Uncharted Territory

July 7, 2008

Righting Rights Issues: Issues

Filed under: Economics, Rights issues — Tim Joslin @ 5:49 pm

I spluttered on my morning coffee on Saturday when I read the advice to HBoS rights holders in the Guardian “Money” section (which I always enjoy reading for its coverage of telecomms and other rip-offs if there’s time left after the Killer puzzle in the main section!). What the Guardian writers neglect to tell their readers is that even though the HBoS share price is below the rights issue price (275p), and has been consistently for some days now, the rights still have value. This is because they are now in effect an option to buy the stock at 275p. This option is of value to people who, for example, may have sold HBoS shares short (no-one’s going to buy them simply to participate in the issue when they can buy the shares more cheaply in the open market). The short sellers will have to buy HBoS stock back at some point to close their position, and having an option to do so at 275p would protect them against some sudden good news on the UK housing market, say (I know, I know, we can but live in hope) or some sudden heavy buying of HBoS (perhaps more probable) causing the shares to rise suddenly. With many short-sellers trying to buy to close their positions at the same time it’s possible for the share price to rise rapidly – an extreme case of the phenomenon is termed a “bear squeeze”. An option to buy at 275p would limit any losses short-sellers could incur, or lock-in profits, depending on the price at which the shares were sold short. Investors may also want to buy the rights just in case HBoS shares do rise above 275p by the issue date (18th July), in which case they would be able to participate in the issue.

Right now the HBoS share (bid) price is showing 273.25p, and the rights are worth 6.25p (at HBoS). None of the following constitutes financial advice, but a “best guess” must be that the shares will not change very much at all before the rights issue date of July 18th – otherwise there would be an excess of buyers or sellers and the price would have already moved… Now, HBoS are offering to deal in the rights for nothing, so if you’re definitely not going to participate in the rights issue, it’s likely to be best to sell the rights straightaway. I say straightaway since the value of the option will decline (unless the share price increases) as we approach July 18th (because it expires on that date and the less time there is, the less chance HBoS shares will increase in value).

On the other hand, if, all along you’ve remained happy to “take a long-term view” and invest at 275p you could simply buy the shares in the market this afternoon for less than 275p and sell the rights for 6.25p each.

But if you simply let the rights lapse and the unsold shares are sold in the market it is very unlikely you will get anything back, let alone the “free money” the Guardian mentions. If no-one wants HBoS shares today at 273.25p it’s not likely they’ll be queueing up to buy them at 275p on July 18th, is it? Unless something changes, of course.

At first I assumed it was just the Guardian that was omitting the crucial bit of information that the rights have value even if the share price is below the issue price. But the Guardian was not alone. They report themselves that: “One newspaper this week bluntly advised shareholders to ‘dump this document in the recycling’ as the issue was dead in the water.”

Sunday morning, and once again I found myself spluttering on my coffee. An email from Motley Fool linked to an article “HBoS Rights Issue: Yay or Nay?”. Now, this is a freebie from an organisation that, if I understand their business model correctly, would like me to subscribe to premium content investment advice. Well, it hardly encourages me to sign on the dotted line when they identify the various options:

“1. You take up your rights, sending off a cheque for the full amount

2. You partially take up your rights. In practice, you sell most of your rights and use the proceeds to buy some shares. This process is sometimes called tail swallowing.

3. You sell all your rights and receive the proceeds which will depend on the market price at that time.

4. You do nothing and, at the end of the rights issue process, your rights are sold and you receive the proceeds.”

and go on to say:

“However, when the share price falls between the announcement and completion of the rights issue there is an additional complication. If the share price falls below the rights issue price there is no point taking up your rights as you can buy the shares more cheaply on the open market. This is why it often pays to wait and see what happens with a rights issue rather than making a decision straight away. A share price fall of this magnitude also means there will be no money available to fund option 2 and no sale proceeds from options 3 and 4.”

As I’ve already demonstrated, it is simply not true that there will be “no sale proceeds” from option 3. By the same token, if you chose option 2, HBoS would (presumably) sell the rights for you now at around 6.25p each, so, since you’re likely to have at least 100 rights, you would end up with a few shares come July 18th.

Since the media are fairly consistently encouraging people to ignore the rights issue altogether I wondered how much this might be costing the poorer-than-last-year HBoS shareholders. The prospectus advises me that the Rights Issue is of 1,499,662,328 shares – call it 1.5 billion (who skimmed the missing 337,672, I wonder?!). HBoS has a lot of direct retail investors – though unfortunately the Rights Issue prospectus doesn’t seem to tell me the number of shares in small holdings – but if it’s even 10% of the stock that’s 150 million rights. If even 10% of these fail to sell their rights because of what they’ve read in the press, then that’s 15 million rights that have lapsed unnecessarily. This is not enough to swamp the market – HBoS are selling far more than that on a daily basis – so they could be sold for (say) the 6.25p on offer today. 15 million x 6.25p is near enough £1m. So on my assumptions (which I consider fairly generous), the press would have cost the suffering shareholders of HBoS amongst their readers a collective £1m windfall. Not to mention their employers the massive fines for giving poor financial advice which are surely heading their way! 😉

Surely avoiding little slips like this in future would justify for a week or two of remedial training for a few financial journos at their friendly local business school.

But I digress.

I wanted to revisit my previous post on this topic, which got a little confused towards the end.

The issue of how banks raise additional capital is kind of important because, if they can’t do this successfully, they have no choice but to continue to ration mortgages (given the lack of any sign of a reopening of the market for mortgage securities – I’d have thought this would be a priority for GB at the G8, but not as important as the BOGOFs in my fridge, it seems, not that I don’t agree that these are a scandal). And the longer and tighter the rationing, the greater the suffering of homeowners, particularly first time buyers – often young families – and the fewer houses will get built, storing up even more problems for the future. Not a trivial problem.

Let’s recap. Rights issues by banks are not proving a rip-roaring success: it looks like the HBoS and B&B issues will mostly be left with the underwriters (perhaps they could have a BOGOF promotion or maybe they could give a “free” B&B with every HBoS…). And funds aren’t too enthusiastic to help (TPG at B&B).

I suggested in my previous post, that a number of problems could be avoided by awarding existing shareholders rights to purchase at a discount to the price on the day of the rights issue rather than at an arbitrary price announced prior to shareholder agreement to proceed with a rights issue, i.e about 6 weeks in advance.

I realise this might be a bit counter-intuitive. How can the new shares be at less than the price of the existing shares when in fact they are exactly the same thing? But we mustn’t confuse the cost of the new shares with their value. Only holders of the rights at the issue date will be able to buy the new shares at the offer price. And the market (arbitrage) will ensure that the new shares are issued at (almost) exactly the market price of the old shares less the (market) value of the rights needed to buy them.

In fact, we found laboriously last time, but could have worked out with 5 minutes reflection, that the value of the rights can be established accurately. In my scheme, remember, each existing shareholder receives a right to invest a certain amount of cash in the company per existing share, at a predetermined discount. The actual number of shares their rights will buy is determined by the price on the day of the rights issue (perhaps averaged over the day to prevent market abuse).

Let’s take HBoS as an example. Their share price was at about 460p when they announced that each existing shareholder could buy 2 shares for every 5 shares they already held, at a price of 275p – about a 40% discount at the time. What a bargain! But calamity struck! HBoS has sunk below 275p and most of these shares will be unsold. “Fortunately”, other banks and investment institutions have agreed to underwrite the issue and will offload the shares on HBoS’ behalf at whatever price they can get.

In my scheme, HBoS could have announced instead that every shareholder could invest 550p in new HBoS shares for every 5 they already hold, at a discount of 40% (this figure is not critical) to the price on the day of the rights issue. A tradeable right could have been created for each HBoS share giving the right to invest 110p on July 18th and obtain shares with a market value of 185p on that date.

Putting it this way it’s fairly obvious that the fair value of a right (granted per share held before the rights issue, remember) is 75p. This value will not be affected by any movements in the share price of HBoS before the rights issue date.

HBoS would have to create extra shares to allow for any fall in the share price between the date of the rights issue announcement and the actual rights issue. But this is not a problem. According to the prospectus they have created (as opposed to issued to shareholders) 2.5 billion shares ahead of the current rights issue, rather than the 1.5 billion they need. There’s nothing stopping them creating 10 or 100 times as many. Surplus shares can always be cancelled, or just retained by the company (all subject to agreement at shareholders’ meetings, of course).

Now, I suggest that this new method would avoid many of the problems we’re seeing:

– most important, it’s much more likely the money would be raised. The rights in the case of HBoS would, for example, be worth 75p a share whatever happened to the HBoS share price by the date of the rights issue. The rights price would fluctuate in the market, but not by much, since any fall would allow investors to make an immediate profit on the date of the rights issue. They could obtain the right to buy shares for 75p less than the market price for less than 75p! The value of the rights would never drop to a few pence, representing an option to buy the shares, since anyone owning them would simply lose 75p per share if they allowed them to lapse. It would be crazy not to either exercise the right or sell it.

– because the rights issue would not rely on the share price remaining above a predetermined level, traders (such as those evil hedgies!) could not profit by creating a short-selling bandwagon (with the ever-present temptation of spreading a few malicious rumours) hoping to make the issue fail, creating an overhang of shares in the market, depressing the share-price further. Short-sellers, of course, are hoping to buy back the shares for less than they paid for them. In the new scheme it becomes more rather than less important to take up your rights as the company’s share-price declines, since you receive more new shares the lower the company’s share price on the day of the rights issue. This acts against the short-sellers.

– in fact, I can’t think of how a rights issue based on a discount to the market price on the issue date rather than weeks before could come under speculative attack. The only potential problem I can think of is that holders of the rights would have an interest in lowering the share price before the rights issue date – they would gain at the expense of shareholders who had sold their rights – but to try to lower the share price would be market abuse (which could happen with any stock anyway). No bandwagon would develop because as soon as the overall value of the company fell below the market consensus, investors could profit from either buying the shares or the rights. This risk could easily be addressed by averaging the share price on which the rights award is based over a trading day (or longer). There’s also an inbuilt check for market manipulation: any movement of the rights significantly above fair value (75p in the HBoS example) would be a red flag to the regulatory authorities (though significant positions would also have to be disclosed, as at present). [The rights would be expected to trade at a little more fair value, 75p in my example, because they allow the holder to pay for HBoS stock in the future – i.e. the balance (110p per right in my HBoS example) can be invested elsewhere until the issue date.]. [Postscript: The fact that any market-manipulators would also be possibly able to profit by pushing the share price up and shorting the rights, is another factor weighing against a market bandwagon developing in the shares and/or the rights between the rights announcement and issue dates, in my suggested scheme].

– the costs of underwriting are much reduced. In my HBoS example, very few shareholders are likely to leave 75p on the table, so the underwriters would have very few shares to sell. In fact, the underwriters would most likely achieve more than the discounted price for shares to be sold on (but less than the market price), so would command a fee less than the value of the lapsed rights! That is, shareholders taking up the offer (or selling their rights) and the underwriters would make a small profit at the expense of any shareholders who allow their rights to lapse (judging by the post from Computershare which I “return to sender” unopened on a regular basis, some such shareholders may well have died some years ago!). At present the company (i.e. shareholders) have to pay a significant fee (I’ve read of 2-3% of the rights issue fee) to the underwriters whether or not the issue fails, and lapsed rights of a failed rights issue are worthless (i.e. no-one profits directly from the existence of lapsed rights since like a share option they have no intrinsic value).

I suggest that my new scheme is closer to the original intention of rights issues. The basic idea of a rights issue, I suggest, is that shareholders all agree at a meeting to put some more money into a company either to exploit an opportunity (e.g. develop a new product, fund a takeover) or to cover losses or a change in the economic climate threatening the company’s cashflow position or its ability to raise cash any other way (e.g. by issuing debt). The fact that the share price can fall below the rights issue price is merely a result of bureaucratic delays and the need to grant shareholders a period to raise the cash or sell their rights. The scheme I’ve described would sidestep the problems that can result from this delay, particularly in today’s fast-moving markets.

Worth a try?

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2 Comments »

  1. […] I wanted to provide an update to my previous post, as I have become aware of a couple of nuances and thought some more about the rights issue […]

    Pingback by Righting Rights Issues: Further Reflections « Uncharted Territory — July 10, 2008 @ 12:29 am

  2. […] issues remain dysfunctional as I explored here, here and here around 18 months ago (when HBoS was sensing a hat around, ironically enough). All […]

    Pingback by Lloyds Rights Issue complexity: Um, why don’t we just change the rules? « Uncharted Territory — November 3, 2009 @ 10:40 am


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