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When Rights Go Wrong

Recent banking rights issues show which parts of the process work — and which don’t.
Tim Burke, CFO Europe Magazine
October 3, 2008

It takes a combination of bad luck and bad decisions to become a textbook example of how to mishandle a rights issue. Bradford & Bingley found this out the hard way. First, the UK mortgage lender announced a £300m (€374m) capital increase in May after denying press reports that it was considering such a move. Next, as its share price fell and its chief executive, Steven Crawshaw, stepped down on health grounds, the bank slashed the rights issue offer price and promised private equity firm TPG a 23% stake in the company in return for a £179m investment. Then, when ratings agency Moody's downgraded the bank's stock, TPG dropped out of the deal and the share price fell close to the new issue price of 55p. While institutional investors jumped in after TPG's withdrawal, existing shareholders took up less than 30% of the new shares by the deadline in late August.

Many of Bradford & Bingley's woes were self inflicted, accelerated by poor management and antiquated information systems that left it slow to react to its own problems and fast-changing moods of the market. But the drawn-out saga also shows that rights issues, previously regarded as a pedestrian way to raise funds, have their drawbacks during these troubled times. (So troubled, in fact, that Bradford & Bingley was nationalised in late September.) The question now is what changes can be made so that other companies raising funds find the rights route quicker and simpler?

Much Could Change...
With the first anniversary of the start of the credit crunch having just passed, a record number of banks have gone to shareholders for record amounts of cash through rights issues. (See "Cap in Hand" at the end of this article.) Belgian-Dutch bank Fortis, part-nationalised over the same weekend as Bradford & Bingley, tapped shareholders for €13 billion in September 2007 to help fund its portion of the takeover of ABN Amro. France's Société Générale announced a €5.5 billion rights issue in January this year to help it recover following its massive rogue trading case. And another French bank, Natixis, is currently closing a €3.7 billion rights issue to repair its damaged balance sheet. But it's the struggles of Bradford & Bingley and two other UK banks — RBS and HBOS — that have attracted the most attention.

With their rights issues underwritten by investment banks, the three companies were never in danger of missing out on getting the funding they wanted, but their fortunes were nonetheless varied. Less than 9% of the shares in HBOS's £4 billion capital raising were taken up by shareholders. RBS's £12 billion rights issue — the largest ever in Europe — was successful, but its shares were extremely volatile during the offer period.

Because of such share price swings, many finance experts have begun to wonder whether there are problems in how rights issues are brought to market. Merrill Lynch underwrote part of RBS's issue, and Rupert Hume-Kendall, the bank's chairman of global equity capital markets, says he's rarely seen a company "so heavily buffeted" by speculative investors "just attempting to make whatever money they could out of shorting stock, hedging stock, moving it backwards and forwards." He adds that the experience left him with "a very strong feeling that there should be significant restrictions on trading during the rights offering period."

The Financial Services Authority (FSA), the UK watchdog, has already taken action. In June it confirmed that investors would have to disclose "significant short positions" in companies making a rights issue. While it noted that short selling is "a legitimate technique, which assists liquidity and is not in itself abusive," it added that "the rights issue process provides greater scope for what might amount to market abuse." Since then, market turmoil has prompted the FSA to ban outright short selling in financial stocks until January 2009. Beyond short selling, the watchdog has launched a review into how capital raisings can be made "more orderly and efficient." Whether changes following the review will be made to the law, regulation or just best practice remains to be seen.

For its part, the Association of British Insurers, whose 400 members account for some 20% of all investments on the London market, suggests the rights issue timetable could be shortened and prospectus requirements simplified.

Other changes UK experts say may be beneficial include a more flexible use of institutional investor guidelines on pre-emption rights — whereby existing shareholders have first right of refusal for new shares — so that foreign investors are more readily able to invest in London-listed companies during a rights issue. "You have western companies in distressed financial conditions looking to raise funds from shareholders who perhaps don't have the funds to give, and you have capital surpluses in the Middle East," says John Lane, a partner at law firm Linklaters. "Pre-emption is a major feature of the UK market and will continue to be. It shouldn't, however, be a straightjacket. Having some non pre-emptive elements alongside rights issues will increasingly need to be looked at."

Where should the UK look for inspiration? In countries such as France and Portugal, shareholders are allowed to bid for the rump of a rights issue — the shares left over when all investors have taken up or rejected their rights — before it becomes available, which eliminates what Hume-Kendall calls the "rough and tumble" auction of the rump that often occurs at the end of a UK rights issue. In Australia, companies use a dual timetable which ensures that institutional investors are signed up in a matter of days rather than weeks, cutting the time for which underwriters are "on the hook" for that portion of the capital, giving retail shareholders a longer period in which to exercise their own rights.


...But Probably Won't
For the London market to swipe all the remaining good ideas from other jurisdictions would be a daunting degree of change for bankers, advisers and companies alike. Reality is likely to be more prosaic, and few onlookers expect sweeping changes to come from the FSA review, which is expected to complete before the end of the year. Bankers speaking with CFO Europe, for example, agree with the ABI that pre-emption rights are a central part of the process. It seems more likely that a slight tweaking of the rules is on the cards.

The timetable could be shortened, perhaps by reducing the offer period from 21 to 14 days. As Russell Julius, head of equity capital markets at HSBC, points out, in an age of email, insisting that shareholders receive and send paper documents during the offer is old-fashioned, and a week could be shaved off a typical rights issue by requiring shareholders to communicate electronically. Julius also believes that the review might lead to more widespread use of a "stand by" pricing system, so that the price of a rights issue isn't announced until the night before the shareholders EGM, reducing instability in the issuer's share price during the rest of the process.

Whatever happens, the current turmoil in credit markets makes it likely that companies in more sectors will consider rights issues for raising funds, and their CFOs may wonder what lessons they can take from the experiences of their financial-services peers. For Linklaters' Lane, it's a matter of deepening their knowledge. "Some of the companies that have engaged in rights issues might have welcomed a clearer understanding of some of the market risks and changes to banks' approach to risk management, as well as the nature of the sub-underwriters," he says. "I wonder if there isn't a case for better education of boards of directors about what's involved in the process."

By way of example, Lane cites the difference between UK rights issues of old — when the use of long-only institutional shareholders to handle sub-underwriting reduced the risk for the underwriting bank — with today's practice, in which the involvement of hedge funds and other market participants may exacerbate volatility in the issuer's share price. "If companies made more effort at an early stage of a share issue to understand how their banks and shareholders are managing their risk, they would be better able to respond effectively to market volatility, short selling and dramatic changes in investor sentiment," suggests Lane. That's something for cash-hungry CFOs in many industries to start pondering sooner rather than later.

Tim Burke is senior editor at CFO Europe.





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