Pre-emption rights are taken more seriously in Britain than almost anywhere else, yet the merits of our treasured system of rights issues are being sorely tested by the present raft of cash calls among banks.
Despite deep discounts when they were launched, the Royal Bank of Scotland rights issue only just scraped home, Bradford & Bingley's was a fiasco that could easily have sunk the mortgage bank completely, and the HBOS issue threatens to be left with the underwriters.
Are rights issues really an appropriate capital raising mechanism for the distress cash calls we have witnessed in recent months? This was one of the subjects of debate at yesterday's summit of City leaders at Mansion House, hosted by the Chancellor, Alistair Darling.
The Financial Services Authority has agreed to have a long, hard look at the whole system, which, even if not eventually abandoned, certainly needs modernising to give it the speed and effectiveness required by today's fast-moving capital markets. Yet these are perilous waters, and we must be careful not to junk a system which in many respects remains superior to the costly and untransparent alternative of American share placements.
The purpose of a rights issue is to protect existing shareholders from dilution by giving them first rights of refusal on any capital raised. If they don't want to subscribe, then their rights are sold in the market so they still get the proceeds of any discount.
Unfortunately, it is hard to argue that any of the three banking rights issues announced in recent months has acted to the benefit of existing shareholders. To the contrary, by creating a target price for short-selling hedge funds to chase, they seem only to have harmed the long-term interests of the company and its investors.
Would it not be better to adopt the American system, where, as with Lehman Brothers last week, new shares are placed with friendly investors at the narrowest discount the market will tolerate, thus getting the process of capital raising over and done with cleanly and effectively before the market has a chance to deteriorate further?
Such an approach might have prevented the Bradford & Bingley debacle, where there was a serious danger of the company not getting its money at all, an out-turn which could have triggered a life-threatening run on the bank. It might also have spared the present pain at HBOS, and possibly protected the share price from the pummelling of recent weeks.
What's gone wrong is that the rights process, with the accompanying requirement to circulate shareholders with detailed documentation on the business and its plans, simply takes far too long – astonishingly nearly three months in the case of HBOS.
This has made capital raising highly vulnerable not just to short-selling speculators, but also to a general deterioration in the economic environment. The outlook for banks has got markedly worse since HBOS announced its rights issue, with outright recession now more likely and central bankers forced to turn hawkish on interest rates to stamp out inflation. The world has changed, yet the rights were designed for the world as it was.
Even if Barclays and others who have not yet done rights issues were minded to follow suit, the whole process has now become so discredited that they probably wouldn't dare. The rights issue system is in danger of becoming an obstruction to the provision of possibly vital rescue capital. At the very least, the process needs to be made quicker, possibly by allowing electronic mailing of documentation and money.
Yet it is a bit late for reform now, and, in any case, it would require changes in both British and European law. The need is immediate. Barclays, which had determined not to go the rights issue route to new capital and instead has been seeking "strategic" new investment from sovereign wealth funds and others, has been wrestling with how to deal with pre-emption rights and found no easy way around them.
Guidelines require that pre-emption must be applied for new shares issued above 5 per cent of existing capital. Bank share prices have sunk so low that 5 per cent cent would no longer be enough to make a material difference to capital ratios at Barclays.
Even so, we should tread warily in scrapping a system of capital raising which in most cases works well. There is considerable vested interest behind the lobby to adopt the American placement method, where fees are far higher than are earned on a traditional British underwriting. For evidence of this, just look at the extortionate fees being charged to Bradford & Bingley by Goldman Sachs for bringing in Texas Pacific as an investor after the original rights issue came unstuck.
What's more, pre-emption continues to provide a powerful defence against incumbent management diluting existing shareholders with those more friendly to its ambitions. Rights issues need reform, but let's not throw the baby out with the bathwater.Reuse content