Related research from the Program on Corporate Governance includes Cheap-Stock Tunneling Around Preemptive Rights by Prof. Fried and Holger Spamann (discussed on the Forum here).

In a paper recently posted on SSRN, Powering Preemptive Rights with Presubscription Disclosure, I put forward a proposal to make preemptive rights more effective: requiring the controller of a firm to disclose its subscription decision before outside investors decide their own.

Most corporations around the world have a controller: control is concentrated in the hands of either a single shareholder or a small group of shareholders acting in concert. Almost every unlisted (private) firm is a controlled firm. And many listed firms in the U.S. and most listed firms outside the U.S.—in Europe, Asia, and South America—are controlled firms.

In a controlled firm, outside investors are potentially vulnerable to tunneling transactions that shift value to the controller, including the sale by the firm of cheap securities to the controller: “cheap-issuance tunneling”. To reduce cheap-issuance tunneling, most jurisdictions around the world grant preemptive rights as a difficult-to-waive statutory default in unlisted and listed firms; opting out can require super-majority shareholder approval, be subject to judicial review, or lead to substantial limits on the issuance amount. As a result, outside investors often have preemptive rights in an issuance.

Building on joint work with Holger Spamann, I explain that preemptive rights can prevent cheap-issuance tunneling when outsiders know that the offered securities are cheap. However, preemptive rights fail to prevent such tunneling when outsiders cannot tell whether the offered securities are cheap or overpriced. In particular, fear of buying overpriced securities will cause some outsiders to rationally refrain from purchasing, and these refraining outsiders will suffer losses if the securities are, in fact, cheap. On the flip side, participating outsiders will suffer losses from another type of mispriced-issuance tunneling (“overpriced-issuance tunneling”) when the securities’ price is, in fact, high.

I then demonstrate that outsider losses from cheap-issuance tunneling (and overpriced-issuance tunneling) could be substantially reduced by requiring the firm to disclose the controller’s subscription commitment before outsiders must decide their own, thereby enabling outsiders to “mimic” the controller. Such presubscription disclosure, which is already required by the People’s Republic of China (PRC) for certain issuances by listed firms, should be imposed on both unlisted and listed controlled firms. However, outsiders should be free to collectively opt out of the rule if they believe that the transaction (and other possible) costs associated with presubscription disclosure outweigh the benefits.

The presubscription disclosure rule would be enforced by requiring the firm to disclose, after an issuance is completed, the controller’s actual subscription. If the controller fails to fulfill her commitment, the issuance would be cancelled and funds would be returned to participating investors, the approach used by the PRC. If the controller indicates she is refraining (that is, not subscribing for any securities), but then somehow acquires securities in the issuance, the controller’s purchases would be rescinded.

In a listed firm, anti-circumvention measures may be needed, as the controller could seek to “undo” a subscription commitment by sales in the open market (or by entering into hedging transactions). If outsiders believe the controller might circumvent in this manner, presubscription disclosure will be a less informative signal about the value of the offered securities. To make presubscription disclosure effective at curbing cheap-issuance tunneling (as well as overpriced-issuance tunneling), regulators must ensure that the controller’s disclosed plan—whether it is to subscribe or to refrain—provides an accurate picture of her overall transactions in the firm’s securities. For example, regulators could bar controllers from offsetting or hedging transactions for a particular period of time around the issuance.

The full paper is available here.

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