The need for speed
Rights issues returned with a vengeance in 2008 and their popularity for capital raising shows no sign of waning. But in the UK there is some concern about the time they take to complete, leading the Rights Issue Review Group to consider reforms to speed the process up. Jeremy Hill and James Parker, partner and associate respectively at Debevoise & Plimpton, report on the options available.
A rights issue is an offer of new shares to existing shareholders in proportion to their respective holdings. The new shares are subscribed for in cash and are invariably offered at a substantial discount, generally between 20%-40%, to the market price at the time. This makes them an attractive proposition for investors, and an effective means of raising capital for issuers.
But in the UK, the traditional rights issue model is flawed: its lengthy timetable, especially where a general meeting is required to increase share capital, authorise directors to allot shares or disapply statutory pre-emption rights, arguably opens the process up to market abuse. Short selling is easier to perpetrate and there is an increased likelihood of issuers experiencing changes in their financial position during an offer period, potentially necessitating a change of the terms of the offer.
Underwriters may wish to exercise their rights under material adverse change and other termination clauses in underwriting agreements to extricate themselves from deals which they no longer wish to participate in. Further, the longer the period during which the underwriter is “on the hook”, the higher the underwriting commissions that will be charged.
Among the recommendations of the UK’s Rights Issue Review Group last November that were implemented by the FSA was a reduction of the minimum subscription period for rights issues in respect of which the statutory pre-emption provisions are disapplied, from 21 days to 10 business days. The FSA is committed to a further reduction and over the coming months will listen to the views of the market.
Open offer with compensation
Rights issues are generally preferred to open offers by shareholders because they offer a pre-emptive right to subscribe for new shares and the opportunity to receive compensation if this right is waived. Under an open offer, shareholders who do not take up their entitlement to new shares in full simply suffer dilution.
The open offer with compensation would follow the format of the traditional open offer but, as with a rights issue, allow the bookrunner to sell any shares not taken up under the offer. The issuer would receive the subscription price, while shareholders waiving their entire entitlement receive their pro-rata share of any surplus, if such unsubscribed shares are sold at a premium to the aggregate of the subscription price plus associated sales costs. The open offer model does not allow for the trading of nil-paid rights during the offer period – the right to subscribe for new shares is simply accepted in whole or in part or declined. But it does allow the offer to run concurrently with a general meeting notice period if a general meeting is required. So where a general meeting is required, the timetable for a compensatory open offer would be at least 10 business days shorter than for a rights issue.
Lloyds Banking Group recently conducted a successful placing and compensatory open offer and other issuers may now follow suit. But a compensatory open offer will not be any quicker than a rights issue where no general meeting is necessary as it will still have to remain open for 10 business days. Until the FSA amends listing rule 9.5.10, specific authorisation by way of a shareholder resolution will still be required for the offer to involve a discount exceeding 10%.
Analysis by the Rights Issue Review Group of overseas markets revealed only one leading pre-emptive model - the Australian Rapids model (renounceable accelerated pro-rata issue with dual-bookbuild structure) that is obviously shorter than the structures currently used in the UK.
The Rapids structure is similar to an open offer with compensation: there are no nil-paid rights which can be traded during the offer period and at the end of the offer period the rump (unsubscribed shares) is sold in the market, with the subscription price going to the issuer and any profit distributed pro-rata among the non-accepting shareholders.
Rapids differs from the open offer with compensation in that it splits the pre-emptive offer between institutional and retail shareholders, with the institutional offer run on an accelerated timetable. This splitting of the share register is determined by the issuer following consultation with its financial advisors, with regard for the identity of underlying beneficial shareholders behind nominee accounts. It divides the equity raising into four stages: institutional entitlement offer; institutional bookbuild; retail entitlement offer; and retail bookbuild.
Institutional shareholders may subscribe for their pro-rata entitlement at a fixed offer price and are required either to accept or renounce their entitlement within two days of the offer’s launch. Once completed, the bookbuild sale process sees those shares not taken up by institutional shareholders offered for sale to institutional investors. Any excess of the bookbuild price above the fixed offer price is distributed pro-rata among those institutional shareholders who do not take up their entitlement in full or in part.
Following the institutional bookbuild, shareholders classified as retail are given the opportunity to participate in the retail entitlement offer on the terms set out in a prospectus lodged with the Australian regulator. The offer period normally lasts for three weeks, giving these generally less sophisticated investors more time to consider fully, whilst in possession of all material information, whether or not, and to what extent, to accept the offer. Retail shareholders receive the same pro-rata entitlement to new shares as institutional shareholders at the same fixed offer price.
The bookbuild sale process sees the shares not taken up by retail shareholders offered for sale to institutional investors at the retail bookbuild price. If this exceeds the fixed offer price the excess is paid pro-rata to those retail shareholders who do not take up their entitlement in full.
For companies with a significant institutional shareholder base, the majority (experience suggests between 60%-80%) of the proceeds of a Rapids capital raising will be received in very short order through the institutional component. The settlement and allotment of new shares under the institutional entitlement offer and bookbuild occurs simultaneously, seven to 10 days after the launch of the offer. The allotment of shares and the settlement of the retail component occur approximately one month after the launch.
Due to the brevity of the institutional element of the offer, the risk of market conditions deteriorating during the course of the offer period is significantly reduced. An issuer can therefore be far more confident that it will receive the majority – at least the institutional proportion – of the proceeds of the offer.
But despite its obvious attractions, Rapids incorporates a number of features which inhibit its compatibility with UK practice. The institutional offer is made before a prospectus is published, while section 85 of the Financial Services and Markets Act of 2000 requires that a prospectus be issued before an offer is made.
Certain exemptions do exist and it may be unnecessary to publish a prospectus in advance of an offer where, for example, the offer is made exclusively to qualified investors or to fewer than 100 persons (excluding qualified investors) in any one EEA member state. Equally, it would probably not be too onerous to require an issuer to bring forward the publication of the prospectus by a few days so it is published before the institutional component begins. Yet concerns remain that it is irresponsible to allow institutions to invest having had so little time to digest the contents of the prospectus.
The fact that the institutional element of the Rapids model is significantly shorter than the current 10 day minimum in the UK would require changes to both the listing rules (rule 9.5.6) and the admission and disclosure standards (paragraph 3.9).
The listing rule restriction on discounts in excess of 10% would also prove problematic and would need to be lifted in order to make Rapids viable. Share dealings are suspended during the institutional offer on a Rapids capital raising, which the UK markets are keen to avoid. And listing principle 5 requires a listed company to treat “all holders of the same class of its listed equity securities that are in the same position equally”. There remains some doubt as to whether the splitting of the shareholder register and the running of two separate processes under the Rapids system adheres to the spirit of this principle.
It is therefore probable that the FSA will conclude that the Rapids model would require too many amendments to the current law to be worth considering for adoption in the UK. It would perhaps come as too great a shock to the conservative, increasingly risk-averse UK fundraising system.
But it seems very likely that the compensatory open offer will become a genuine alternative to the rights issue, since the compensatory element goes a long way towards making up for the loss of the ability under a rights issue to trade in nil-paid rights. The only significant amendment required to existing law and regulation would be the dropping of the 10% limit on discounts - a restriction which can already be avoided, provided the terms of an offer at a greater discount are specifically approved by the issuer’s shareholders.
Inevitably, the FSA will recognise the need for speed in raising capital, which will lead to more, and faster options being made available to listed companies seeking to raise additional equity finance than exist at present.