When a company is short of capital, it can raise funds through rights issues or placings. However, fundraising can be detrimental to the shareholders if any of the company's majority shareholders or market manipulators have ulterior motives and use this as a manipulative tool. Investors should therefore pay close attention to the purpose of these fundraising activities and ascertain whether there is a compelling case to invest more money to buy the rights shares.
Highly dilutive rights issues
Shareholders should have a good understanding of the subscription ratio and price discount. The subscription ratio is the amount of additional shares that the shareholders can buy based on their existing shareholdings. The rights shares will invariably be offered at a discount over the market price to encourage existing shareholders to take them up.
Rights issues can have a dilutive effect on share value. In general, the higher the subscription ratio and the larger the price discount, the larger the dilutive effect and potential dilution to the non-subscribing shareholder's investment. The Stock Exchange of Hong Kong (SEHK) refused a rights issue that was on the basis of 20 rights shares for 1 share and at a 90% price discount at the end of 2016. The dilutive effect of the rights issue would have been 85%; in other words, if the original share price was $10, the theoretical ex-rights price would be $1.5. If shareholders did not subscribe to the rights shares, the theoretical value of their shareholdings will be diluted by as much as 85%.
Repeated rights issues at high ratio with sizeable discounts are likely to alarm the shareholders. There was a case whereby a company, after two rounds of highly dilutive fundraising exercises, proposed yet another fundraising within two years. The cumulative dilutive effect would have been 97% if the proposal had gone ahead.
Share consolidation before a rights issue
A share consolidation is used to reduce the number of shares being traded. Following several rights issues and placings, the share price of the company may have fallen substantially. In such cases, the company may propose a rights issue after a share consolidation, in order to meet the minimum trading price requirement. This could potentially be regarded as a downward price manipulation tactic.
Transfer of ownership
Fundraising exercises can lead to transfer of ownership interests of a company. If retail shareholders do not subscribe to the rights shares, then the underwriter can take up the unsubscribed shares via the underwriter arrangement. A shareholder who does not participate will suffer a drop in shareholding which opens the opportunity for others, such as majority shareholders and controlling shareholders, to strengthen their control or get the control over the company.
Highly dilutive rights issues have come under scrutiny in recent years because some of these have resulted in substantial dilution of retail shareholders' interests. The Securities and Futures Commission, together with the SEHK, are adopting a rigorous approach and closely monitoring highly dilutive fundraising activities. There have been instances where highly dilutive and repeated fundraising activities have been curbed as it was not in the best interests of the shareholders as a whole.
27 October 2017