Preemptive Rights and Other AntiDilution Protections around the World

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Preemptive Rights and Other Anti-Dilution
Protections around the World

• Vladimir Atanasov, College of William and Mary
• Art Durnev, McGill University
• Larry Fauver, University of Miami
• Katherine Litvak, University of Texas at Austin

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Two Contributions

• Methodological
• Measuring Laws and Institutions
• Substantive
• Study Relationship Between Law and Equity Markets

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Measuring the Law

• Why?
• Cross-country studies
• Improve functioning of the legal system
• Improve financial markets or other economic
  measures by changing the legal system

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Existing Approaches to Measuring the Law

• Quantify statutes and other components of the
  legal system
• Naïve leximetrics (counting words or paragraphs)
• Shareholder protection indices
• Ask experts for overall assessment
• Local experts evaluate the combined outcomes of
  statutes, practice, and enforcement

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Difficulties in Measuring the Law

• The law is a complex system
• A good understanding of both the parts and the
  relations between the parts is necessary
• Experts may understand the parts but can be
  easily overwhelmed by all possible interactions
  in the whole system

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Measuring Investor Protection
Version 1.0 La Porta et al (1998) Pistor
(2000) Lele and Siems (2006)
Version 2.0 Djankov et al (2006) Nenova (2006)
Version 3.0 (beta) ADFL (2007) Litvak (2006)
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Problems with Generation 1 Leximetric Approaches

• Ad hoc choice of statutes
• No concrete causal mechanism between law and
  finance in mind
• Lack of detail in coding statutes
• La Porta et al, 1998 Preemptive Rights 1 for
  26 countries, Preemptive Rights 0 for 23

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Improvements in Generation 2

• Identifies the causal link Law affects
  Tunneling, Tunneling Affects Finance
• Focuses on a particular transaction
• Identifies relevant statutes that regulate the
  transaction

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Remaining Problems of Generation 2

• No interaction among statutes
• Enabling statutes
• Complements vs. substitutes
• No interaction between statutes and other
  mechanisms and transaction costs
• Ownership structure
• Financing costs
• Trading costs

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Remaining Problems of Generation 2

• Unsuitable for policy recommendations
• If taken at face value, recommends that all
  statutes are set to 1
• No estimate for relative importance of statutes
• No estimate for relative costs of switching from
  one statute to another

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We Propose a New (Generation 3) Approach

• Like Generation 2, we focus on a particular
  transaction
• Equity dilution
• Identify all relevant statutes that regulate this
  transaction

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Our Approach (Cont.)

• Develop a model of the transaction
• Derive the effects of the combined set of legal
  statutes on payoffs for controlling and minority
  shareholders after incorporating transaction
  costs
• Identify and explicitly model the various
  interactions that may be important

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Benefits of Our Approach

• Potentially valuable for policy makers
• Relative importance of statutes
• Enabling and complementary statutes
• Optimal statutes given set of frictions and other
  mechanisms in the economy
• Ex ante costs for various parties from switching
  from one set of statutes to another

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Why We Choose Equity Offerings

• A source of new capital
• Increase firm value via new investment in
  positive value projects
• A form of financial tunneling
• Allow a controlling shareholder to transfer
  wealth from remaining shareholders via dilution

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Equity Dilution

• Necessary conditions for transfer of wealth from
  minority to controlling shareholders to occur
• Large amount of new shares are issued
• Issued shares are at discount to fair value
• Some shareholders are excluded from participation
  in the issue

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Equity Dilution around the World (Table 2)

• Emerging markets
• Private equity placements with related parties
• Classic equity issues
• Targeted repurchases
• Debt for equity swaps

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Equity Dilution in the U.S

• Privately-held companies
• Public corporations
• Stock watering schemes
• Targeted repurchases
• Executive compensation
• Investment companies
• Closed-end fund scandals pre-1940
• Mutual fund market timing

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Mechanisms that May Prevent Dilution

• Reputation
• Financial Intermediaries
• Investment banks
• Auditors
• Blockholders
• The law
• Domestic
• Foreign

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Importance of Legal Protections in Local
Jurisdiction

• Emerging markets may have underdeveloped or
  non-existing other protective mechanisms
• Hard to import foreign laws by cross-listing

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A Taxonomy of Anti-Dilution Statutes

• Three major groups of statutes regulate dilution
• Preemptive rights
• Minimum price provisions
• Approval Rights
• Other relevant statutes
• Freeze-out protections
• Price manipulation regulations

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Anti-Dilution Statutes in the U.S.The 1940
Investment Company Act

• Regulate the issuance of equity by closed-end
  funds
• Minimum price provisions
• Issue price above NAV
• Approval by shareholders (or SEC)
• Minimum 50 of all shareholders
• Issue rights to all shareholders

OR
OR
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Model

• Issue i new shares at a discount ddilute
• Shareholders decide whether to purchase pj of
  their proportional stake and sell remaining sj
  rights to other investors (if rights are
  transferable)
• Controlling shareholder purchases all
  unsubscribed shares if possible
• Then freezes-out remaining shareholders

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Basic Dilution Mechanics
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Frictions

• Financing issues
• Budget constraints b0, bj, possibly due to margin
  requirements
• Interest expense r
• Fixed cost of financing R
• Subscription costs
• Fixed cost S

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Some Preliminary Results

• Interactions among statutes
• Preemptive rights and freeze-out provisions
• Preemptive rights, minimum price provisions, and
  approval rights

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Some Preliminary Results

• Interactions of costs and statutes
• Preemptive rights and financing costs
• Interactions of ownership structure and statutes
• Preemptive rights and largest and second-largest
  minority shareholder stake

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Conclusion

• First to provide a taxonomy of anti-dilution
  statutes and other relevant regulations
• First to model these statutes in a unified
  framework
• Identify important interactions that are relevant
  for law and finance empirical work

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To Do List

• Finalize the model structure
• Minimum pricing provisions
• Approval rights
• Solve the model numerically
• Simulate values for various costs
• Simulate ownership structure
• Record resulting solutions for shareholder
  participation, discount of offering, size of
  offering, size of wealth transfer
• Calculate an Expected Dilution Measure for a
  given set of statutes and transaction costs

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Possible Extensions of the Framework

• In addition to statutes account for
• Administrative Decisions
• Judicial Opinions
• Institutional Rules
• Stock Exchanges, Self-Regulatory Bodies
• Contracts
• Informal Arrangements, Norms
• Combinations of the Above
• plus economic variables

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Preemptive Rights

• Transferable
• Securitized and traded on an exchange
• Rights or warrants
• Waivable
• Pay-in-full vs. conditional capital increase
• Oversubscription option

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Minimum Price Provisions

• Basis price
• Book value
• Market price
• Fair value
• Discounts allowed
• For underwriting expenses
• For liquidity or other reasons

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Approval Rights

• Who votes
• Board of directors
• Majority of shareholders
• Majority of disinterested shareholders
• Simple vs. supermajority
• Majority of all vs. voting shareholders

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Model Timeline
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Effect of Preemptive Rights in the Model

• Four cases
• No preemptive rights
• Non-transferable rights
• Rights transferable to existing investors
• Securitized rights, transferable to anyone

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Solving the Model

• Figure out pricing of rights in t 3 (if rights
  are transferable)
• Depend on freeze-out discount and competition
  between potential buyers
• Given pricing of rights and financing and
  subscription costs, minority shareholders choose
  optimal pj and sj
• Given expected choice of pj and sj and financing
  costs, C chooses optimal ddilute and i.