Understanding rights issues

A rights issue is an invitation to existing shareholders to purchase additional new shares of company. More specifically, this type of issue gives existing shareholders securities called ‘rights’ which give the shareholders the right to purchase new shares at a discounted price during a stipulated period. For a good stock it is a bargain to get additional shares “rights” at a discounted price and ensure that one’s shareholding is not diluted by the additional shares offered onto the market.

Rights are generally issued on ratio basis e.g. two-for-three rights issued, which means that for every 3 shares held, a shareholder is entitled to 2 rights. Although existing shareholders have the privilege to buy a specified number of new shares from the firm, at a price usually lower than the prevailing market rate, some may choose to sell part or all their rights on the open market since these rights are transferable.

Because the company is getting the shareholders' money in exchange for issuing rights, a rights issue is a source of funds for the company issuing it. Companies therefore turn to rights issues in order to raise capital.

 Troubled companies typically use rights issues to pay down debt, especially when they are unable to borrow more money. But not all companies that pursue rights offerings are shaky. Some with clean balance sheets use them to fund acquisitions and growth strategies. For reassurance that it will raise the finances, a company will usually, but not always, have its rights issue underwritten by an investment bank or an insurance company.

        
Responding to a rights issue

As a shareholder, you essentially have three options when considering what to do in response to the rights issue. You can:

• Purchase all/part of one’s rights.
• Ignore (renounce) your rights completely.
• Sell all/part of one’s rights through the stock market.
• Transfer all/part of one’s rights to a family member.

1. Take up the rights to purchase in full or in part

To take advantage of the rights issue in full; a shareholder will apply for all the rights allotted to them. Shareholders can also apply for non subscribed rights. These are rights that are allotted to shareholders but not take up. To apply for non subscribed rights, a shareholder will purchase ADDITIONAL SHARES as well. Shareholders can opt to purchase part of one’s entitlement by paying only for the rights that one can afford.

2. Ignore the rights issue

A shareholder may not have the money to purchase the additional shares even at a discounted price and may decided to let their rights expire. This is not normally recommended. If you choose to do nothing, your shareholding will be diluted because of the extra shares issued.

3. Sell your rights to other investors
In some cases, rights are not transferable. These are known as ‘non-renouncable rights’ But in most cases, your rights allow you to decide whether you want to take up the option to buy the shares or sell your rights to other investors. One can decide to sell one’s rights or sell a few and purchase the rest. Rights that can be traded are called ‘renouncable rights’, and after they have been traded, the rights are known as "nil-paid rights".

4. Transferring the shares to a family member.

A shareholder can opt to transfer the rights to a member of the nuclear family. Rights can therefore be transferred to one’s Mother/Father or ones sister/brother or one’s child. Evidence of the relationship must be submitted for the transfer to be effected.

5. The Provisional Allotment letter

This is a temporary document of title by which new shares are offered to shareholders during a rights issue. The PAL shows each shareholder’s entitlement to the new shares, and can be traded in part or in full.

A PAL comes in 4 forms:

• PAL A; This allows the shareholder to buy the shares in full or in part while opting to sell the balance or transfer it to a member of their nuclear family (This is made available to Shareholders in their Mail);
• PAL B; Members of the public who are not shareholders can also participate in this offer by buying the rights off the stock market. PAL B facilitates the purchase;
• PAL C; This form is filled in by the beneficiary of the transfer if a shareholder opts to transfer one’s rights;
• PAL D: This is filled in by shareholders who wish to sell their rights on the stock market. Shareholders can choose to sell all or part of their rights.

NOTE: PAL B, C & D is made available through the broker agent.

Caution statement

It is awfully easy for investors to get tempted by the prospect of buying discounted shares with a rights issue. But it is not always a certainty that you are getting a bargain. One may need to ascertain the purpose of the additional funding before accepting or rejecting a rights issue. Be sure to look for a compelling explanation for the rights issue undertaking. Sure, a rights issue can offer a quick fix for a troubled balance sheet, but that doesn't necessarily mean management will address the underlying problems that weakened the balance sheet in the first place. It would, for example be more risky to invest in a company issuing rights for the purpose of paying debt.

This is because such a company may not be able to increase profits as a result of the additional capital leading a reduction in Earning per Share(EPS) and subsequently reducing the company’s share price. On the other hand, a company seeking to increase production is more likely to have an impressive balanced sheet – a common symptom of an increasing share price.

Bottom line..., be informed first, and then invest.