In the past months, some of Europes biggest banks and corporates have announced plans to raise funding from existing shareholders through rights issues. Royal Bank of Scotland (RBS) has raised 12 billion through a rights issue, the largest ever in Europe. HBOS (Halifax Bank of Scotland) has asked shareholders for an extra 4 billion. And Imperial Tobacco launched its previously announced 4.9 billion cash call. How do we explain this trend? What does it mean for shareholders and what is the role for lawyers?
For banks in particular, the need for a strong capital base (i.e. a satisfactory assets to liabilities ratio) has been reinforced by the impact of the credit crunch, with the impact being more significant for some than others. Companies are raising equity finance to boost their capital strength and fund acquisitions.
Rights issues have been rare in recent times because debt has been relatively inexpensive and readily available, so companies needing cash preferred to borrow. Since the credit crunch, however, raising equity has become more attractive. A share sale allows a company to raise money without having to take on debt. However, a major disadvantage to equity financing can be the difficulty of actually finding buyers for the shares.
A rights issue involves a company issuing extra shares to raise capital, and offers them to existing shareholders in proportion to their current shareholding (although for legal reasons some shareholders outside the UK may be excluded). The HBOS rights issue will offer existing investors two new shares for every five they hold, whilst both Carlsberg and Imperial Tobacco are offering shares on a one-for-one basis. The lawyers at Allen & Overy, which has been advising on all three of these rights issues, have been responsible for drafting the documents which inform the shareholders of the terms of the rights issue.
The price at which the shares are offered is usually at a discount to the current market price, which gives investors an incentive to buy the new shares. RBS’s and HBOS’s rights issues were made at discounts of 46 and 45 per cent respectively to the closing share price of the last trading day before the announcement to the market.
A ‘provisional allotment letter’ (PAL) is sent to shareholders, provisionally allotting them their pro rata entitlement of shares.This document gives shareholders the right to buy the additional shares, but not the obligation; they are simply given first refusal over this new stock. A shareholder can take up all, some or none of the rights on offer. The mechanics for those who hold shares in CREST, mainly institutional investors, are different but the principles are the same.
If a shareholder takes up the rights, he ensures that his existing percentage shareholding is not diluted. Of course, this also increases a shareholders exposure to the company. This is done by submitting the PAL and the necessary payment before the end of the offer period. Shareholders will watch the market price of their shares. They will not want to take up their rights if the share price has fallen below the subscription price, since it would then be cheaper to buy the shares on the open market.
If a shareholder renounces the rights, his shareholding will be diluted. Each right has a value in theory, the difference between the subscription price and the theoretical ex-rights price (the level to which the stock is expected to fall once the new shares are issued). Before the end of the offer period, the rights can be sold to other investors, earning the holder a cash compensation for the dilution if they are sold at a premium. These are called nil paid dealings.
Alternatively, an investor could do nothing and let the rights issue lapse. These ‘lazy shareholders’ may nevertheless, still be in for some money. At the end of the process, the issuer’s underwriters will usually sell any lapsed rights. Any money raised is returned to those shareholders, minus the costs.
Normally a rights issue is underwritten to ensure that the money is still raised even if shareholder appetite dries up. This means that the underwriter (usually an investment bank or broker) guarantees that the company will receive the equity finance it needs by agreeing to take up, at no less than the subscription price under the rights issue, any shares which are not taken up by shareholders and which cannot be sold by them in the market. These arrangements will be recorded in an underwriting agreement.
Companies wanting to implement a rights issue tend to require a shareholder meeting to approve the necessary resolutions, although this is not always the case. As a trainee at Allen & Overy, I have been assisting in the drafting of the shareholder circular and the necessary resolutions to be put to shareholders.
Recent commentary has suggested concern over continuing financial market volatility, the size of some companies’ losses, higher funding costs and a likelihood that credit market conditions will remain difficult. This, coupled with more shares being issued for investors to absorb, may well result in lower stock prices.
Many companies are making rights issues, but it must be remembered that there are only a limited number of investors. A rights issue should enhance an institution’s ability to trade going forward as the company will be better capitalised, with a strengthened balance sheet. For those shareholders who do think, as the Bank of England has suggested, that the credit crisis is nearly over, taking up the rights offers may make sense. However, we may well see a number of other companies proposing rights issues in the near future.