Corporate finance: New equity becomes an issue

Unlike equity markets in most other parts of the world, pro rata pre-emption
rights have long been a cornerstone of company law and London stock market
practice.

Last year, Paul Myners submitted a report to the DTI on the impact of
pre-emption rights on companies seeking to raise finance for innovation and
growth. He concluded that pre-emption rights should remain, but that a
‘Pre-Emption Group’ be established to produce guidance on when it would be
permissible for such rights to be disapplied. The group was formed under the
umbrella of the Financial Reporting Council and produced its statement of
principles in May.

The group’s statement of principles has been designed to help the
case-by-case dialogue between companies and shareholders; the group will
continue to monitor the development of best practice and will issue an annual
report, but will not intervene or comment on specific cases.

Principles

• The overarching principles in the statement make clear that pre-emption rights
are a cornerstone of UK company law, and as such they can only be disapplied by
a special resolution of shareholders. But a degree of flexibility may be
appropriate where it would be in the company’s and shareholders’ interests to
issue shares on a non-pre-emptive basis.

• Companies have a responsibility to indicate as soon as possible their
intention to disallow pre-emption rights and to enter into dialogue with
shareholders.

• Shareholders, in turn, have a responsibility to engage in dialogue with
companies and to consider each non-pre-emptive equity issue on its merits, using
the usual investment criteria. Likewise, shareholder advisory services should
listen to what companies have to say in such circumstances.

The principles are intended to apply to non-pre-emptive share issues for cash
by companies listed on the main market. AIM-quoted companies are encouraged to
apply these principles, though investors recognise that greater flexibility is
likely to be justified in the case of such companies.

Routine, non-controversial requests are more likely to be agreed to by
shareholders if such requests represent no more than 5% of the ordinary capital
in any one year.

In the absence of suitable advance consultation and explanation, companies
should not issue more than 7.5% of their ordinary share capital for cash in any
three-year period, the statement says.

Price discount

Pricing of the new shares is a relevant consideration, and an equity issue
priced at more than a 5% discount is not likely to be regarded as routine.
(While the size of discount in a conventional rights issue is almost entirely
irrelevant (save for some capital gains tax issues for shareholders who choose
not to exercise their rights), for a non-pre-emptive issue, the greater the
discount the greater the dilutive effect of the issue.)

Companies should ensure that they are raising capital on the best possible
terms, particularly if the capital-raising is to enable a transaction that is
likely to enhance the company’s share price.

The statement emphasises that the purpose of these principles is to ease the
granting of authority below the figures stated above and not to rule out
approvals above them. Requests which would exceed these levels should be
considered by investors on a case-by-case basis.

Membership

Membership of the Pre-Emption Group included finance directors from Cambridge
Antibody Technology plc, GUS plc and AMEX plc, as well as a number of
institutional investors and investment banks. The chairman is Scott Dobbie.

PRINCIPLE ISSUES:

While it clearly isn’t possible to define all the circumstances in which
investors might be willing to allow a non-pre-emptive equity issue to proceed,
the principles suggest some general considerations that are likely to be
relevant.
These are reproduced below:

The strength of the business case: In order to make a reasoned
assessment shareholders need to receive a clear explanation of the purpose to
which the capital raised will be put and the benefits to be gained. For example,
in terms of product development or the opportunity cost of not raising new
finance to exploit new commercial opportunities – and how the financing or
proposed future financing fits in with the life-cycle and financial needs of the
company.

The size and stage of development of the company and the sector within
which it operates: Different companies have different financing needs.

For example, shareholders might be expected to be more sympathetic to a request
from a small company with high growth potential than one from a larger, more
established company.

The stewardship and governance of the company: If the company has a
track record of generating shareholder value, clear planning and good
communications, this may give shareholders additional confidence in its
judgement.

Financing options: A wide variety of financing options are now
available to companies.
Companies should explain why a non-pre-emptive issue of shares is the most
appropriate means of raising capital, and why other financing methods have been
rejected.

The level of dilution of value and control for existing shareholders

The proposed process following approval: Companies should make clear the
process they would follow if approval for a non-pre-emptive issue were to be
granted. For example, how dialogue with shareholders would be carried out in the
period leading up to the announcement of an issue.

Contingency plans: Company managers should explain what contingency
plans they have in place in case the request is not granted and the implications
of such a decision.