What is wrong with rights issues?
Introduction
A rights issue is an issue of rights to purchase new shares, which are issued pro rata to the existing shareholders, Armitage (2007). Rights issues were the dominate form of seasoned equity offers for fund raising in the United Sates and the United Kingdom . However, there has been a swing to other forms of share issues. The US has shifted towards firm commitments, Eckbo and Masulis (1992). In this the underwriter guarantees the sale of the issued stock at the agreed-upon price. The shift in the US occurred in the 1960’s. In the UK there has been a move towards open offers. Open offers are similar to rights issues but investors are unable to sell the stocks that they purchase under the open offer to other parties. The change in the UK occurred much later than the US, with the shift occurring in the 1990’s.
The purpose of this paper is to examine why this shift has occurred, and discover what academics believe to be wrong with rights issues. In order to achieve this goal two papers on the subject will be reviewed. The first paper to be reviewed will be Eckbo and Masulis (1992) and the second will be Armitage (2007). Once both papers are reviewed there will be a conclusion which will compare the two and conclude on their main contribution to knowledge.
Eckbo and Masulis (1992)
Background
Eckbo and Masulis (1992) open their paper by explaining the decline in rights issues and the surge in firm commitments. To show this Eckbo and Masulis use a sample of 1,249 equity offers between 1963-1981.
Eckbo and Masulis highlight the puzzle Smith (1977) presents. Smith finds that rights issues have lower costs than firm-commitments. Smith also states that the rights issuer can assure the success ...
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... that selling large blocks of shares plus rights is rather costly and means the apparent cost advantage of rights issue is illusory. The cost of selling new shares plus rights has not previously been documented as a material cost in rights issues.
Both the papers are credible in their own right and provide answers for the decline in rights issues. Eckbo and Masulis (1992) is more credible for US markets and Armitage (2007) is more credible for the UK markets. However, Armitage (2007) may be the more credible paper as it finds the long run abnormal returns following rights issues with pre-renounced shares are not consistently negative or significant, which would suggest the issuers were fairly valued. This finding slightly disproves Eckbo and Masulis (1992) abnormal return results and over/under valuation theory but Eckbo and Masulis (1992) sample is much greater.
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Ownership dispersion hypothesis explains that underpricing is used to insure oversubscription of the shares issues. Booth and Chua (1996) and Brennan and Franks (1997) argue that firms have the incentive to underprice shares with the aim to create a diffuse ownership base and improve market liquidity of their shares. Thus ownership structure increases the difficulty for outsiders to challenge the board of management (Mai, T.L. 2011).
Security, in business economics, written evidence of ownership conferring the right to receive property not currently in possession of the holder. The most common types of securities are stocks and bonds, of which there are many particular kinds designed to meet specialized needs. This article deals mainly with the buying and selling of securities issued by private corporations. (The securities issued by governments are discussed in the article government economic policy.)
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Regulation 26 (1)(c) prohibits the issue of shares during the offer period which will entitle the holder to voting rights in the company. Such an issue would require a special resolution by postal ballot to be passed. The case of Howard Smith v. Ampol Petroleum throws some light on this issue as well. In this case, Millers was subject to a takeover offer by Ampol Petroleum. A competing offer was made by Howard Smith Ltd. This bid by Howard Smith was supported by the Board of Millers who considered the former to be the white knight in the situation. To facilitate the bid, the company made a further issue in order to reduce Ampol to minority shareholders. The court in this case held that the directors of the company had a fiduciary duty and their power to issue further shares must always be for a ‘proper purpose’. Since Millers made the issue with the sole purpose of diluting the majority voting power, the issue was held to be not proper. The court held that the test to determine whether an issue was proper is to take
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Throughout societies in history and presently, we can see the employment of two primary forms of rights: positive and negative. The bulk of the following attempts to highlight the differences between the two. The proponents of each will also be discussed.
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MYERS, S.C. and MAJLUF, N.S., 1984. Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13(2), pp. 187-221.
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Zachariassen, F., & Arlbjørn, J. (2011). Exploring a differentiated approach to total cost of ownership. Industrial Management & Data Systems , 111 (3), 448-469.