Rights Offers and Delaware Law

Under Delaware law, a securities issuance by a public or private firm in which all investors may participate pro rata (a “rights offer”) is generally seen as treating corporate insiders and existing outside investors alike. This view makes it difficult for nonparticipating outsiders to prevail on a “cheap-issuance” claim: that the insiders sold themselves cheap securities via the rights offer.

In a paper recently posted on SSRN, Rights Offers and Delaware Law, I explain how insiders can use rights offers to sell themselves cheap securities at outsiders’ expense, and suggest how courts applying Delaware law should probe the fairness of rights offers.

Under Delaware law, any transaction (including a securities issuance) allegedly benefitting insiders at outsiders’ expense can give rise to “entire fairness” review, under which insiders must prove that both price and process were fair. However, by structuring an issuance as a rights offer, which appears to protect outsiders, insiders have gained substantial legal insulation from outsiders’ claims. Certain cases (e.g., WatchMark v. ARGO (Del. Ch. 2004)) suggest that the use of a rights offer could lead to review under the much more lenient business judgment rule. When a rights offer is followed by a merger, other cases (e.g., Feldman v. Cutaia (Del. Ch. 2007)) suggest that insiders may well be able to avoid any judicial review whatsoever. And, even if fairness review cannot be avoided, the use of a rights offer may well go far to help satisfy entire fairness.

Delaware judges generally understand that a rights offer does not actually protect what might be called “impeded” outsiders: outsiders who face barriers to participation. Thus, Delaware judges have been reluctant to insulate insiders from cheap-issuance claims arising out of a rights offer when insiders allegedly knew the outsiders lacked adequate capital or faced procedural hurdles to participating. But rights offers are often as seen as fair to unimpeded outsiders, making it difficult for claims of cheap-issuance expropriation to succeed.

I show, however, that rights offers fail to put even unimpeded outsiders on an equal footing with insiders, and that insiders can use rights offers to engage in cheap-issuance expropriation. The reason is information asymmetry. Outside investors have much less information than insiders about the value of the firm and its securities, whether the firm is unlisted or listed. They may thus not know whether the stock on offer is cheap or overpriced, and whether they should participate in a rights offer.

In unlisted firms, outside investors are often completely in the dark. Such firms are generally not subject to mandatory periodic disclosure requirements either under the federal securities laws or state corporate law. Even when a sophisticated outside investor in an unlisted firm carefully negotiates informational rights, these rights are not self-enforcing; the investor may need to engage in expensive litigation to get access to the most basic information, including the identities of the firm’s officers and directors, the firm’s balance sheet and income statement, and the firm’s capital structure.

The situation is better if the firm is listed and thus subject to mandatory disclosure and more vigorous enforcement of anti-fraud laws. But information asymmetry persists, as made clear by the abnormal profits executives make trading in their own firms’ shares. The reason is simple: even if a firm could be compelled to disclose all “material” facts, insiders would still have unique access to “sub-material” facts and other “soft” information (such as their own plans for how to run the firm) that often give them a much better sense of firm value.

Information asymmetry in both unlisted and listed firms leads to what I call a “zone of uncertainty”—a range of prices in which outsiders cannot tell whether securities offered by a firm are cheap or overpriced. As asymmetry increases, this range widens. Prices far enough beyond the boundaries of the zone will be sufficiently high or low that outsiders can easily figure out whether the offered securities are overpriced or cheap. But within the zone, outsider will be uncertain. Suppose, for example, that outsiders in an unlisted firm believe that the firm’s shares are worth between $5 and $15 each. If insiders have the firm offer additional shares for $10 each, outsiders will not know whether the offered shares are cheap or overpriced.

An offer price within the zone of uncertainty enables insiders to put outsiders between a rock and a hard place, as it forces outsiders to choose between two options, each of which (in expectation) leads to expropriation: (1) exercise rights to buy, risking overpriced-issuance expropriation or (2) refrain, risking cheap-issuance expropriation.

Because there is a risk of cheap-issuance expropriation and a risk of overpriced-issuance expropriation, there is no surefire way to protect against expropriation. Outside investors must decide which risk they fear more and expose themselves to the other. Those outsiders more fearful of cheap-issuance expropriation will choose to buy at $10 per share, putting themselves at risk of buying overpriced securities. Those more fearful of buying overpriced securities will not subscribe, eliminating that risk, but then making themselves vulnerable to cheap-issuance expropriation. If $10 is actually cheap, and at least some outsiders refrain, cheap-issuance expropriation occurs. In short, information asymmetry can make outsiders rationally reluctant to participate in an issuance that, unbeknownst to them, is cheap, thereby enabling insiders to buy a disproportionate amount of underpriced securities.

Delaware law does not, but should, require insiders to disclose in advance their planned participation in a rights offer. However, I explain that such disclosure would only reduce outsiders’ problem, not eliminate it. To the extent the firm either explicitly subsidizes insiders’ participation in the rights offer by financing their purchases or implicitly subsidizes their participation by providing insiders with a disproportionate share of the issuance proceeds, outsiders cannot reliably infer from insiders’ participation that the securities are cheap. They may thus refrain, and be hurt by cheap-issuance expropriation.

I also explain that the inability of rights offers to protect outsiders is likely to be greater if the firm is private (and thus not subject to disclosure requirements applicable to public firms). It is also likely to be greater if the offer or the capital structure of the firm is particularly complex. Thus, the problem is likely to be most severe in a private firm with a complex capital structure, such as a VC-backed startup with multiple classes of preferred stock.

My analysis suggests that courts applying Delaware law should more closely probe rights offers for substantive fairness toward outsiders. I close by describing various features of rights offers, outsiders, and firms that increase the risk of expropriation and thus raise red flags about an issuance’s effects on outsiders.

The complete paper is available here.