Control Expropriation via Rights Offers

Rights offers are a relatively common capital raising method. In a rights offer, the company’s existing shareholders are given the opportunity to purchase newly-issued shares in proportion to the amount of shares they already own (pro-rata) for a specific subscription price per-share. Typically, rights offers are conducted at a discount to the underlying share’s trading price.

Given that rights offers allow all shareholders to participate in the issuance in proportion to their existing shareholdings and under the same terms, the traditional view had once been that rights offers are fair to all shareholders. Previous scholarly work has shown, however, that rights offers cannot fully protect outsiders from insider expropriation. Specifically, corporate insiders can sell themselves cheap stock – a scenario coined as “cheap stock tunneling” – even when the issuance is conducted as a rights offer. First, when some shareholders are limited in their ability to participate in attractive rights offers, say for lack of sufficient funds, the formal right to participate does little to protect such shareholders. Second, Fried and Spamann have recently shown that corporate insiders can capitalize on their informational advantage to engage in cheap stock tunneling via rights offers. Namely, corporate insiders can intentionally set the subscription price within a “zone of uncertainty” – a price range for which outsiders cannot tell for sure whether the price is too high or too low. When the subscription price is set within this range, outsiders who participate risk purchasing overpriced stock, while outsiders who refrain from participating risk cheap-stock tunneling. To balance these two risks, outsiders exercise only part of their subscription rights, and some cheap-stock tunneling is facilitated.

My paper adds to prior research by uncovering a different form of expropriation via rights offers, that can take place even absent any impediment to participation or informational asymmetry. Specifically, my paper shows that dominant, non-controlling shareholders (“insiders”) can utilize an overpriced rights offer to expropriate control. In an overpriced rights offer, the subscription price is intentionally set outside (above) the “zone of uncertainty, so that all shareholders are equally aware that the price is too high. Although outsiders face no obstacles to participate in the rights offer, they are deterred by the high subscription price, and refrain from participating. This clears the way for insiders to acquire a disproportionate number of shares and cement control. Once control shifts, the new controller is in a position to extract private benefits from the firm at outsiders’ expense. Furthermore, the new controller would be the sole recipient of a future control premium. These expected benefits of control make the high subscription price worth paying from insiders’ perspective, so that the rights offer is effectively cheap for insiders but overpriced for other shareholders.

Importantly, in the vast majority of settings, outsiders cannot efficiently coordinate to thwart insiders’ takeover efforts, or hope to gain control through the offer themselves. Thus, outsiders resort to non-participation. Essentially, given that insiders and outsiders are differently situated, their equal treatment (through a rights offer) has an unequal effect.

If overpriced rights offers were merely value-shifting, i.e. would solely transfer value from outsiders to insiders without shrinking the corporate pie, rational parties could anticipate the future expropriation and adjust their dealings accordingly. However, as is often the case with self-dealing transactions, overpriced rights offers may also be value-destroying, with costs arising both ex-post and ex-ante. Possible ex-ante costs include the transaction costs involved in executing a rights offer, conducting issuances when the firm cannot expand efficiently, and engaging in costly price-depressing manipulation to reduce the short-term stock price and facilitate a cheaper takeover. Another potential cost concerns the creation of inefficient control blocks. Once in control, insiders might run the firm inefficiently to create opportunities for value diversion. Insiders will not fully internalize the full cost of their lacking management, however, as it will be partially borne by outsiders as a negative externality. For insiders, the control shift and subsequent value reduction are desirable, as long as insiders’ private benefits offset insiders’ share of value reduction and the premium paid for control. Importantly, the lower the premium paid by insiders to cement control, the wider the range of control-transfers that might be sought by insiders, including inefficient transfers. In the overpriced rights offers setting, insiders can set a modest premium to discourage outsider participation and force the control-shift, thereby aggravating the potential for inefficient transfers.

Ex-post, overpriced rights offers might further shrink the corporate pie by aggravating the lemons problem in the capital markets. Where insiders’ opportunistic tendencies are left unchecked, investors are expected to react by discounting the stock of all companies that might undergo abusive issuances. While such a discount will indeed compensate well-diversified shareholders, it will nonetheless increase the cost of capital born by all firms. Furthermore, the prospect for future control theft might lead parties to overinvest in costly contractual protections, such as the right to block future issuances, or underuse otherwise beneficial arrangements such as “shared control”, under which founders share control with VCs in exchange for VC funding.

Generally, under current Delaware law, rights offers are subject to lenient treatment. They are often perceived as treating all shareholders equally, and are thus reviewed under the deferential business judgement rule. However, my analysis shows that rights offers do not always level the playing field between insiders and outsiders. Corporate insiders might engineer an overpriced rights offer to cement control, rather than use traditional takeover methods such as a tender offer, in order to bypass judicially-created duties for change-of-control transactions. Allowing insiders to evade judicial scrutiny by dressing a takeover as a rights offer could create a loophole in takeover law. Thus, courts should subject rights offers to a case-by-case analysis that carefully considers each offer’s dynamic and underlying circumstances. If a rights offer is used by insiders as a takeover tool, courts should subject the issuance to a thorough review, as with any other change-of-control transaction. In particular, the board should demonstrate that it acted to maximize the premium paid by insiders.

I further suggest that stock exchanges adopt a mandatory price-adjusting mechanism for rights offers, that will mechanically guarantee that an offer’s subscription price will be lower than or equal to the underlying share’s trading price. If adopted, this mechanism will prevent insiders from deliberately designing out-of-the-money rights offers in public firms. Moreover, the proposed mechanism will eliminate the risk for unintentional premium rights offers caused by price fluctuation. As such, this mechanism can help maximize shareholder participation in rights offers, and reduce firms’ cost in protecting against rights offer failure.

A link to the full paper is available here.