RIGHTS OFFERINGS – THE GOOD, BAD AND UGLY WHEN STARVED FOR CASH

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In the current economic environment, where companies’ share prices are significantly depressed and outside financing is hard to come by, a rights offering provides a viable way of attracting investment from existing shareholders. A rights offering occurs when a company issues rights, at no cost, to its shareholders to purchase additional shares of the company. It is, in essence, a cash call to existing shareholders providing them with the opportunity to purchase a pro rata portion of additional shares at a specified per share price typically set below the market price.

A rights offering may be effected by means of a prospectus offering in compliance with applicable securities laws and, if the shares of the company are publicly traded, in compliance with the policies of the applicable stock exchange. Several jurisdictions also have securities laws that provide for a prospectus exemption for rights offerings, in which case the rights offering is made pursuant to a rights offering circular.

In essence, a rights offering is similar to a warrant or an option distribution because it enables the holder to acquire another security. However, a rights offering differs from a warrant or an option distribution in that the right can only be granted to an existing shareholder. Rights are typically transferable and can be transferred at cost to third parties but cannot be granted to investors who are not shareholders.

The Good

The decision to finance through a rights offering is shaped by both considerations regarding the unavailability of bank financing and the current economic market. It offers a viable alternative to reducing debt and strengthening the company’s overall equity, without the need to find new investors.

It is less costly than a traditional underwritten equity offering and less risky in circumstances where the company is not sure that it is capable of triggering the necessary investment excitement among the investing public.

A rights offering relies on the existing shareholder base and allows all major participants with vested interests to retain their proportionate share of the company.

The Bad

A rights offering by a high profile company intended to strengthen its balance sheet is often a sign of distress. When profits are low, the potential dilution of future profits is not greeted with great optimism by shareholders. Without an appropriate change to the underlying business, a change in the capital structure is not of great benefit to the shareholders.

A more optimistic variation of a rights offering is when it is used to fund an expansion although shareholders may be equally suspicious of ill-advised “empire building” by management.

A very significant discount to market price can also be regarded as a means to extricate the company from foreboding issues rather than to secure future growth opportunities.

The How To (The Ugly)

A rights offering’s attractiveness and success depend on a number of key factors.

The pricing of a rights offering is the most difficult and important step in structuring the offering. A significant discount to market price can be a great incentive to existing shareholders’ participation in the offering. It is also mandated by the Toronto Stock Exchange (the “TSX”) rules that TSX listed companies are expected to offer the rights at a significant discount to market price. Sometimes the discount will be more significant if the shareholders’ appetite for the shares needs to be stimulated. This discount means that there is an inherent value in the rights offered that can be realized immediately upon distribution, provided the rights are transferable even if the shareholders do not want to take up the shares themselves. For exchange listed companies, the general rules is also that the subscription price for shares to be acquired on the exercise of rights during the rights offering cannot be less than $0.05 per security.

Rights offered at above-market price are subject to stricter securities regulatory rules, some of which are triggered if rights are issued to 5 to 10 per cent or more of the outstanding security-holders or for 5 to 10 per cent or more of the issued securities of a class, all depending on the jurisdiction of issuance. For example, under the above circumstances, insiders are not allowed to increase their proportionate interest in the company if the subscription price is greater than the market price or if there is no published market for the shares.

A second consideration is whether the rights offered should be made transferable or not. The transferability feature of the rights gives existing shareholders a choice between allowing their interest in the company to remain undiluted or realizing an immediate profit by selling the rights and thereby mitigating the economic effect of dilution. The TSX and the TSX Venture Exchange (the “TSX Venture”) mandate that rights be transferable for TSX and TSX Venture listed companies and that the rights be listed. Any proposed restriction on the transfer of unlisted rights must receive the prior consent of the relevant exchange.

A third consideration in structuring the offering is the decision whether to seek a stand-by commitment by a major shareholder or a financial institution. An issuer should structure an offering as a stand-by offering if the issuer must raise a specific amount.  The stand-by commitment acts as a guarantee that the necessary amount is raised even if the shareholders choose not to participate in the rights offering.

An issuer may also consider a stand-by commitment if the issuer’s share price is extremely volatile. Most shareholders will wait to the end of the period of the offering to decide whether to exercise their rights. As consideration for the risk taken, the stand-by commitment party is usually paid a fee plus an amount per share for each unsubscribed share purchased. In some cases, the stand-by commitment party may agree to split the profit made with the issuer if the rights offering is under-subscribed and the subscription price is below the market price. A stand-by commitment party can gain a fee income plus a guaranteed significant ownership position. Alternatively, a stand-by commitment party may also gain the ability to realize on the market difference by acquiring below-market shares and selling rights or shares at market.

In Ontario, a rights offering can only be implemented without a prospectus if the offering does not result in an increase of more than 25 per cent in the number of the company’s outstanding securities, including amounts raised in other rights offerings completed within the previous 12 months.

In addition, the TSX has discretionary authority to require a shareholder vote in the event that a dilutive share issuance that “materially affects” the control profile of an issuer continues in effect. Generally speaking, the control profile of an issuer is deemed to have been affected if an action results in a person or a combination of persons (or companies) acting in concert holding more than 20 per cent of the voting securities of the issuer. The net result is that a shareholder approval will generally be required for a rights offering where a stand-by commitment, when exercised, will result in the stand-by commitment party exceeding the 20 per cent of the outstanding voting securities. Shareholder approval may also be required even if the amount is less than 20 per cent.

As with any offering, companies should carefully prepare themselves. The conduct of a rights offering is generally regarded as material non-public information.

The company should also confirm before commencement of the process that it has sufficient authorized shares to fulfill the subscription rights. If that is not the case, then a company may need to seek shareholder approval to amend its articles before commencement of the rights offering.

Timing of the offering is an important consideration. It is important to note that the exercise period for a rights offering usually lasts for at least 21 days following the date on which a prospectus is sent to shareholders. If relying on a prospectus exemption, the exercise period cannot be longer than 45 days after the date the rights offering was accepted by the applicable securities regulatory authority. This timing is dictated by securities law rules and exchange rules.

The company must exercise caution in making decisions and representations with respect to the intended purposes for the proceeds. In Ontario, a company cannot rely on an the prospectus exemption to conduct a rights offering if the intended purposes for the use of the proceeds is stated to be the reactivation of a dormant or inactive issuer, for the financing of a material undertaking that would constitute a material departure from the business or operations of the issuer or if an excessive consideration is payable to the managing dealer.

Conclusion

A depressed equity capital market calls for consideration of all possible alternatives to traditional financing. Rights offerings may be a viable option for publicly listed companies with a significant number of shareholders with a vested interest in the company’s future. The success of a rights offering depends on a number of key factors. If timed carefully and structured as an exempt offering, it should be a less risky and costly alternative to a traditional prospectus offering that can infuse fresh capital in a cash starved but promising business enterprise.

The content of this article is based on the law in the Province of Ontario and is intended as general information only and is not intended nor shall be construed as legal advice.

Lucie Kroumova practices in the areas of corporate/commercial law, securities and mining law with McLean & Kerr LLP, Toronto.

By Lucie Kroumova

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