In September 2004, the DTI announced that it had asked Paul Myners to investigate whether pre-emption rights when new shares are issued hinder certain public companies from raising finance for innovation and growth and, so far as there are problems, to recommend possible solutions. The biotechnology industry has claimed that the current regime makes it difficult and expensive for companies to finance research and product development.
Mr Myners, supported by representatives from industry, private equity companies and City investment institutions, has now published a consultation document: "The impact of shareholders' pre-emption rights on a public company's ability to raise new capital". This describes the current pre-emption regime, draws some international comparisons and outlines the main issues. The consultation period ends on 16th December 2004, and the intention is to report early next year.
The current pre-emption rights regime
Pre-emption rights are enshrined in provisions in the Companies Act 1985 derived from the EC Second Company Law Directive. They are intended to protect a company's shareholders against the erosion of their voting power and the value of their investment. Shares allotted for cash must first be offered to existing shareholders pro-rata to their shareholdings, and there is a prescribed timetable for the offer. The classic method of complying with the statutory pre-emption rights is by means of a rights issue. A rights issue is made by means of the issue of a renounceable letter (or other negotiable document) that may be traded (as "nil paid" rights) for a period before payment for the securities is due.
Under the Companies Act public companies, unlike private companies, cannot opt out of the pre-emption regime, but they can waive pre-emption rights for a period of up to five years by a special resolution of shareholders, requiring a 75% majority of votes cast. A waiver can be granted generally for all issues or on a case-by-case basis - without limit as to the size of the issue. When shares are allotted to a specific person or persons on a non-pre-emptive basis, this is referred to as a placing.
In practice, the scope for publicly-quoted companies to make non-pre-emptive issues is much narrower than is allowed under the Companies Act. They have to comply with the more restrictive provisions on pre-emption contained in guidelines (the Pre-emption Guidelines) issued by the investment committees of the two main bodies representing institutional investors in the United Kingdom, the Association of British Insurers (ABI) and the National Association of Pension Funds (NAPF). The Pre-Emption Guidelines limit cash placings to up to 5% of the issued share capital in any one year and up to a maximum of 7.5% of the issued share capital in any rolling three-year period. Both the UKLA and the ABI and NAPF limit the discount at which shares may be issued on a placing.
UK biotechnology companies look enviously across the Atlantic to their US counterparts where pre-emption rights seem to be the exception rather than the rule.
The New York Stock Exchange requires shareholder approval for any issue of shares that:
- will result in a change of control; or
- equals 20% or more for the total votes or number of shares outstanding (other than (i) public offerings for cash or (ii) private offerings for cash if the shares are sold for less than the greater of the book or market value of the shares).
NASDAQ requires shareholder approval for any issue of shares that:
- will result in a change of control;
- equals 20% or more of the total votes or the number of shares outstanding; or
- equals 20% or more of the total votes or number of shares outstanding which is made at a price less than the greater of the book or market value of the stock.
US biotechnology companies frequently use so-called PIPEs (Private Issues of Public Equities) to raise cash with minimum paperwork and a short timetable. PIPEs are generally used by companies that believe that there will be insufficient demand for their securities amongst the public markets and are hoping to interest less mainstream investors in the private markets, such as hedge funds or private equity investors. The PIPE structure in the US capital markets is particularly attractive to issuers, as it allows a placement of securities without waiting for registration by the US Securities and Exchange Commission. These issues are aimed at the more risk-tolerant investors as they involve a period when the securities are unlisted and therefore less liquid.
The BIA response
The BioIndustry Association (BIA) has welcomed the publication of the consultation paper. The BIA has long been lobbying the UK Government to change the current pre-emption regime, which it sees as imposing inflexible restrictions on its member companies. The BIA has proposed that the pre-emption regime should be amended to permit UK listed lifescience companies to issue up to at least 20% of their share capital on a non pre-emptive basis. This limit would apply to companies with a market capitalisation of less than £1 billion.
The BIA claims that, even taking account of the existing differences in the sizes of the two sectors, pre-emption rights were a significant factor in the UK's biotechnology sector raising less than 1/16th of the capital raised in the US. The BIA says that the ability to obtain non pre-emptive funding quickly and without significant documentation requirements is crucial in the biotechnology market, where stock market sentiment can change rapidly.
The BIA is currently preparing a detailed response to the consultation paper.
UK shareholders and their concerns
UK investment institutions see the principle of pre-emption rights as a vital safeguard for their ownership rights, arguing that adherence to the pre-emption principle prevents transfer of value to third parties and safeguards their rights as owners to hold management to account. If these companies were permitted to sell new shares to third parties, the ownership rights of existing shareholders would be weakened and they would suffer dilution of their economic interests as regards their future entitlement to earning streams. At the heart of the argument is the belief that investors cannot be expected to take responsible investment decisions in the long-term interests of stakeholders if they run the risk of being diluted.
The ABI and the NAPF have argued, not unreasonably, that creating additional flexibility for the lifesciences sector would lead inevitably to pressure for all companies to be treated in the same way. The ABI and NAPF have pointed out that their guidelines can be waived under certain circumstances. There are a number of cases where permission has been given for up to 10% of the share capital to be raised. Antisoma is cited as a biotech company that has recently been given the go-ahead by the ABI to seek a 10% non pre-emptive issue authority to be voted on at its AGM.
The consultation paper makes the interesting observation that many institutions that argue strongly for pre-emption rights to be retained in the UK nevertheless invest considerable amounts in the US market and other jurisdictions where pre-emption rights are weaker or non-existent.
The Consultation Paper
Views are sought in the consultation paper on various issues, including:
- whether the criteria for determining whether or not to disapply pre-emption rights should be set out in the pre-emption Guidelines and, if so, what those criteria should be;
- whether the "comply or explain" shareholder engagement model should be applied to the application of pre-emption rights, and how that could work in practice;
- whether the growth in overseas ownership of UK companies has implications for the universal application of the pre-emption Guidelines (and whether the views of international investors are sufficiently taken into account);
- whether there is scope to apply the pre-emption Guidelines differently according to the size of the company;
- whether there is any evidence of shareholder value abuse through non- pre-emptive issues in the US;
- whether the UK should move to a US style "liability approach" - in other words, leaving disgruntled shareholders to seek compensation in the courts by taking class actions - rather than maintaining the "property approach", which confers an absolute right for minorities to avoid dilution. If not, whether the property approach could be more flexible and allow a company to choose from various pre-emption right options (for example, regimes that allow 5%, 10%, 20% or other limits to non-rights issues, where the market would price the shares accordingly);
- the feasibility of other capital-raising models, and whether they offer a practical way around the "pre-emption" problem, in terms of size of issue and speed, and the relative costs;
- rules on capital-raising in the US, including where the balance of advantage lies between the constraining effects of pre-emption rights and their safeguarding of shareholder value and owners' rights; and why the lack of pre-emption rights in other jurisdictions apparently does not deter UK investors, and what price is placed on the additional risk.
For further information please contact Charles Waddell at [email protected] or on +44 (0)20 7367 3602.