Cheap-Stock Tunneling Around Preemptive Rights

Cheap-Stock Tunneling Around Preemptive Rights

Jesse Fried, Holger Spamann

July 03 2018

Corporate insiders may engage in tunneling—transactions to transfer value from outside shareholders to themselves. Reducing tunneling is corporate law’s most basic function, as fear of tunneling undermines entrepreneurs’ ability to raise capital from outside investors. Preemptive rights are the oldest and most widely-used tool for preventing one of the main forms of tunneling, “cheap-stock tunneling:” an equity issue to the insiders at a low price that economically dilutes the interest of outside shareholders. To defend against cheap-stock tunneling, preemptive rights give all shareholders the right to participate pro rata in equity offerings. In listed firms, preemptive rights are implemented via “rights issues” in which a firm distributes to all shareholders pro rata rights to buy additional shares.

The conventional view is that preemptive rights are effective against cheap-stock tunneling. According to the leading comparative corporate law treatise (Kraakman et al. 2017, p. 182), “preemptive rights … discourage controlling shareholders from acquiring additional shares from the firm at low prices.” Around the world, issues featuring preemptive rights are quite common because many non-U.S. jurisdictions grant preemptive rights as a default whose waiver can require super-majority shareholder approval, regulator review, or both. And although preemptive rights are no longer the default in the U.S., the logic of preemptive rights still has currency in U.S. law: U.S. courts have rejected cheap-stock tunneling claims by outside stockholders on the grounds that the controlling shareholder had voluntarily offered pro rata participation in the issue, an offer often made by a controlling shareholder precisely to cut off minority remedies.

Our paper shows, however, that preemptive rights provide only partial protection against cheap-stock tunneling when corporate insiders know that the shares are cheap but outsiders, with inferior information, believe that the shares could be either cheap or overpriced. The crux of the matter is that cheap-stock tunneling is not all outsiders need to worry about when deciding whether to exercise their preemptive rights: They also need to worry that the controller might have set the offer price high, either because insiders hope to sell overpriced shares to others or because insiders expect to privately benefit from the issue proceeds. While it should be clear that preemptive rights cannot solve these two other problems, our novel insight in this paper is that the mere possibility of their presence partially undermines preemptive rights even in the domain where these rights are thought to be effective: cheap-stock tunneling.  If outsiders cannot figure out whether the offer is cheap or overpriced, outsiders are damned if they participate in the issue and damned if they do not (at least probabilistically). The result, we show, is that some outsiders will not exercise their preemptive rights when the price is in fact (and unbeknownst to them) cheap and thus cheap-stock tunneling will occur.

Our paper shows that preemptive rights are not completely useless, as they do prevent the most extreme forms of cheap-stock tunneling. Our analysis provides an additional reason, however, why both sophisticated investors in unlisted firms and regulators of listed firms supplement preemptive rights with other mechanisms to reduce cheap-stock tunneling, such as caps on equity issues, director fiduciary duties, supermajority voting requirements, or even issue-veto rights. Finally, our analysis sheds light on outside-shareholder and insider behavior around equity issues, particularly rights issues by listed firms with controlling shareholders.