Powering Preemptive Rights with Presubscription Disclosure

Most corporations around the world have a controller: control is concentrated in the hands of either a single shareholder or a small group of shareholders acting in concert. Almost every unlisted (private) firm is a controlled firm. And many listed firms in the U.S. and most listed firms outside the U.S.—in Europe, Asia, and South America—are controlled firms.

In a controlled firm, outside investors are potentially vulnerable to tunneling transactions that shift value to the controller, including the sale by the firm of cheap securities to the controller: “cheap-issuance tunneling”.  To reduce cheap-issuance tunneling, most jurisdictions around the world grant preemptive rights as a difficult-to-waive statutory default in unlisted and listed firms; opting out can require super-majority shareholder approval, be subject to judicial review, or lead to substantial limits on the issuance amount. As a result, outside investors often have preemptive rights in an issuance.

Building on joint work with Holger Spamann, I explain that preemptive rights can prevent cheap-issuance tunneling when outsiders know that the offered securities are cheap. However, preemptive rights fail to prevent such tunneling when outsiders cannot tell whether the offered securities are cheap or overpriced. In particular, fear of buying overpriced securities will cause some outsiders to rationally refrain from purchasing, and these refraining outsiders will suffer losses if the securities are, in fact, cheap. On the flip side, participating outsiders will suffer losses from another type of mispriced-issuance tunneling (“overpriced-issuance tunneling”) when the securities’ price is, in fact, high.

I then demonstrate that outsider losses from cheap-issuance tunneling (and overpriced-issuance tunneling) could be substantially reduced by requiring the firm to disclose the controller’s subscription commitment before outsiders must decide their own, thereby enabling outsiders to “mimic” the controller. Such presubscription disclosure, which is already required by the People’s Republic of China (PRC) for certain issuances by listed firms, should be imposed on both unlisted and listed controlled firms. The paper explains how such a requirement should be structured, including simple anti-circumvention measures.