COVID-19 Coronavirus: Fund Needs Cash? How about a Rights Offering?

Introduction

In the current and rapidly changing economic environment, many companies are experiencing significantly depressed stock prices and a dire need for liquidity. During periods when conventional primary offerings are not feasible, rights offerings offer an attractive solution to issuers in need of a cash infusion. In particular, rights offerings provide viable capital-raising opportunities for closed-end funds, which generally cannot otherwise issue additional common stock at a price below their net asset value (“NAV”), and for business developments companies (“BDCs”), which generally cannot issue shares of their common stock at a price below their NAV without prior shareholder approval.

Overview of Rights Offerings

In a rights offering, issuers grant existing shareholders the opportunity to purchase additional shares of common stock at a discounted price for a limited time, which can range from a few weeks to a few months. The specified price of each share is typically set below the current trading price of the issuer’s stock and is almost always set at a discount to the issuer’s NAV. Shareholders receive one right for each share held on the record date. The number of rights required to purchase one new share varies, and that ratio determines the size of the offering.

A rights offering can be structured as a transferable or non-transferable offering. In a transferable rights offering, shareholders who do not wish to exercise their rights may sell such rights to third parties in the open market. Rights granted in these offerings are generally listed and traded on a securities exchange. In a non-transferable rights offering, shareholders may not sell their rights, and all unexercised rights expire after the exercise period. In most rights offerings, all or nearly all shares offered are sold.

Subscription Mechanics

Rights offerings are completed in two phases: the primary subscription period and the oversubscription period. At the commencement of a rights offering, shareholders are automatically granted one right for each share held on the record date. In the primary subscription phase, participating shareholders may purchase additional shares using a ratio predetermined by the issuer. For example, in a one-for-three rights offering, shareholders may exercise three rights to purchase one additional share at the specified discounted price. To purchase the additional shares, shareholders must tender the cash purchase price plus the required number of rights in exchange for the number of shares desired. Shareholders must exercise their rights within the subscription period in order to buy additional shares at the discounted rate. In a transferable offering, shareholders who purchased rights in the secondary market may participate in the primary subscription. After the completion of the primary subscription, shareholders who fully participated in the primary subscription are eligible to participate in the oversubscription phase, which gives such shareholders the opportunity to acquire any shares not purchased in the primary subscription. However, persons who acquired their rights in the secondary market are typically not permitted to oversubscribe.

The number of shares available in the oversubscription period may be increased by an overallotment, usually equal to 15% or 25% of the size of the offering. If shareholders wish to purchase more shares than the number of shares available, the shares are prorated according to the size of each shareholder’s existing holding.

Stock Sales Priced Below NAV

Issuers such as closed-end funds, including BDCs, must consider the mechanics for pricing stock below NAV. There are generally two ways for BDCs to issue shares below NAV. First, BDCs can obtain shareholder approval under Section 63(2) of the Investment Company Act of 1940, as amended (the “1940 Act”) to issue shares below NAV. This method may be time-consuming and ineffective without significant shareholder support. The second option is to rely on Section 23(b)(1) of the 1940 Act, which permits closed-end funds, including BDCs, to issue shares below NAV in connection with an offering to the holders of one or more classes of the fund’s capital stock. This second option forms the basis for rights offerings.

Backstop Investor

In a direct rights offering, the issuer only sells shares to shareholders who exercise their rights in the primary subscription period and any oversubscription period; there is no backstop or standby purchaser. Issuers conducting a direct rights offering risk having an undersubscribed offering, which may limit the amount of capital they could raise. To eliminate this risk, issuers may wish to engage the services of a backstop investor, which is a third party (usually an investment bank or an affiliate of the issuer) that agrees to purchase any shares not purchased in the oversubscription period. The issuer typically enters into an agreement with the backstop investor prior to the commencement of the rights offering whereby the backstop investor commits to buying any shares not purchased in the oversubscription period. This arrangement guarantees that the offering will be fully subscribed and enables the issuer to raise the necessary capital.

Subject to the limited exception below, the backstop investor generally must be an existing shareholder in rights offerings that rely on Section 23(b)(1). In a non-transferrable rights offering, only existing shareholders can participate. In a transferrable rights offering, an investment bank or other purchaser is permitted to purchase the transferrable rights directly from the existing shareholders in the secondary market. While persons who purchased rights in the secondary market are permitted to participate in the primary subscription, they generally are not permitted to oversubscribe. By design, a backstop investor is expected to purchase unwanted shares in the oversubscription, which an investor cannot do in a non-transferable rights offering, and may not be able to do in a transferable rights offering, unless it is a shareholder on the record date.

An investment bank or any other purchaser that wishes to serve as a backstop investor can ensure its ability to participate in the oversubscription by buying shares of the issuer in the secondary market and becoming a shareholder before the record date of the rights offering. As long as the backstop investor becomes a shareholder by the record date, it may participate in both the primary subscription and the oversubscription periods.

However, as noted above, there is one narrow exception. Where a BDC has obtained shareholder approval to issue shares below NAV in reliance on Section 63(2) of the 1940 Act, an investment bank or other purchaser which does not otherwise own shares of the issuer may act as a de facto backstop investor by purchasing shares not acquired by existing shareholders in the rights offering at the discounted price directly from the issuer.

In the situation where a fund is relying on Section 23(b)(1), the fund may not compensate the backstop investor since funds cannot pay a fee to certain shareholders for purchasing shares because this would, in effect, result in the sale of shares to different holders on different terms.

To determine whether a backstop investor is needed, issuers are allowed to “test the water” with qualified institutional buyers and institutional accredited investors.

Dilution

Despite the flexibility that rights offerings can provide to issuers, any company considering a rights offering should be aware of its dilutive effects on existing shareholders’ share NAV. Where the subscription price is below the NAV per share of the issuer, the offering will result in a dilution in the NAV per share of each existing shareholder, regardless of whether shareholders exercise their rights. The degree of dilution depends on the number of new shares issued relative to the number of shares outstanding and the amount of the discount to NAV at which those shares were issued. Historically, dilution levels range between 2% and 7%. For example, suppose Issuer A has 900 shares outstanding, its NAV is $10.00 and the market price of its securities is $9.00 per share. Issuer A has a fully subscribed, one-share-for-three rights offering priced at $8.00 per share, representing a 20% discount to NAV. At the conclusion of the offering, Issuer A would have 1,200 shares outstanding, each with a NAV of $9.50, resulting in a dilution of $0.50 per share or 5%. Dilution occurs because new shares are issued below NAV, and that discount reduces the NAV of all of an issuer’s shares.

By design, dilution in a rights offering affects all shares equally, but does not necessarily affect all shareholders equally. As illustrated by the example above, non-participating shareholders are left with the same number of shares, each at a reduced NAV plus the proceeds from the sale of their rights if the rights are transferable. Therefore, in a transferable rights offering, the proceeds from the sale of shareholders’ rights partially offset the dilution caused by the issuance of shares priced below NAV. Shareholders who fully participate in the rights offering and those who oversubscribe end up with their original, diluted shares plus new shares acquired at a discounted price. The discounted price of the additional shares can more than make up for the dilution of their original shares if some shareholders do not participate. As such, there effectively can be a transfer of wealth from non-participating shareholders to participating shareholders. This wealth transfer can be more pronounced in non-transferable rights offerings because rights not exercised by existing shareholders are forfeited. The desire to avoid dilution of their holdings and profit from oversubscribing are strong motivators for some shareholders to participate in the rights offering.

Requirements for Rights Offerings by Funds

Closed-end funds and BDCs are subject to additional requirements with respect to rights offerings. Section 18(d) of the 1940 Act requires the rights to be issued exclusively and ratably to the fund’s shareholders and to expire not later than 120 days after their issuance. Directors of such funds have an obligation to make a good faith determination that the net benefit to the shareholders of the offering, including those shareholders who choose not to exercise their rights, outweigh the potential dilution.

In addition to the regulatory limitations discussed above, rights offerings are regulated by securities exchange rules. While there are no federal securities laws requiring rights offerings to be open for a specified period of time, the New York Stock Exchange requires issuers to give shareholders at least 16 days to exercise their rights. The exercise period for rights offerings typically last for about 30 days and rarely shorter than 15 days.

Additional Requirements for Transferable Rights Offerings when Relying on Section 23(b)(1)

When relying on Section 23(b)(1), rights offerings must fully protect shareholders’ preemptive rights and must not discriminate among shareholders (except for the possible de minimis effect of not offering fractional rights). In a transferable rights offering, management is required to use its best efforts to ensure an adequate trading market for the rights, which gives shareholders who do not wish to exercise their rights the opportunity to sell their rights. This can be accomplished by listing such rights on a securities exchange. In addition, the ratio of the offering cannot exceed one new share for each three rights held.

Dealer Manager

A dealer manager may be used to assist with the rights offering. Fees charged by dealer managers vary, but may be up to 4.00% or more of the offering price. In offerings with a high solicitation fee, a dealer manager may act as a de facto backstop investor for a transferable rights offering. The dealer manager will purchase unwanted rights in the secondary market, exercise such rights and collect the agreed-upon fees. Generally the dealer manager acts as a facilitator for a rights offering and assists in increasing the transferability of the rights and the subscription of the shares. The board of directors of the issuer will need to consider the effect of these fees in its dilution analysis.

Required Filings

Certain filings with the U.S. Securities and Exchange Commission (the “SEC”) are required in order to register the subscription rights and the shares to be issued in connection with rights offering. If an issuer has an effective shelf registration statement on file with the SEC that covers subscription rights and shares to be issued, the issuer can take down the subscription rights and the shares off the shelf with no SEC review. The issuer will need to file a prospectus supplement as well as a supplemental listing application with a securities exchange. Additional listing obligations may be required by the respective securities exchange.

Subsequent Rights Offerings

It is permissible for an issuer to launch subsequent rights offerings so long as the previous exercise period has ended and the offering was concluded before the commencement of the subsequent offering.