The Rights Issue

The following article aims to highlight the various elements of a rights issue of companies whose shares are listed on the stock exchange. A company that requires additional capital, be it for growth or for regulatory purposes, will turn on its shareholders for that funding either because other sources may be more expensive, or because it is not allowed to do otherwise in terms of regulation (especially with licensed institutions such as banks) or because it wants keep a healthy balance between its debt and equity proportions.

Preemption rights (the right to be offered the first option in a transaction) afforded to shareholders in our Companies Act require that if a company wishes to increase its share capital, the company needs to make an offer to its shareholders for them to be able to participate in the increase in shares. Why is such right important? This right is best explained in an example – let’s assume a company has 100 shares in issue held equally amongst 10 shareholders. At this stage, each shareholder owns 10% of the company. The company needs to increase its share capital through the issue of 100 new shares. Without such right, the company may issue those shares in favour of an entirely new shareholder. Suddenly, the previous 10 shareholders no longer own 10% of the company, because their 10 shares, now a percentage of 200 shares, shrink their holding to 5% of the company. The instance where the percentage holding goes down (in this case from 10% to 5%) is known as dilution of shareholding. With preemption rights afforded in our company law, the company is bound to offer the new shares first to the existing shareholders, and then to anyone else should the existing shareholders not wish to take up their entitlement of the new shares – this will give the option to the shareholders as to whether they opt to take up the shares or not and hence be diluted.

For the company to be allowed to issue new shares immediately to new shareholders, the existing shareholders, in a general meeting, will need to resolve (agree) to allow the company to do so.

Therefore, in terms of the preemption right of shareholders, when a company wishes to increase its share capital through the issue of new shares, it would typically go for a rights issue. As the name implies, depending on the number of shares that an existing shareholder holds, s/he will have a right to acquire new shares in the company in proportion to their existing holding. Thus, if a shareholder holds 5% in a company, it will be entitled to 5% of the new shares. The entitlement of each shareholder is typically disclosed in a purposely drawn-up document (known as “Prospectus” – further detail below) as the number of new shares entitled for a number of shares held – e.g. 5 new shares for every 20 shares already held.

The company issuing the new shares needs to have the ability to do so in terms of ‘balance’ of authorised but unissued shares. The share capital of a company consists of the issued number of shares forming part of the authorised number of shares of the company. In essence, the company would typically have a number of authorised shares (which is the maximum amount of shares that can be in issue at any point in time) and from that authorised amount of shares, it would have a number of issued shares (the shares that have been allotted as paid up share capital to the company’s shareholders). The issued shares can never be more than the authorised shares and as such, before a company proceeds to launch a rights issue, it needs to ensure it has enough balance of authorised and unissued shares for this corporate action. If the balance of authorised unissued shares is not enough for this corporate action, then the company needs to call a general meeting to seek approval from its shareholders to increase the authorised share capital and thus create the necessary balance.

The process with a rights issue of listed entities in Malta would commence with the preparation of a prospectus, which will be addressed primarily to its shareholders, giving them an overview of the company, its business, the risks related to the company and its financial status (in the part known as the Registration Document) and produce an understanding of the mechanics of the rights issue as well as a description of the characteristics, the risks, rights and obligations pertaining to the shares being issued (in the part known as the Securities Note).

The prospectus will also include the price of the rights. In pricing the new shares, the board of directors of the company would need to consider the nominal value of the shares – this is a level below which a company may never issue its shares for – and the value of the shares of the company on the secondary market. Pricing the new shares at a premium to the market value of the shares on the secondary market would not make the offer attractive, as investors would go to the secondary market to purchase shares at a lower price than that offered to them via the rights issue exercise.

Once the prospectus is approved by the competent authority within the Malta Financial Services Authority (MFSA) and the necessary company announcements are made, the company sends out a copy of the rights issue prospectus and an application pack to the shareholders as at the record date – shareholders on the company’s register of members as at the record date would be eligible to participate in the rights issue. This date is set by the company and is typically announced in the same announcement that the company publishes on the submission of an application to the MFSA for the approval of the prospectus and the admissibility to listing of the new shares subject to the rights issue.

The application pack that is sent out to shareholders would include what are known as provisional allotment letters (or PALs). These are forms which allow an existing shareholder a number of options in relation to the rights assigned to him/her. Perhaps the most straightforward right is that of acceptance of all the rights assigned to the shareholder. This form will simply require a shareholder to sign and return to his/her preferred financial intermediary (from a list included in the prospectus) along with the payment for the shares being acquired. This particular PAL is not transferable - if a shareholder wishes to ‘pass on’ the right to the shares to someone else, in full or in part, the other form(s) would apply. The other PAL allows the existing shareholder to either take up part of the entitled shares or assigns part or all of the entitlement to someone else. If a shareholder wishes to transfer part of all the entitlement to another investor, there will be space in the PAL which would allow for such transfer. It would then be up to the incoming investor to pay up for the new shares being transferred to him/her.

Any rights to the new shares which are either not taken up by the existing shareholder nor transferred to someone else become known as ‘lapsed rights’. What is particularly seen when the rights issue is large is that the existing shareholders who take up their full entitlement of the rights are allowed to make a provisional application (typically in the same PAL where they apply for their full rights) for any lapsed rights available. Another option available is to have an underwriter for the lapsed rights – someone who steps in and takes up any balance (or pre-agreed amounts from the balance) of lapsed rights – underwriters are typically either banks or could also be majority shareholders of the company). Lapsed rights may also be made available to financial intermediaries to subscribe for the new shares either for their own trading account or on behalf of clients or funds.

What is particular with lapsed rights is the possibility of there being a bidding process – the rights for the new shares are priced in the prospectus, however, the lapsed rights may be subject to a bidding process whereby those applying for lapsed rights may do so competitively at a price which is at least the price of the rights but can be higher, thus ensuring a better chance of acquiring the new shares if the price is higher than that of other bidders for the lapsed rights. The company has the obligation under the Listing Rules to distribute any premium obtained in the lapsed rights bidding process to the non-accepting shareholders to whom those lapsed rights relate (this only applies were the premium per non-accepting shareholder equates to amounts of EUR5 and over).

All shareholders, as the company’s owners, partake in all risks and rewards attached to that shareholding. It is therefore very important for shareholders to understand the rights and obligations pertaining to their shareholding in companies ahead of acquiring and owning shares.

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