At one time or another, most deal lawyers have been involved in transactions in which rights offerings were used to help cleanse issuances of securities to a big investor. The theory is that since every stockholder is being offered the opportunity to buy on the same terms as the investor, the pricing of the share issuance will be insulated from challenge. There’s also some evidence that a properly structured rights offering may help protect insiders from liability for share issuances to controlling stockholders as well.
Well, if Harvard Law prof. Jesse Fried is correct, we may we may need to rethink the benefits of rights offerings. That’s because he just tossed the proverbial “turd in the punchbowl” in the form of this article, in which he contends that rights offers provide insiders with an opportunity to issue themselves stock at bargain prices & at the expense of outside stockholders. Here’s an excerpt from Fried’s recent blog on his article:
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.
Fried argues that the informational asymmetry problem is greater in private companies that aren’t subject to the SEC’s disclosure rules and in companies with complex capital structures. He argues that courts need to more closely scrutinize the fairness of rights offerings to outsiders in light of these concerns.
– John Jenkins