Rights Issue–What Is It?

Rights Issues Are Common Overseas

In the US, investors generally want companies to finance new projects using debt, not equity.  When a new stock issue is needed, the company finds an investment banker, registers the issue and sells the stock at close to the prevailing market price to whomever is willing to buy it.

Most of the rest of the world thinks this is very peculiar, in two ways:

–Foreign markets typically want expansion to be funded through equity, not debt.

–Investors also don’t want their percentage interest in the company to be diluted without their say-so.  They expect companies to give the first chance to buy any new stock to existing shareholders, in proportion to the amount of stock they hold prior to the new issue.  This second expectation is usually enforced through company by-laws that require all equity issuance above a certain size be done through a “rights issue.”

What They Are

“Rights” are essentially short-term warrants, giving the holder the ability, but not the obligation, to buy new shares of a company’s stock at a specified strike price.  They usually only have a life of a few weeks.

In the UK, the custom is that each right gives the buyer the ability to purchase one new share.  The size of the new equity issue is controlled by distributing rights on, for example, a “1 for 10” basis, meaning the holder receives one right for every ten shares he holds.  In other places, the effect is the same but the terminology is different.  One right is distributed for each outstanding share of stock, but it may take ten rights to acquire one new share.

Other key items about rights are:  strike price; ex date, the first trading day on which a new buyer of the stock is not entitled to the right; expiration date, or the last day on which the right can be exercised, after which it becomes worthless; and trading dates for the rights, if any.

Most rights issues allow for public trading of the rights, usually for two or three weeks (because the right can be transferred, these rights issues are sometimes called renounceable).  The holder has three choices:  he can exercise the right and buy the new stock; he can sell the right to a third party in the market; or he can let the right expire, or lapse, unexercised.  In some issues, however, the rights are not transferable (these are called non-renounceable issues), so the holder either exercises the right or allows it to lapse.

During a rights issue, the stock is usually weak

Rights issues are usually pretty bad for a stock’s price.  Even though existing shareholders demand to be given the first chance to acquire new shares, they’re not always the most enthusiastic buyers.  Institutions may already have positions as large as they feel comfortable with.  Long-standing individual shareholders of a stock that has gone up a lot may simply not have enough money to take up all of their rights.

Selling often begins as soon as the rights issue is announced.  Speculative traders may short the stock  because they know this is a time of stock weakness.  Institutional investors may try to sell enough at least some of their current holdings to pay for the rights they take up.

Taxable investors with a low cost basis may not want to sell the stock, though.  They will wait for rights trading to begin and sell their rights then, potentially pushing the stock down further.  Institutions will also finish their position trimming by selling rights.  Arbitrage depresses the stock  in lockstep with the rights.

Setting the Strike Price

Setting the strike price for the rights is an art.  The price can’t be set so high that the stock trades down through the strike price.  In that case, no one would exercise their rights and the issue would end up in the hands of the underwriters, who, not being interested in keeping positions for a long time on their trading books, would seek to sell their shares into the market.  Not only would the failure of the rights issue be seen as a vote of no confidence by existing shareholders (who should know the company better than anyone else), but, because the transaction is so public, the market would be very aware of the large overhang of stock on the underwriters’ books.

On the other hand, the setting of the strike price is a statement of the underwriters’ confidence in the strength of the company and of demand for the new issue.  So the price can’t be set so low that it smacks of desperation.

Underwriting and Sub-underwriting

The vast majority of rights issues are underwritten, meaning that  third parties, typically one or more investment banks, agree for a fee that they will buy at the strike price any shares that remain in the issue because of unexercised rights.  Underwriters, in turn, often sub-underwrite their exposure, typically to favored clients.

Sub-underwriting is often misunderstood by Americans, who usually are legally barred from acting in this capacity.  Sub-underwriters receive a fee, now about 2% of the amount they agree to underwrite.  But that’s only part of their compensation.  They also can benefit from the issue shortfall, which in normal times is like getting a favorable allocation of stock in a “hot” IPO.

Even in the most successful rights issue, a small portion of the rights, say, 5%, will not be exercised.  Why?  It may be someone’s administrative error in not giving instructions to exercise in time.  It may be a retail holder is away on vacation during the issue or just doesn’t bother to figure out what’s going on.  For the sub-underwriter, however, these mistakes can be very lucrative.  For example, suppose the sub-underwriter agrees to underwrite 1,000 rights with a strike price of $50.  He will receive 2% of $50,000, or $1,000, as an underwriting fee.  If the shortfall is 5%, he also buys 50 shares at $50 each.  If the stock has fallen from $100 to $75 during the rights issue and bounces back to $80 shortly after, the sub-underwriter gains $30/share or $1,500 from being able to buy stock at the strike price of the rights.

A minor point:  often the newly-issued stock is not entitled to the next upcoming dividend, so for a short while it may trade at a slightly lower price than the regular stock.

“Theoretical” ex-rights Pricing

How does the market evaluate the price of a stock on the first day it trades ex-rights?  When is it up or down?  The answer is more market custom than deep theory, but investors reason as follows:

Let’s assume today is the first day of ex-rights trading and that the stock closed yesterday at 100.  The rights issue is 1 for 5 at 70, that is, the right is to buy one new share at 70, and is being distributed on the basis of one right for every five shares held at the close of business yesterday.

For good or ill, the custom is to assume yesterday’s price values the stock accurately and that the new shares are issued instantaneously.  The new situation is 5 (old) shares @ 100 each + 1 (new) share at 70, which equals 6 shares valued at 570.  This amounts to 95 per share.  If the ex-rights stock trades below 95, it is considered to be down on the day; if it trades above 95, it is considered to be up.

A Cumbersome Process

A rights issue period is usually a good time to buy a stock, because the process can create a period of stock price weakness that bears no relation to the company’s future prospects.  In most cases, the stock reaches a low point during rights trading and rebounds sharply after the rights expiration date.  One might argue that if the company were free to sell to any potential buyer, it would receive a higher price for the new stock and would avoid the downdraft to the stock price.

Nevertheless, the process is deeply grounded in UK and European attitudes toward the role of the shareholder in company operations and in beliefs about proper capital structure.

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