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In March 2009, HSBC PLC strengthened its finances by making a preemptive rights offering of new equity. The bank quickly raised $18.5 billion dollars.

Unlike Citibank, Bank of America, and other giant US banks, HSBC did not have to sell its soul to the government to stay in business.

HSBC had the good fortune to be headquartered in the UK and to have much of its investor base in Europe and other countries where preemptive rights are the law and the customary way to raise capital.

The hidden beauty of preemptive rights

Some countries, including the United Kingdom, insist that companies give shareholders the preemptive right to subscribe to a new issue of the same class of stock that they own, in proportion to their holdings. If shareholders do not wish to subscribe, they may sell their rights to others on the stock exchange.

Often, to encourage shareholders to exercise their subscription rights, the issuer will offer the new shares at a discount from current market value. In the case of HSBC the discount was 40% — which virtually forced the issue to be taken up.

HSBC at Canary Wharf, London

Preemptive rights are advantageous to stockholders that don’t want to see their equity diluted by a board that might be too inclined to issue stock to take over other companies, or to hand out stock options that provide extra remuneration to management.

Companies with conservative ownership, looking to the long-term, find preemptive rights useful because a rights issue at a substantial discount from market, effectively frees the company from expensive and intrusive investment bankers.

Who hates preemptive rights and why

The mortal enemies of preemptive rights issues are investment bankers and fund managers.

The reasons are obvious:

Once a company has a wide distribution of its stock traded on an exchange, it can raise additional capital simply by declaring an issue of preemptive rights at a substantial discount.

Investors are virtually forced to either take up their rights, or sell them on the exchange to someone else who will take up the rights.

Sometimes the services of an underwriter might be necessary to serve as a standby subscriber, but often, when a company has enough investors and when its stock is actively traded, the company can handle the issue entirely on its own — saving substantial underwriting fees.

Mutual fund managers also often hate preemptive rights, especially when the rights issue is at a big discount. Such discounted issues force fund managers to use cash to exercise the rights at a time when they may not have cash available.

Also, if fund managers are required to sell rights on the exchange, the arbitrage between the theoretical value of the rights and the quoted price may represent a loss for the fund.

US corporations that like to use share issues to acquire other companies without having to explain too much to their own shareholders, find preemptive rights burdensome and an annoyance to their plans for financial engineering.

The dominant role of investment bankers, free-wheeling corporate management, and fund managers in the US capital market, and the silence of ordinary investors and the SEC, has led to rights issues being relatively rare, although such issues are common elsewhere.

Preemptive rights helped HSBC

Hong Kong Shanghai Banking Corporation (HSBC) by Q4 2008, faced similar financial constraints as major US banks in the current deep recession. Prices of its stock were crashing, while the need to raise additional funds was increasing rapidly.

A typical underwriting in the US involves trying to set the price of the offering at the market.

However, with delay in getting documents through the SEC and in building a book of syndicators, as the market engages in wild gyrations, underwriting risks and costs increase.

Furthermore, if investment banks are themselves in trouble, they will be too busy trying to survive to help an issuer trying to raise capital in a falling market.

In contrast, preemptive rights have advantages for those issuers that are free to use the technique.

1. First, by setting the offering price far below the market, the delicate task of matching offering and market price is avoided;
2. Second, a heavily discounted rights offering reduces or eliminates the need for investment banks as intermediaries. With capable lawyers and a reliable shareholder base, management can handle the deal by themselves. It doesn’t matter if the investment banking community is busy trying to put out their own fires.

Preemptive rights and Citicorp

Citicorp and the other big US banks should have been aware, well before September 2008, that they had a problem with leverage and that an effective cure would have been to arrange a massive injection of capital.

However, if one is trained to think only in terms a US-type, non-preemptive rights issues at the market, with the standard apparatus of underwriters and book-building, the success of such an issue might indeed seem questionable in mid-year 2008. Especially when the big investment banks were scrambling themselves, trying to resolve their own troubles.

But I suspect that a dramatic preemptive rights issue, say at a discount of 40 or 50% from market, might very well have done the trick — saving those banks that were able to think outside of the cultural box of the US market from the tender mercies of the US Treasury Department.

We’ll never know, of course. Monday morning quarterbacking is not useful.

But looking forward, some traded US corporations that have problems with leverage might benefit from studying the potential benefits of preemptive rights offerings.

What do you think?