Why underwrite rights offerings? Some new evidence

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Journal of Financial Economics 46 (1997) 223-261

ECONOMICS

Why underwrite rights offerings? Some new evidence O y v i n d B o h r e n a, B. E s p e n E c k b o b'c'*, D a g M i c h a l s e n a Norwegian School of Management, Elias Smiths vei 15, N-1300 Sandvika, Norway b Stockholm School of Economics, Sveagvagen 65, S-113 83 Stockholm. Sweden cNorwegian School of Economics and Business Administration, Helleveien 30, N-5035 Bergen-Sandviken, Norway

Received 14 August 1995; received in revised form 5 May 1997

Abstract We examine rights issues on the Oslo Stock Exchange, where seasoned public offerings now take place almost exclusively through use of the relatively expensive standby underwriting method rather than unsinsured rights. We show that the propensity to use standby underwriting increases as expected shareholder takeup decreases, that the market reaction to uninsured rights offers is significantly positive, and that standbys elicit the least favorable market reaction to the public issue announcement. These and other cross-sectional results are consistent with the asymmetric information framework of Eckbo and Masulis (1992) and help resolve the longstanding rights offer paradox. Keywords." Rights; Underwriting; Shareholder-subscription; Issue-costs; Adverse-selec-

tion JEL classification." G24; G32; D82

1. Introduction In a rights offer, current shareholders are given short-term warrants to purchase newly issued shares on a pro rata basis at a discount relative to the current market price of the stock. Because the value of the right increases with the subscription price discount, a deep discount makes it prohibitively costly not to exercise the right. Thus, standard economic theory suggests that, absent

* Correspondence address: Stockholm School of Economics, 11383 Stockholm, Sweden. 0304-405X/97/$i7.00 (cD 1997 Elsevier Science S.A. All rights reserved PII S 0 3 0 4 - 4 0 5 X ( 9 7 ) 0 0 0 3 0 - 5

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information asymmetries, an underwriter guarantee and a deep rights offer discount are substitute mechanisms for ensuring full subscription to the rights offer, and thus predicts a preference for employing the low-cost uninsured rights method. However, as shown most extensively by Eckbo and Masulis (1992) on US data, relatively large, exchange-listed issuers show a strong preference for the underwritten method despite its significantly greater direct costs. ~ The purpose of this paper is to provide new empirical evidence that helps resolve this puzzling empirical regularity, often referred to as the 'rights offer paradox'. Our empirical analysis examines seasoned equity offerings on the Oslo Stock Exchange (OSE), which is a relatively small and closely held stock market where issuers continue to have a strong preference for the rights offer method. Corporate statutes in the major industrialized countries grant shareholders the right of first refusal to purchase a new issue of voting stock. Thus, unless shareholders have voted to amend the charter or otherwise explicitly withdrawn this right, a firm contemplating a seasoned public offering of equity must employ the rights offer flotation method. Throughout this paper, we refer to rights offers without an accompanying underwriter guarantee as 'uninsured rights'. In a rights offer where the issuer elects to insure the proceeds through an underwriter, the underwriter guarantees the unsubscribed portion of the rights issue that remains at the end of the rights subscription period. We refer to such rights issues as 'rights with standby underwriting', or simply 'standbys'. If the issuer wants to insure the proceeds without using rights, it can employ a firm commitment guarantee, in which the underwriter assumes full responsibility for selling the shares to the public. The latter flotation method is not observed for public offerings on the OSE and is therefore not included in this paper's empirical analysis. International comparisons of flotation method choices are interesting, as the relative frequencies of uninsured rights, standby rights, and firm commitment underwriting offerings of seasoned common stock differ substantially across countries. For example, over the past 60 years, publicly traded U.S. companies have gradually switched from uninsured rights to standbys and, finally, to the firm commitment underwriting method, which accounted for 99% of all issues by 1980 (Eckbo and Masulis, 1995). A similar trend is observed on the Tokyo Stock Exchange where, prior to the mid-1970s, almost all equity issues were rights offerings (Kato and Schallheim, 1995). Equity issuers in smaller capital

1Eckbo-Masulis report that direct flotation costs for industrial issuers average 6%, 4%, and 1% of the offering proceeds for firm commitment underwritten offers, standbys, and uninsured rights offers, respectively. Evidence on various aspects of direct flotation costs associated with seasoned equity offerings are also found in Smith (1977), Hansen and Pinkerton (1982), Smith and Dhatt (1984), Bhagat et al. (1985), Bhagat and Frost (1986), Booth and Smith (1986), Riner (1987), H ansen (1989), Hansen and Torregrosa (1992), and Denis (1993).

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markets, however, continue to use rights offers. For example, approximately 30% of all equity issues in Canada are sold through uninsured rights and standby offers (Eckbo and Verma, 1992). Moreover, seasoned offerings in European domestic equity markets, including the OSE, are sold almost exclusively through either uninsured rights or standbys. 2 In order to understand the increasing preference for underwritten offers, researchers have appealed to various factors that tend to make the use of the uninsured rights method relatively expensive. These include capital gains taxes (Smith, 1977), transaction costs of reselling rights (Hansen, 1989), wealth transfers to convertible security holders due to antidilution clauses (Eckbo and Masulis, 1992), and costs associated with external financing under asymmetric information (Heinkel and Schwartz,1986; Eckbo and Masulis, 1992). In this paper, we focus in particular on implications of the asymmetric information framework of Eckbo and Masulis (1992) for the standby underwriting decision, as well as for the associated market reaction and stock price change in response to the issue announcement. The paper extends the empirical literature on the flotation method choice in at least four directions. First, we provide a detailed description of the choice of seasoned equity flotation methods, issue characteristics, and direct flotation costs on the OSE. Multivariate regressions reveal that uninsured rights have lower direct flotation costs than standby rights throughout the sample period 1980-1993. Prior to 1985, uninsured rights were the dominant flotation method. However, following increased domestic and foreign public share ownership of OSE stocks by the mid-1980s, issuers started switching to standby offers, which have since become the dominant flotation method. Thus, the somewhat paradoxical preference for the more expensive (standby) underwritten offers is observed also in an institutional setting that is quite different from the major US stock exchanges. Second, we are the first to provide evidence on expected shareholder subscription as a determinant of the flotation method choice, a central variable in the Eckbo-Masulis model. While shareholder demand for the new issue depends on investor characteristics which are difficult to quantify (personal wealth constraints, diversification benefits, value of control rights, etc.), these characteristics most likely differ between the US markets and the closely held Norwegian equity market studied here. Thus, to the extent that shareholder takeup is an important determinant of firms' choice of flotation method, we expect to find a different set of flotation methods used in Norway than in the US, as is in fact

2See, for example, Marsh (1979) for UK issues, Loderer and Zimmerman (1988) for issues in Switzerland. and Hietala and L6yttyniemi (1991) for issues in Finland. Comparable evidence on equity flotation methods are also found in MacCulloch and Emanuel (1990) for New Zealand, Dehnert (1991) for Australia, and Dhatt et al. (1996) for South Korea.

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observed. We find that the probability that the issuer selects to underwrite a rights offer increases significantly as expected shareholder takeup decreases, as predicted. Third, examining the determinants of the market reaction to issue announcements by means of nonlinear cross-sectional regressions, we document several pieces of evidence that further support the hypothesis that issue markets reflect information asymmetries that potentially influence the issuers' flotation method decision: We find that the two-day announcement effect of rights offers is (i) significantly positive and greater for uninsured rights than for standbys, (ii) more negative the greater the issue size, (iii) more negative the greater the preannouncement runup in the issuers' stock price, and (iv) more positive the greater the proportion of the voting stock held by board members and the CEO prior to the issue. Finally, we focus on the potential information content of the rights offer discount. In Norway, information on the discount is contained in the first announcement of the issue, which takes place a minimum of five weeks prior to expiration of the rights offer period. Heinkel and Schwartz (1986) argue that managers of relatively high-quality firms are reluctant to issue rights with deep discounts due to a potential negative signaling effect. However, we find little evidence of managerial reluctance to issue rights with a deep discount, nor do we detect any significant evidence that a deep discount signals negative information about equity value. The latter finding is similar to the conclusion in Eckbo and Masulis (1992) on US data. However, our test provides a more powerful rejection of the Heinkel and Schwartz (1986) argument due to the early determination and announcement of the discount in our Norwegian rights offers. The rest of the paper is organized as follows. Section 2 develops empirical predictions concerning the standby decision under conditions of information asymmetry. Section 3 provides a detailed characterization of the sample of rights offers, including offer frequencies, issue size, subscription levels, offering price discounts, and ownership structure. Section 4 examines the standby decision by using probit analysis. Section 5 presents evidence on the valuation effect of offering announcements, including the effect of the subscription price discounts on stock returns. Section 6 concludes the paper.

2. The standby decision under asymmetric information 2.1. Asymmetric inJbrmation in issue markets: Empirical motivation In the introduction, we observed that direct flotation costs of seasoned equity offers in the US differ significantly across flotation methods, with the costs being highest for firm commitment offers (6% of offering proceeds on average for

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industrial issuers), lowest for uninsured rights (1% on average), and with standby costs in between (4% on average). As summarized in Table 1, it has also been shown that the market on average reacts negatively to equity offerings by firms listed on the New York- or the American Stock Exchange, and that this average negative market reaction is greatest for firm commitment offerings and

Table 1 Sample-size-weighted average two-day abnormal common stock returns of announcements of seasoned public security offerings. Returns are weighted averages by sample size of the returns reported by the respective studies (returns marked with a '*' are significantly different from zero at the 5% level or higher). Type of security offered

Flotation method

Type of issuer Industrial

Utility

Panel A: Issues by NYSE/Amex listed US companies Common stock"

Preferred stock b Convertible preferred stock b Convertible bonds c Straight bonds d

Firm commitment Standby rights Uninsured rights Firm commitment Firm commitment Firm commitment Rights Firm commitment Rights

- 3.1" - 1.5" - 1.4 -0.8 - 1.4" - 2.0" - 1.1 - 0.3 0.4

- 0.8* - 1.4" 0.2 0.1 - 1.4" n.a. n.a. - 0.1 n.a.

Panel B: Common stock issues, internationally ~ UK Finland Korea Switzerland Canada Australia Japan

Rights and standbys Rights and standbys Rights and standbys Rights and standbys All flotation methods Rights and standbys Firm commitment

2.1" (month) f 4.9 1.0" 2.0* (month) f - 4.0* - 2.0 0.4*

~Firm commitment offerings: Asquith and Mullins (1986), Masulis and Korwar (1986), Mikkelson and Partch (1986), and Eckbo and Masulis (1992). Rights offerings: Hansen (1989) and Eckbo and Masulis (1992). bMikkelson and Partch (1986) and Linn and Pinegar (1988). ~Dann and Mikkelson (1984), Eckbo (1986), Mikkelson and Partch (1986), Jangigian (1987), and Hansen and Crutchley (1990). dDann and Mikkelson (1984), Eckbo (1986), and Mikkelson and Partch (1986). ~Marsh (1979) (UK), Hietala and L/Syttyniemi (1991) (Finland), Khang (1990) and Dhatt et al. (1996) (Korea), Loderer and Zimmerman (1988) (Switzerland), Eckbo and Verma (1992) (Canada), Dehnert (1991) (Australia), and Kang and Stulz (1996) and Kato and Schallheim (1995) (Japan). rThis abnormal return is meaured over the month of the issue announcement.

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smallest for uninsured rights, with standbys in between. The negative market reaction to firm commitments is economically significant: The - 3% average two-day announcement period price drop associated with industrial firm commitment offerings is equivalent to a loss of approximately 20% of the proceeds of the average issue. In sum, a decision to underwrite equity issues (whether using a standby or firm commitment contract) results in both relatively high direct flotation costs and a greater loss of equity value at the time of the issue announcement. A viable theory of the standby decision must account for both these two observations. The evidence in Table 1 also indicates that seasoned public offerings for cash in the US have nonpositive announcement effects regardless of the type of security offered (straight debt, convertible debt, common stock), and that the market reaction is more negative when the issuer is an industrial firm as opposed to a regulated public utility. As with the rights offer paradox, it is difficult to explain these results in terms of classical theories of optimal capital structure choice which assume that issuers and market participants are symmetrically informed. Since value-maximizing managers make optimal capital structure adjustments only when the expected benefits are positive, the assumption of symmetric information suggests that the market reaction to such adjustments will be nonnegative (regardless of the security or issuer type). Similarly, if underwriting is simply insurance under symmetric information, one would not expect firm commitment underwritten offerings to be associated with a more negative market reaction than rights offers, as Table 1 generally indicates. The apparent exception in Table 1 is the positive average market reaction to underwritten offerings in Japan. However, Kato and Stulz (1996) document significantly negative average market reaction to relatively large issuers, while small issuers on average experience significantly positive announcement effect. Kato and Schallheim (1995) also document significantly lower announcement effects in 'formula-price' than in 'fixed-price' underwritten offerings. The latter method represents the greatest underwriter commitment as the offering price is fixed three weeks prior to the offering date. In the US, the offering price is fixed typically on the day prior to the offering day (Eckbo and Masulis, 1992). The evidence in Table 1 is broadly consistent with market expectations of adverse selection in issue markets. That is, assuming managers do not have an incentive to sell underpriced stock, the market demands a price discount in order to hedge against the risk that the offered security is overvalued. As shown by Myers and Majluf (1984), the adverse selection price discount increases with the idiosyncratic risk of the security issued, which is consistent with the evidence in Table 1. Moreover, as argued by Smith (1986) and Eckbo and Masulis (1995), the generally smaller market reaction to utility issues is consistent with the proposition that there is typically less adverse selection risk associated with a public utility issue than with an industrial issue. The investment and financing decisions of utilities are highly regulated, which lowers the probability that

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a utility announcing a stock offer is attempting to take advantage of an informational asymmetry in the stock market. For our purposes it is important to note that under the adverse selection interpretation of the evidence in Table 1, available mechanisms to communicate private information to the market must be imperfect in the sense that they do not completely eliminate the information asymmetry between the issuer and the market. 3 In other words, a viable model for the standby decision should account for the presence of a residual information asymmetry even when the firm employs an underwriter to certify the true quality of the issuer. Thus, models which assume that underwriters have the ability to fully reveal issuer type do not explain the evidence in Table 1. Since the direct costs of underwriting are higher than the direct costs of an uninsured rights offer, only the highest-quality (undervalued) firms would select underwriting. However, this in turn implies that the market reaction to a standby rights offer should be more favorable than the market reaction to uninsured rights, which is contradicted by the evidence on US rights issues in Table 1. As discussed below, however, the evidence is consistent with the partial revelation, asymmetric information framework of Eckbo and MasuIis (1992). 2.2. The standby decision in Eckbo and Masulis (1992)

Eckbo and Masulis (1992) develop a model in which certain issuers select the relatively expensive underwritten method and the equilibrium market reaction to such issues is more negative than the market reaction to uninsured rights issues. Fig. 1 and Table 2 illustrate the predictions of their model in the context of a decision to underwrite a rights offer. (Eckbo and Masulis also include firm commitment underwriting in their analysis. Extension to the firm commitment case is relatively straightforward but is excluded here since this flotation method is not used on the OSE.) Suppose a firm faces a short-lived profitable investment opportunity that requires a commonly known level of new equity financing. The firm's objective is to maximize the intrinsic value of the old shares. The firm thus

3 These mechanisms include using financial intermediaries such as investment bankers (underwriters) who have built a reputation for truthful information disclosure and for not selling overpriced stock to the public (Booth and Smith, 1986; Beatty and Ritter, 1986, Titman and Trueman, 1986, Tinic, 1988, Benveniste and Spindt, 1989, and Blackwell et al., 1990), using compensation contracts to change managerial incentives not to issue when undervalued (Dybvig and Zender, 1991), using private placements where sophisticated investors have access to proprietary firm information (Wruck, 1989), maintaining excess financial slack and a capacity to issue risk-free securities (Myers and Majluf, 1984), selling securities in separately incorporated subsidiaries ('equity carve-outs') in order to avoid some of the information asymmetry associated with buying residual claims in the parent company (Schipper and Smith, 1986), and issuing callable convertible debt instead of stock (Stein, 1992).

230

0. Bohren et aL /Journal of Financial Economics 46 (1997) 223-261 total flotation c o s t s

U

.~ 0 ~

It-

k

standbyrights firm chooses

~

s

~sStandby rights uninchooses sured rights

firm

"

1

Fig. 1. Illustration of the flotation method choice for a hypothetical undervalued issuer in the adverse selection model of Eckbo and Masulis (1992). Total flotation costs represent the sum of direct costs (f) and expected wealth transfer c to outside investors. The value ofc depends on the portion 0 ~
issues a n d invests o n l y if the net p r e s e n t value of the p r o j e c t exceeds t o t a l f l o t a t i o n costs. T o t a l f l o t a t i o n costs consist of the s u m of direct c o s t s f ( r e g i s t r a tion a n d legal fees, m a i l i n g costs, u n d e r w r i t e r fees, etc.) a n d the c o n d i t i o n a l e x p e c t e d w e a l t h transfer c f r o m o l d to new Shareholders. This w e a l t h transfer represents the difference b e t w e e n the intrinsic (full i n f o r m a t i o n ) value a n d the m a r k e t value of the shares sold. T h e value of c is zero o n l y in the special case in which the issue d e c i s i o n fully reveals the shares' intrinsic value (e.g., M y e r s a n d Majluf, 1984). W i t h p a r t i a l revelation, however, issuing firms are m i s p r i c e d ex post, i m p l y i n g n o n z e r o equilibrium values of c. In the E c k b o - M a s u l i s f r a m e w o r k , the value of c is d e p e n d e n t o n the f l o t a t i o n m e t h o d . This is i l l u s t r a t e d in Fig. 1 for the case of a n u n d e r v a l u e d issuer (c > 0). T h e h o r i z o n t a l axis is the fraction 0 ~< k ~ 1 of the rights issue t h a t the firm expects will be p u r c h a s e d b y c u r r e n t s h a r e h o l d e r s . T h e value o f k is a s s u m e d to be e x o g e n o u s l y d e t e r m i n e d b y i n d i v i d u a l s h a r e h o l d e r characteristics, which g e n e r a l l y include p e r s o n a l wealth c o n s t r a i n t s , d e m a n d for diversification, a n d

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Table 2 The choice of uninsured rights versus rights with standby underwriting, and the implied market reaction to the issue announcement, in the adverse selection model of Eckbo and Masulis (1992). Flotation method choice conditional on shareholder takeup, k (observable to market)

True firm quality: (unobservable to market)

High quality (undervalued firm)

High k

Low ka

Uninsured rights

(a) Underwriter 'ineffective':

(undervalued shares sold to current s/h)

(b) Underwriter 'effective':

Uninsured rights

(a) Underwriter 'ineffective':

(overvalued shares sold to current s/h)

(b) Underwriter 'effective':

Adverse selection low (ARu ..~ O)

(a) Underwriter 'ineffective': Adverse selection high

No issue Standby rights

Low quality (overvalued firm)

Standby rights No issue

Market inferences:b (issue announcement effect, AR)

(AR~ < O)

(b) Underwriter 'effective': Positive selection (AR~ > O) Low-k issuers do not use uninsured rights

~The underwriter is 'effective' or 'ineffective' when the probability that the underwriter will detect the true quality of the issuer is greater or lower than a certain threshold value. bThe issue announcement effect AR is the change in the issuer's secondary market price at the time when the market is informed of the flotation method choice. Adverse selection is infered to be low in the pool of high-k issuers since both under- and overvalued firms issue (ARu ~ 0). In the pool of low-k issuers the market's inference concerning adverse selection depends on the market's view of the effectiveness of the underwriter. With "ineffective'underwriters, there is adverse selection in the pool of standby offerings, and the market reaction is negative (AR~ < 0). With 'effective" underwriters, only high-quality firms select to go through the underwriter certification process, and there is positive selection in the pool of standby issuers (AR~ > 0).

c o n t r o l benefits from m a i n t a i n i n g one's p r o p o r t i o n a l o w n e r s h i p of the issuer's equity. F o r a given issue size, stock sales to c u r r e n t s h a r e h o l d e r s r e d u c e the p o r t i o n o f the issue t h a t m u s t be offered to o u t s i d e investors a n d therefore also reduce the p o t e n t i a l wealth transfer c (see also K r a s k e r , 1986). Thus, in Fig. 1, c is d e c r e a s i n g in k, with c = 0 when the entire issue is p u r c h a s e d a n d held b y c u r r e n t s h a r e h o l d e r s (k = 1). T h e curve u - u in Fig. 1 represents the t o t a l costs of u n i n s u r e d rights (fu + cu), while s - s r e p r e s e n t s the costs of s t a n d b y rights (fs + cs). T h e precise l o c a t i o n of these two curves d e p e n d s on firm-specific factors (such as the degree of i n f o r m a tion a s y m m e t r y ) , c h a r a c t e r i s t i c s of the m a r k e t ' s p r i o r d i s t r i b u t i o n of firm types, as well as the effectiveness of the u n d e r w r i t e r in identifying a n d c o m m u n i c a t i n g the true issue value. G i v e n the evidence on direct f l o t a t i o n costs f discussed

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above, the two cost curves are likely to exhibit two central properties. First, with full shareholder takeup (k = 1), uninsured rights have the lowest total flotation costs. This follows since c = 0 for both flotation methods, and since the direct costs of standbys is the sum of the direct costs of uninsured rights plus the standby fee. In other words, at k -- 1 the endpoint of s-s exceeds the endpoint of U--U,

Second, the slope of s-s is smaller than the slope of u-u provided the underwriter has some ability to reduce the information asymmetry between the firm and the market. That is, for a given value of k, the effect of quality certification by the standby underwriter is to reduce issue mispricing and therefore the expected wealth transfer c on the portion of the issue that is ultimately sold to outside investors. In effect, underwriter certification and current shareholder takeup are substitute mechanisms for reducing adverse selection costs c, with the marginal certification costs (the underwriter fee) exceeding the marginal benefits (reduced c) only for values of k exceeding ks in Fig. 1. Thus, in this example, the issuer selects uninsured rights if k > ks and selects standby underwriting if k ~< ks. Table 2 illustrates the equilibrium implications of this decision process with 'high' and 'low' values of the firm-intrinsic values and the shareholder takeup variable k. The value of k is assumed to be publicly known as, in practice, the value of k becomes public knowledge during the rights offer period as the portion 1 - k of the issue trades in the secondary market for rights. The market perceives the underwriter to be either 'effective' or 'ineffective' depending on whether or not the probability that the underwriter will detect the true issuer quality is greater or smaller than a certain threshold value. (Note that the greater the effectiveness of the underwriter, the smaller the slope of the total cost curve s-s in Fig. 1.) As summarized in the lower part of Table 2, the market infers that high-k firms, whether of high or low quality, will select the uninsured rights method over the standby method. This implies that adverse selection is low in the pool of uninsured rights, which in turn produces a small negative or zero market reaction to the average issue announcement. Thus, the model predicts that we should observe relatively high k-values and relatively small or zero announcement-induced abnormal stock returns (ARu ~ 0) in the pool of uninsured rights. Note that the market reaction will be positive if the issue announcement also reveals the existence of an investment project with a value that is higher than anticipated by the market. The prediction in Table 2 focuses on the negative effect of adverse selection, and the degree of adverse selection is low in the pool of high-k issuers. Moreover, the model predicts that the probability of observing uninsured rights increases with the value of k. Low-k issuers select standby rights, and the market reaction is more negative the less effective the underwriter. With 'ineffective' underwriters, an undervalued, low-k firm prefers not to issue over issuing using standby underwriting, thus

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creating adverse selection in the pool of standby offers, with a corresponding negative market reaction to the issue announcement (ARs < 0). With 'effective' underwriters, the pool of standbys can exhibit positive selection (and thus ARs > 0), as overvalued firms now prefer not to issue. Absent an observable empirical proxy for underwriter effectiveness, we treat the question as to whether the equilibrium on the OSE is characterized by positive or negative selection in the standby pool as a purely empirical issue. Additional predictions emerge from this framework. For example, since firms with high k-values are more likely to use uninsured rights, and to the extent that the value of k decreases as the firm's equity capitalization and degree of share ownership dispersion increase, the frequency of rights offers should be higher for relatively small, closely held firms. The fact that smaller, private companies tend to use the rights method more frequently than publicly traded firms is consistent with this size argument. This may also explain the greater use of rights in foreign jurisdictions (including Canada and most countries in Europe and the Pacific Basin) characterized by smaller and relatively closely held firms. Furthermore, for a given value of k, if the net benefit of underwriting increases with the degree of information asymmetry between the issuer and the market, we expect industrial firms to use underwriting more often than regulated firms. This prediction is supported by evidence on offer frequencies across industrial and utility equity issuers presented by Eckbo and Masulis (1992). We examine this issue on the OSE by separating issues by financial companies from issues by non-financial firms.

2.3. Signaling and the rights offer discount In principle, the issuer can guarantee full subscription to the rights offer by setting a sufficiently low subscription price. However, managers appear reluctant to issue rights with a deep discount. One concern is the possibility that a deep discount signals negative information about the 'stock's true value. Heinkel and Schwartz (1986) formalize this information signaling argument. In their model, offer failure is costly, and an uninsured rights issuer who privately expects the stock price to fall over the rights offer period selects a low offer price relative to the current (uninformed) market price in order to prevent offering failure. In equilibrium, market participants infer the issuer's private information from the magnitude of the offer price discount, causing the price of overvalued firms to fall. Thus, the Heinkel-Schwartz model predicts that greater discounts will cause larger downward adjustments in the stock's secondary market price. Hietala and L6yttyniemi (1991), who study rights offers in Finland, present a dividend-based argument with the opposite empirical implication: Greater discounts are associated with greater upward adjustments of the issuer's stock price. In Finland, as well as in Norway (see Bohren et al., 1997), there is a tendency for firms to set their dividends as a percent of the par value of

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common stock. Since a rights issue does not change the par value per share, the greater the discount (which necessitates issuance of a greater number of shares in order to raise a given amount of capital), the greater the implied dividend increase. If dividend increases convey favorable information about the true value of the firm, then one should observe a positive correlation between the size of the rights offer discount and the market reaction to the issue. A necessary condition for this to hold is that managers are reluctant to reduce the level of dividend. Kalay (1980) discusses managerial reluctance to cut dividends, while Eckbo and Verma (1994) document empirical evidence that managers of exchange-listed Canadian firms tend to cut the dividend when they have sufficient voting power to do so. We examine both the Heinkel-Schwartz and Hietala-L@ttyniemi predictions in the empirical analysis below.

3. Characteristics of equity rights offers on the OSE The primary data source for identifying security offerings and offering characteristics is the OSE Daily Bulletin and OSE annual reports. The information in the Bulletin is augmented with issue prospectuses and with Oslo Bors Informasjon's data on security prices, returns, and trading volume for all OSE stocks over the sample period. Moreover, all offers are announced in a major financial newspaper (typically the national Dagens N~eringsliv) either on the same day or the trading day following the OSE Bulletin. We include the newspaper announcement date as well as information on offer characteristics that appears in the news item describing the issue. Finally, data on direct flotation costs and shareholder characteristics are constructed using company annual reports. 3.1. Offering frequencies and average issue size In Norway, the seasoned equity issuance process starts when management requests shareholder authorization for the issue. The approval may be given for a specific issue or for a specific amount to be raised within the following year or until the next general shareholder meeting. By law, shareholders have the first right of refusal to purchase the new issue. Thus, unless this preemptive right is waived at the shareholder meeting, the issuer must use a pro rata rights offer. Unlike in the US, Norwegian corporate law prevents shareholders from permanently waiving their preemptive right by means of a charter amendment. (Preemptive rights charter amendments became popular in the US at the beginning of the 1970s, paving the way for the subsequent surge in firm commitment underwritten offers; see Bhagat, 1983.) However, in any given year the right can be temporarily waived to enable the issue to be sold in a public offering or a private placement or to be sold to a target firm in a takeover bid or to employees under stock ownership plans. Over the period 1980-1993, firms

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trading on the OSE undertook a total of 206 equity rights offers and another 212 private placements and offers directed to target firms in takeovers. (Issues to employees, either simultaneously with a rights offer or as a standalone targeted issue group, totaled 161 over the same period.) As shown in Table 3, our sample includes 200 of the population of 205 rights offers, of which 79 (39%) are uninsured rights and 121 (61%) are rights with standby underwriting. Because the capital requirements governing financial (banks and insurance) corporations make their equity issues more predictable, we single out financial institutions from the general population of issuers. Financial corporations issued 37 of the 79 uninsured rights offers and 25 of the 121 standby offers. Interestingly, issuers sometimes select a partial standby contract in which the underwriter guarantee covers less than 100% of the issue. In these partial standbys, which account for 36 of the 125 standbys, the underwriter guarantee averages 48% (median 50%). With a partial standby, the firm must also decide whether the guarantee is for the first part or last part of the issue. For example, a 50% guarantee applied to the first part implies that the underwriter takes up 20% if shareholders subscribe to 30%. The same guarantee applied to the last part of the issue implies a takeup of the full 50% in this case. All guarantees in our sample of 36 partial standbys are for the last part of the issue. The decision to insure the second half of the issue may reflect managerial expectations that current shareholders will take up at least the first half. There is, however, no direct evidence of shareholder subscription precommitments that would substantiate this proposition. Evidence on shareholder takeup is examined in more detail in Section 4 below. There is a marked trend towards an increased use of standby underwriting throughout the sample period, while uninsured rights had almost disappeared by 1993. Sixty of the 79 uninsured rights offers took place before 1985, while 92 of the 121 standbys occurred after 1984. (While not shown in Table 3, the latter part of the sample period also experienced a substantial increase in the number of private placements.) The population shift towards standby underwriting coincides with regulatory and market changes which started to take place in 1985 and which made it less costly for both domestic and international investors to hold stocks on the OSE. These changes include lower regulatory obstacles to foreign ownership, lower transaction costs of trading resulting from both increased competition between brokerage firms and a computerized trading system allowing continuous quotes, and the emergence of index-based mutual funds. According to annual reports of the Oslo Stock Exchange, these changes have resulted in an increase in liquidity, share ownership dispersion, and, in particular, foreign ownership of OSE-listed stocks. Table 4 shows the average and median market value of the issuers' total equity and issue size across uninsured rights and standbys. The average issue size increases substantially from the first to the second sample period shown in

236

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the table. This is true whether one measures size as the dollar value of issue proceeds, as the percent increase in the number of shares outstanding, or as the issue proceeds in percent of the issuer's total equity. For example, as shown in the last column of Table 4, over the period 1980-1984 nonfinancial firms had 14 rights offers with an average issue size was $9.1 million, representing 17.2% of outstanding equity and causing an increase in the number of shares outstanding of 42.4%. Over the period 1985-1993, the corresponding average nonfinancial issue was $21.1 mill'ion, representing 60.4% of outstanding equity and increasing outstanding shares by 76.3%. Moreover, over the second sample period, 1985-1993, firms selecting standby offerings are on average substantially larger, in terms of total equity, than firms selecting uninsured rights.

3.2. Subscription price discounts Norwegian firms are required by law to set the rights offer price a minimum of three weeks prior to the beginning of the rights offer period. Since the minimum rights offer period is two weeks, the issuer (and the standby underwriter) must project the firm's secondary market price at least five weeks ahead when determining the optimal rights offer discount. The rights offer price is included in the first public announcement of the rights issue. In contrast, the offer price in US rights offers is not publicly disclosed until immediately before the start of the rights offer period, which is on average four weeks after the first Wall Street Journal announcement of the pending rights offer (Eckbo and Masulis, 1992). Table 5 shows the average and median percentage values of the discount in the rights offer price relative to the stock's secondary market price on the day before the announcement day as well as relative to the price on the offer expiration day. Firms in Norway are legally prohibited from issuing shares below the stock's par value, which was a binding constraint in ten of the 200 issues. The rights offer discounts for these ten offers are only slightly lower than for the sample at large. The announcement day is the earliest day the offer was announced in either Dagens N~eringsliv (the leading national business newspaper) or in the daily OSE Bulletin. For most offer categories, average discounts relative to the offer announcement day of the offer are relatively large, and larger during the early part of the sample period than in the period after 1984. For example, in the second row, the average announcement-day discount in nonfinancial issues is 67.4% in the period 1980-1984 and 24.9% after 1984. Perhaps surprising, nonfinancial issuers show no tendency to substitute a deep offer price discount for an underwriter guarantee: the average discount is similar across uninsured rights and full standbys. Financial issuers, on the other hand, lower the average subscription price discount somewhat when adding an underwriter guarantee: over the 1985-93 period, the average announcement-day discount for financial issuers is 26.1% for uninsured rights and 8.7% for standbys. We return to the

0. Bohren et al./Journal of Financial Economics 46 (1997) 223-261

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issue of the relationship between discounts and the direct costs of alternative flotation methods in Section 4. 3.3. O w n e r s h i p structure and s h a r e h o l d e r takeup

As discussed in Section 2, current shareholder demand for the stock issue plays a potentially important role in the standby decision. Sale to current shareholders lowers expected adverse selection costs and possibly the underwriter fee. However, shareholder takeup is driven in part by factors outside the issuer's own control, including personal wealth constraints and diversification benefits as well as corporate control benefits. While these factors are unobservable to the econometrician, they help determine the cross-sectional dispersion in share ownership structure. Thus, we include characteristics of the issuers' share ownership in the empirical analysis of shareholder takeup. Tables 6 and 7 show the mean and median values of these characteristics, while the statistical significance of their marginal impact on the standby decision is discussed in the context of cross-sectional regressions in the next section. Table 6 reveals that the average percent of outstanding equity held by the 20 largest shareholders is relatively high on the OSE, and increases somewhat from the first to the second subperiod. For the uninsured rights category, the percent held by the 20 largest shareholders increases from 54.0% in the 1980-84 period to 61.0% after 1984. In the standby rights category, the corresponding averages are 45.1% and 72.2%. The average percent held by insiders, which we define to include members of the board of directors and the chief executive officer, also increases over the sample period from about 6 to 10% when measured at the beginning of the issue year. Table 6 also indicates only small movements over the year of the issue in the ownership positions of both insiders and the group of the 20 largest shareholders. Moreover, there is little evidence that the average ownership structure characteristics vary systematically with the flotation method. Table 7 shows mean and median percent shareholder subscription precommitments and the percent of the rights traded in the secondary market during the rights offer period. Panel A shows results for uninsured rights, while Panel B is for standby rights offers. The table shows a low incidence of shareholder subscription precommitments (only 19 of the 200 rights issues had precommitments). The average precommitment is for 49.1% of the issue in the standby category (N = 15) and 47.3% in the uninsured rights category (N = 4). The table also shows that all issues were fully subscribed. The subscription levels in Table 7 include underwriter takeup as well as subscription by outside investors purchasing rights in the secondary market. Existing shareholders who wish to purchase more than their pro rata share of the issue so instruct the firm at the time of the subscription decision. These overallotments, which are executed by the investment bank managing the offer,

0. Bohren et al./Journal of Financial Economics 46 (1997) 223-261

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do not show up as trades in the secondary market for rights. As a result, and assuming that a right is traded at most once over the offer period, the percent of rights traded on the exchange, as shown in Table 7, is a good estimate of the proportion of the issue sold to outside investors, This proportion is higher for standbys (13.5%) than for uninsured rights (5.6%) when averaged over the entire sample period. In other words, average shareholder takeup is lower for standbys than for uninsured rights. Moreover, there is some indication that the average shareholder takeup in the standby category decreases over the sample period from approximately 92% during 1980-1984 to about 85% after 1984.

4. Evidence on the standby decision

Table 3 shows a substantial increase in the use of standby rights on the OSE over our sample period. In this section, we first provide evidence on the direct flotation costs of uninsured rights and standbys on the OSE. If the .direct costs of uninsured rights are found to be higher than the direct costs of standbys, explaining the switch to underwriting does not require theoretical arguments beyond those based on direct costs. We report evidence to the contrary, however, which confirms the rights offer paradox on our Norwegian data and which motivates our subsequent tests of the Eckbo-Masulis prediction that increased use of underwriting reflects a decline in the expected value of shareholder takeup. 4.1. D i r e c t flotation costs

Norwegian firms selecting uninsured rights hire an investment bank to provide legal and accounting advice and to analyze the general market conditions. Furthermore, shareholders mail their subscription notifications to the local branch of this bank. For these services, the bank charges a fixed fee plus (typically) 1.5% of the value of shareholder subscriptions. In a standby underwriting arrangement, the investment bank normally organizes and leads the investment syndicate, charging a fixed standby fee. With the exception of one case, the standby underwriting contract did not provide for an additional, variable underwriter takeup fee. Thus, somewhat paradoxically, total costs for current shareholders in a rights offer with standby underwriting are lower the smaller the portion of the issue they take up (since the underwriting cost is fixed and they pay the bank a takeup fee for each new share they subscribe to). Table 8 shows average direct flotation costs for four offer size categories classified by flotation method and issuer type. Panel A is based on the fixed fees paid directly by the firm to the investment bank only, while Panel B also includes the proportional shareholder takeup fee. The takeup fee is computed using the portion of the issue taken up by current shareholders as estimated in

244

0. Bohren et al./Journal of Financial Economics 46 (1997) 223-261

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245

Table 7 using the rights trading volume. Data on direct costs in Panel A are taken from company annual reports. The table includes 143 of the 205 issues for which flotation cost data are available. Most issues fall between $1.6 million and $15 million, and there is evidence of scale economies in the group of nonfinancials for issue sizes up to $75 million regardless of flotation method. For financial issuers in Panel A, average flotation costs as a percent of issue proceeds are 2.3% for uninsured rights, 3.0% for partial standbys, and 3.4% for rights with full standby. The corresponding average costs for nonfinancial issuers are slightly higher: 3.0%, 3.2%, and 4.4%, respectively. Thus, uninsured rights are least expensive, full standbys are most expensive, and partial standbys are in between. Adding shareholder takeup fees in Panel B increases total costs by an average of 1.3 percentage points, and reduces slightly the cost differential between uninsured rights and standbys. Next, we estimate a cross-sectional model for direct flotation costs (DFC). The purpose of this model is twofold. First, we wish to explore in more detail the statistical significance of the univariate cost comparisons in Table 8. Second, univariate cost comparisons can be misleading due a potential selection bias. For example, it is possible that the observed flotation costs of uninsured rights are particularly low because this method is selected when stock return variance is low or when shareholder concentration is high. Since these issue characteristics can reduce direct flotation costs regardless of the chosen flotation method, cost comparisons across flotation methods should condition on the values of these and other issue characteristics. Table 9 shows the ordinary least-squares (OLS) coefficient estimates of the cross-sectional model using the total direct costs from Panel B of Table 8 as the dependent variable. The independent variables include three variables for the size of the issue: log of gross offering proceeds (PRO), PRO a (for scale economies), and the percent increase in shares outstanding ASHR (defined as the number of new shares divided by the number of old shares outstanding). We expect both the direct costs of uninsured rights, as well as the underwriter's standby fee, to increase with issue size. Second, the model includes two measures of issue risk: the standard deviation of the issuer's daily stock return (STF) and the corresponding standard deviation of the market return (STM). STF is produced by the event study reported in Section 5 (below) and is therefore estimated over the 471 days starting 310 days prior to the day of the announcement of the offer. The underwriter fee is expected to increase with both risk categories. Third, the model includes the discount in the rights subscription price relative to the issuer's secondary market price on the day before the announcement day (DISC). We expect that the greater the discount, the smaller the risk of offering failure and, therefore, the lower the underwriter fee. Finally, the model includes two indicator variables for the flotation method: PARTIAL takes a value of one if the issue has a partial standby guarantee and zero otherwise, and FULL is similarly defined for issues with full standby guarantee.

O. Bohren et a l . / J o u r n a l o f Financial Economics 46 (1997) 2 2 3 - 2 6 1

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The coefficient on these indicator variables is used to test the hypothesis that standby offers are more expensive than uninsured rights, conditional on all the offer characteristics included in the empirical model. Data sources for these characteristics are offering prospectuses, Oslo Bors Informasjon, and company annual reports. The sample size in Table 9 is 127, a reduction of 16 from Table 8 due to insufficient data on stock prices for some firms. Overall, only three of the eight explanatory variables are significant in the full sample. Nevertheless, the model explains a significant 38% of the cross-sectional variability in percentage flotation costs for the total sample, with an adjusted R 2 of 89% for issues by financial companies and 42% for issues by nonfinancials. The insignificant intercept and the gross proceeds fail to indicate economies of scale as suggested earlier by Table 8. The percentage change in shares is significant and negative for financial issues, while the two risk variables are generally insignificant for all issue categories. The subscription price discount is significant and positive in the overall sample but insignificant in the two subsamples. As in Heinkel and Schwartz (1986), it is possible that a deep discount proxies for firm-specific risk, which in turn increases direct flotation costs. The values and statistical significance of ?'v and 1'8 for both issuer types indicate that the choice of partial standby underwriting increases the flotation costs and that the full standby guarantee increases these costs further. (An F-test rejects the hypothesis that ?'v = 1'8 at a 1% level of significance.) From this evidence, an uninsured rights offer appears to be the cheapest flotation method in Norway, which raises the question of why managers have increasingly turned to standby underwriting, as shown in Table 3. The following section examines this question in the context of a probit model, in which the key variable is the expected shareholder takeup.

4.2. A probit model for the standby decision In the following empirical analysis, we let K ~ [0, 1] denote our measure of shareholder takeup. As in Table 7, K is computed as one minus the percent of rights traded. We perform a two-step analysis. In the first stage, we estimate a linear regression model for K and use the coefficients from this model to construct an estimate of expected shareholder takeup, denoted/~. In the second stage, we estimate the probability P(S) that a given rights offer is underwritten as a function of/£ and two risk variables. According to the analysis in Section 2, we expect to find a negative relationship between P(S) and/£. As shown in Panel A of Table 10, the stage-one regression model for K contains seven variables that capture aspects of share ownership structure, issue size, and the issue discount. Share ownership structure: We expect shareholders in relatively closely held firms with large inside ownership to have the greatest propensity to subscribe to

248

0. Bohren et al./Journal of Financial Economics 46 (1997) 223-261

a new equity issue. Relatively large shareholders have a greater incentive to maintain their proportional holding in the firm in order to capture monitoring and control-oriented benefits. Also, the presence of large shareholders reduces agency problems and thus increases the likelihood that share issues are part of a value-maximizing investment strategy, which in turn increases shareholder propensity to subscribe. We include four ownership structure variables, of which the first three are as discussed earlier in Table 6: equity value per shareholder (EHELD), the percent of the equity held by the 20 largest shareholders (LARGE20), and the percent of the equity held by insiders (INSIDE). The fourth variable is firm size (FSIZE) measured by the market value of total equity; large firms tend to have more dispersed share ownership, which in turn tends to reduce the propensity for shareholder participation in the issue. Issue size: The larger the issue, the more likely the individual shareholder is facing costly wealth, liquidity, and diversification constraints when subscribing to his or her pro rata share. Thus, we expect K to decrease with issue size. Furthermore, a large percentage increase in the shares outstanding reflects a relatively large investment project, which typically has greater firm-specific risk. Greater firm-specific risk reduces risk-averse shareholders' optimal participation in the issue. As in Table 9, issue size is measured using the percent change in shares (ASHR) and the dollar value of the issue proceeds (PRO). Rights offer discount: Shareholder takeup is expected to increase with the rights offer discount. First, a relatively large subscription discount increases the (proportional) transaction costs of selling the right in the market and thus tends to increase current shareholder subscription and therefore K. Moreover, the greater the discount, the greater is the number of shares required to raise a given offering amount. As discussed in Section 2 above, since there is a tendency for Norwegian firms to set their dividends as a percent of the stock's par value, increasing the number of shares issued implicitly increases the firm's cash-flow commitment to dividends. To the extent that such an implicit dividend increase signals positive information about the firm's long-term future earnings potential, greater discounts are expected to positively affect K. As in Table 9, our measure of the discount (DISC) is the relative difference between the secondary market price on the day before the issue announcement and the subscription price. Based on the full sample of 105 offers with available data, Panel A of Table 10 shows the OLS parameter estimates of the regression model for K. The model explains 38% of the cross-sectional variation in shareholder takeup, with four of the eight coefficients being significant at the 10% level or better. Contrary to our expectations, shareholder takeup decreases with the size of the average prior dollar investment per shareholder (EHELD) and with insider holdings (INSIDE). However, as expected, LARGE20 has a positive impact on shareholder takeup. The F-statistic rejects at a 1% level the hypothesis that all of the slope coefficients are equal to zero. Alternative regression models for K that

O. Bohren et al./Journal of Financial Economics 46 (1997) 223-261

249

include the measures of firm-specific and market risk STF and STM used in Table 9 do not improve the explanatory power of the model. In the second step of the analysis, we estimate a probit model for the probability P(S) that the firm elects to underwrite the rights offer. The variable of primary interest in the probit model is/~, the value of K generated using the coefficients from the regression in Panel A.4 Moreover, the probit model also includes the two firm and market risk variables (standard deviation of daily stock returns) from Table 9, STF and STM, as explanatory variables. These are included in order to capture managerial incentives to underwrite that go beyond the Eckbo-Masulis model. First, managers facing personal offering-failure costs (e.g., personal reputation) have an incentive to ensure success of the offering by selecting standby underwriting to a greater degree than what is implied by the value of K alone. If offering-failure risk increases with firm and market risk factors, then we expect P(S) to increase with STF and STM. On the other hand, to the extent that the underwriter's effectiveness in detecting mispriced stocks (which in part determines the slope of the cost curve s-s in Fig. 1) is decreasing as the amount of firm-specific risk increases, some underpriced, high-risk issuers may select standby underwriting less frequently than implied by the value of k alone. For these firms, P(S) is decreasing in STM. As shown in Panel B of Table 10, the coefficient estimate for/~ is negative and significant, with a p-value of 0.001. Thus, the hypothesis that expected shareholder takeup plays an important role in the flotation method decision receives strong support. Furthermore, the probit regression yields a significantly negative coefficient for STF (p-value 0.008). This fails to support the managerial reputation argument for the choice of standby underwriting, but is consistent with the argument that the marginal effectiveness of underwriters, and therefore the probability of using standby underwriting, decreases with firm-specific risk. Having established empirically that P(S) is decreasing in/~, we now turn to the remaining implications of the Eckbo-Masulis model for the market reaction to the issue announcement. As discussed in Section 2, this model describes an equilibrium in which the market reaction to uninsured rights is more positive than the market reaction to standbys. This follows because the pool of standby issues exhibits the greatest degree of adverse selection. We continue to separate financial from nonfinancial issuers because the adverse selection model also implies a smaller market reaction to issues by regulated firms. This follows

"~Since/~ represents an estimate, the probit regression suffers from a potential errors-in-variables bias. However, this bias appears unimportant as a one-step pooled regression, where the probit model directly includes the explanatory variables for K, does not alter our main conclusions. Moreover, the two-step specification gives a more intuitive formulation of the statistical hypothesis relating the standby decision to the level of expected shareholder takeup K.

O. Bohren et al./Journal o f Financial Economics 46 (1997) 223-261

250

Table 10 Coefficients in the regression for current-shareholder takeup (K, Panel A) and in the probit model for the probability that the issuer chooses to underwrite a rights offer (P(S), Panel B), for 105 equity rights issues on the Oslo Stock Exchange, 1980-1993 (p-values in parentheses)?

Panel A: Model for current-shareholder takeup (K) K = flo + fl~PRO + flzASHR + fl3DISC + fl4FSIZE + flsEHELD + fl6LARGE20 + flTINSIDE flo

[31

1,014 (0.0002)

f12

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f13 0,034 (0,50)

f14 0.027 (0.80)

0,052 (0.14)

fls

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STM)

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7.2

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13.8 (3 d.f.)

Chow-R 2 0.13

Wariable definitions: K = actual shareholder takeup, computed using the rights trading volume. PRO = natural log of gross proceeds of offer. ASHR = percentage change in shares outstanding due to the offer (new shares divided by old shares). DISC = the discount in the rights subscription price relative to the issuer's secondary market price on the day before the offer announcement day. F S I Z E = log of the issuer's total equity value. EHELD = F S I Z E divided by the number of shareholders. LARGE20 = proportion of common stock held by the 20 largest shareholders at the beginning of the year of the offer announcement. I N S I D E = proportion of common stock held by the members of the board of directors and the CEO at the beginning of the year of the offer announcement. S T F = standard deviation of issuer's daily stock return over the estimation period a - 310 through a + 160, where a is the announcement day. S T M = standard deviation of the daily return on the market index over the same period as STF. bP(S) equals one if the offer is standby underwritten and zero otherwise./~ is the value of K estimated using the coefficient values in Panel A. because the regulatory

process reduces the likelihood

i s s u e in o r d e r t o e x p l o i t m a r k e t

that managers

time the

overpricing.

5. Valuation effects of rights offer announcements In this section around

we first present

issue announcements

estimates

of the average

classified by flotation

method

abnormal and

return

issuer type.

0. Bohren et al./Journal o f Financial Economics 46 (1997) 223-261

251

These averages allow useful comparisons with the results of the literature summarized in Table 1, and they form the basis for univariate tests of the Eckbo-Masulis prediction concerning the relative magnitude of the market reaction to uninsured rights and standbys. We then estimate multivariate regressions with the announcement effect as the dependent variable in order to provide a more powerful test of the adverse selection arguments. 5.1. Average abnormal returns

Abnormal returns are estimated using dummy variables relative to the following event dates: issue announcement (a), offer start (b), and offer expiration (e). Abnormal returns for all event windows are estimated simultaneously using the regression model 4

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(2)

j=l

where the "hat' denotes an OLS estimate and 8~.~,,is the estimated standard error of '7~,,. Under the null hypothesis of zero abnormal return, z,, is approximately standard normal for large sample size N. The average number of trading days from announcement a to the beginning of the rights subscription period b is 34 (48 calendar days) for the entire sample. Furthermore, the average number of trading days in the subscription period is ten (14 calendar days). Thus, it takes aplSroximately two months from announcement to offer expiration. In addition, after the expiration date, subscribing shareholders have on average 40 calendar days to pay the firm for the share purchase.

tO. Bohren et al./Journal of Financial Economics 46 (1997) 223-261

252

Table 11 Percent average abnormal stock returns relative to the issue a n n o u n c e m e n t (a), offer start (b), and offer expiration (e) dates for 188 equity rights offers by firms listed on the Oslo Stock Exchange, 1980-1993. The regression model is r jr = ~j q- [~jFmt ~-

~ ?i.d., + ujr

.=,

where r~, and rm, denote the continuously c o m p o u n d e d daily rates of return to firm j and the valueweighted market portfolio; the four d u m m y variables d,, each take on a value of one over the intervals corresponding to each of the four c o l u m n s in the table, and zero otherwise. The issuing firm's a b n o r m a l return over event period n is wj,),~,, where wj, is the n u m b e r of days in the event-period (z-value and percent negative in parentheses), a Offer category

Event period b a-40 through a - 2

a-1 through a

a+l through b - 1

b through e

I. All offers All (N = 188)

2.79 (2.40; 38.8)

0.47 (2.19; 51.1)

- 0.88 (0.46; 53.2)

- 0.85 (0.33; 55.9)

2.88 (1.58; 37.8) 4.77 (1.65; 29.7) 0.99 (0.59; 45.9)

1.55 (4.21; 2.01 (2.85; 1.09 (3.11;

1.41 (2.47; 45.9) - 0.59 (0.62; 54.1) 3.40 (2.87; 37.8)

1.63 (1.88; 47.3) 0.84 (0.56; 45.9) 2.43 (2.10; 48.6)

II. Uninsured rights All (N = 74) Nonfinancials (N = 37) Financials (N = 37)

45.9) 43.2) . 48.6)

llI. Standby rights All (N = 114) Nonfinancials (N = 89) Financials (N = 25)

2.73 (1.81; 39.5) 3.39 (1.31; 39.3) 0.36 (1.38; 40.0)

((-

0.23 0.59; 54.4) 0.36 0.46; 53.9) 0.23 ( - 0.38; 56.0)

(((-

2.36 1.39; 57.9) 2.65 1.12; 58.4) 1.32 0.85; 56.0)

((-

2.46 1.09; 61.4) 2.99 1.42; 62.9) 0.57 (0.35; 56.0)

~Data source: Oslo Bors Informasjon. The sample period starts in January 1980. Due to infrequent trading in some companies, we use bid prices to form daily returns. The estimation uses 471 daily stock returns starting on day a - 310. For event period n, z, = ( l / x / ~ ) ~ ' = l(~j,/~.~,), where the "hat' denotes the OLS estimate and 3~.i, is the estimated standard deviation of ~j,. U n d e r the null hypothesis of zero abnormal return, z, is approximately standard normal for large N. bThe average n u m b e r of calendar days from a n n o u n c e m e n t a to the beginning of the rights subscription period b is 48 (34 trading days). The average n u m b e r of calendar days in the subscription period is 14 (ten trading days). Thus, it takes on average approximately two m o n t h s from a n n o u n c e m e n t to offer expiration. In addition, after the expiration date, subscribing shareholders have on average 40 calendar days to pay the firm for the share purchase.

O. Bohren et al./Journal of Financial Economics 46 (1997) 223-261

253

The first column of Table 11 indicates that the average rights offer announcement tends to occur after a small but statistically significant 40-day runup in the issuer's stock price (2.79% for the total sample, z = 2.40). The runup is statistically insignificant in the uninsured rights sample and only marginally significant in the standby sample. One cannot reject the hypothesis that the abnormal returns over the runup period a - 40 to a - 2 is the same for both flotation methods. This finding is consistent with the conclusion for US rights offers in Eckbo and Masulis (1992). The second column in Table 11 shows the average two-day announcement period abnormal return. The average abnormal return is a significant 1.55% (z = 4.21) for uninsured rights and an insignificant - 0.23% (z = - 0.59) for standbys. The significance of the market reaction to uninsured rights in the total sample holds for both financial and nonfinancial issues, with two-day abnormal returns of 1.09% (z = 3.11) and 2.01% (z = 2.85), respectively. Moreover, the market reaction to standby rights is insignificant whether the issuer is a financial or a nonfinancial corporation. In sum, the average market reaction to uninsured rights offer announcements is significantly greater (more positive) than the average market reaction to standbys, as predicted by the Eckbo-Masulis model. Moreover, the market reaction to issues by financial corporations is lower than the market reaction to industrial issues, which is consistent with the hypothesis that the regulatory environment reduces adverse selection risk. Comparing Table 11 with the extant literature summarized in Table 1, our conclusion concerning the relative announcement effect of uninsured rights and standbys is consistent with the conclusion of Eckbo and Masulis (1992). In their sample of rights offers, the two-day announcement effect is significantly lower for standbys than for uninsured rights, whether the issue is by an industrial firm or a regulated utility. Notice, however, that while the average two-day announcement effect of rights issues on the OSE are met with nonnegative abnormal returns, the average standby rights and firm commitment underwritten offerings in the US cause a significantly negative market reaction. We have no particular explanation for this difference in the level and sign of the market reaction to underwritten offers across the two markets. It is possible that equity issues in Norway (to a greater extent than in the US) are associated with news concerning valuable investment opportunities available to the issuing firm. However, notice also the tendency in Table 1 for equity rights issues in other non-US markets (with the exception of Canada) to produce nonnegative abnormal returns. 5 This raises the possibility that problems of adverse selection are

5 Note that the studies in Table 1 which are based on monthly returns, such as Marsh (1979) for the U K and Loderer and Z i m m e r m a n (1988) for Switzerland, are not directly comparable to studies based on daily returns. Several studies have documented a significant stock price r u n u p over the period just prior to the issue announcement. When present, this stock price runup will bias upwards measures of the a n n o u n c e m e n t effect based on monthly returns.

254

0. Bohren et al./Journal of Financial Economics 46 (1997) 223-261

more severe in the U.S. institutional environment than in smaller equity markets such as the OSE and those represented in Table 1, an interesting topic not pursued further here. The last two columns of Table 11 indicate a further positive post-announcement drift in the stock price of the average financial firm issuing uninsured rights. Over the period between the announcement and the start of the offering (day a - 1 through day b - 1), the average abnormal return is 3.40% (z = 2.87) for this issue category. This drift is on average followed by a 2.43% abnormal return (z = 2.10) over the rights offer period itself (day b through day e). Nonfinancial issuers of standby rights show negative average abnormal returns of comparable magnitudes over these event windows, although none are statistically significant. Moreover, while not shown in Table 11, there is no evidence for any of the offering categories of statistically significant post-expiration date abnormal returns (estimated by adding one dummy variable in the market model for either a two-month, a four-month or a six-month event window, respectively). Overall, the evidence on the post-announcement abnormal returns suggests some short-term updating of issue-related information prior to the offer expiration day. This updating is in a positive direction for uninsured rights and in a negative (but insignificant) direction for standbys, thus exacerbating the difference between the valuation impacts of the two rights offer categories. Issues of significance aside, this is consistent with the partial revelation assumption underlying the Eckbo-Masulis model, which implies that the market continues to look for new sources of information relevant for valuation also after the first issue announcement. 5.2. Cross-sectional analysis of the two-day announcement effect Let ARj denote the two-day abnormal announcement return to issuer j and suppose ARj is determined by a linear cross-sectional model of the form A R j = x j 4 ) + e i, j = 1 , . . . , N ,

(3)

where x~ is a set of explanatory variables and the residual ej is assumed to satisfy E(aj)=O,

E(e,2 ) = a x,

E(a./,~j.)=0

forj~j'.

In thiscontext, ~ represents a summary statistic for variables that are omitted by the econometric model but which are publicly available to participants in the capital market and therefore reflected in the abnormal announcement return AR t . We include the following explanatory variables: x~c~ - (Oo + c~IPROj + c~2DISCj + c~3RUN ~ + dp4ASHR ~ + dpsLARGE20~ + 4)61NSIDE i + c~TPARTIAL i + c~sFULL~ (4)

0. Bohren et aL /Journal of Financial Economics 46 (1997) 223-261

255

where PRO, DISC, ASHR, PARTIAL, and FULL are defined as in Table 10 and RUN = w l ~ is the abnormal stock return over the w days (40 days if there are no missing return observations) prior to the announcement day. LARGE20 is the proportion of common stock held by the 20 largest shareholders at the beginning of the year of the offer announcement, and INSIDE is the proportion of common stock held by the members of the board of directors and the CEO at the beginning of the year of the offer announcement. Following the discussion in Eckbo et al. (1990), suppose investors know that managers decide to issue and invest only after receiving a private signal q~ that indicates that the issue has a positive value. Here, qj denotes the value of the private signal in terms of the share price effect. Thus, conditional upon the issue decision, the market infers that xA~ + rtj > O.

(5)

As a result, when the (unanticipated) event occurs, the market impounds into the firm's stock price the following conditional expected return: E ( A R j I q j > - x j49) = x j(9 + E(qjlqi > - x / o ) .

(6)

In effect, the market's inference truncates the residual term 71ithat measures the value of managers" private information. Consequently, if one estimates the parameter vector ~b using linear estimators (such as OLS or generalized least squares), the nonlinear expectationaI term in (6) ends up in the error term ej in (3), causing the estimated parameter values to be inconsistent. Eckbo, Maksimovic, and Williams provide a consistent estimator for discrete events under the assumption that the private signal r/j is normally distributed and independent across sample firms, i.e., qj ~ N(0, ~oz). In this case, a consistent specification of the cross-sectional model is given by (7)

A R j = x / ~ + ~o N ( x / p / o g ) + ~;'

where (j is assumed to satisfy E ( ~ ) = 0 , E(~2 ) = u2, E ( ~ , ( j , ) = 0

j#j',

and where n(') and N(-) represents the standard normal density and cumulative functions, respectively. The results of the nonlinear estimation are shown in Table 12. The starting values for the optimization are the OLS estimates of Eq. (3) and the residual standard error from the market model estimation, Eq. (1). Several of the coefficients are significant, including the estimated standard error of the private signal, ~b, which is consistent with the underlying information specification. (The

256

O. Bohren et al./Journal o f Financial Economics" 46 (1997) 223-261

parameter co is estimated freely and may come out negative if the econometric model is misspecified.) The coefficient of PRO is negative and significant in the full sample regression, suggesting that adverse selection effects are more pronounced the greater the size of the issue. The variable R U N also receives a significantly negative coefficient, indicating that adverse selection effects are more severe the greater the abnormal stock price runup 40 trading days prior to the issue announcement. This is consistent with the dynamic issue model of Lucas and McDonald (1990), where firms randomly receive valuable investment projects. Temporarily overpriced firms immediately respond by a decision to issue-and-invest while temporarily undervalued firms postpone the issue-and-invest decision until the market prices the firm more favorably. This behavior implies that the average stock issue is preceded by a positive stock price runup. The average values of RUN, which are shown in Column 2 of Table 11, are 2.9% (z = 1.6) for uninsured rights and 2.7% (z = 1.8) for standbys. Of the ownership structure variables LARGE20 and INSIDE, only the latter receives a significant coefficient. The positive value of (])6 indicates that the market reacts more favorably to issues for which the ownership proportion of board members and the CEO is greater. There is a significant overlap between INSIDE and the ownership proportion of the 20 largest shareholders (LARGE20), which probably explains why there is no additional explanatory power from including the latter variable. The two indicator variables PARTIAL and FULL have negative coefficients, with the latter being significantly different from zero. Thus, the market reacts more negatively to a full standby offering than to an uninsured offering, which is consistent with the theory and evidence in Eckbo and Masulis (1992). This result is consistent with the Eckbo-Masulis proposition that adverse selection effects help determine firms' choice of flotation method, and that rational market participants account for this when they react to the news of an equity offering. The difference in the market reaction to partial and full standbys is statistically significant only at a 10% level. Thus, while the market distinguishes between uninsured rights and standbys, the distinction between partial and full standbys is less important. Finally, Table 12 also provides evidence on the hypothesis concerning the information content of the offer price discount. In Norway, the subscription price discount is announced along with the first announcement of the rights issue. Thus, the dependent variable ARj reflects the market's reaction to the discount, DISC. The value of coefficient q5z is negative but insignificant, failing to support either the negative information-signaling argument of Heinkel and Schwartz (1986) or the positive dividend-related signaling argument of Hietala and LiSyttyniemi (1991) discussed earlier in Section 2.

10. Bohren et al,/Journal of Financial Economics 46 (1997) 223-261

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6. Conclusion

In the US as well as internationally, there is a trend towards selecting underwritten flotation methods when issuing seasoned equity as well as other more senior securities. For industrial issuers in the US, this trend caused the uninsured rights offer method to virtually disappear by the early 1980s, while rights offers still account for the majority of domestic equity issues in the smaller Canadian, European, and most Pacific Rim capital markets. We show that in Norway, the trend produced a substantial shift away from uninsured rights towards rights with standby underwriting, with the latter flotation method accounting for more than 97% of all seasoned equity offerings in the 1990s. The trend towards greater use of underwritten offers occurs despite substantial evidence that the direct flotation costs associated with the uninsured rights method are significantly lower than the underwriter fee. This empirical regularity is confirmed on our Norwegian sample of equity rights offers as well. Eckbo and Masulis (1992) argue that this 'rights offer paradox' can be resolved by considering the potentially large adverse selection costs that would arise were the issuer to make a rights offer when current shareholders do not wish to take up the issue and accordingly sell their rights in the secondary market. Shareholder takeup is in part determined by factors such as personal wealth constraints and demand for diversification, which are beyond an issuer's control. These factors tend to limit shareholder participation in equity issues by relatively large, widely held firms. This argument suggests that issuers anticipating low shareholder takeup should turn to underwriters for (imperfect) quality certification in order to avoid the relatively high adverse selection costs of the rights offer method in the face of heavy sales of rights. We test this argument directly using data on a sample of 200 (of a population of 206) uninsured and standby rights offers on the Oslo Stock Exchange over the period 1980-1993. Our sample is interesting because we have access to previously unavailable information on current shareholder takeup and because shareholder demand for new issues is likely to be substantially greater in the closely held equity market studied here than in the US. Moreover, our institutional setting is one where issuers always use rights - there were no firm commitment contracts on the OSE during our sample period. This contrasts with studies on US data in which fewer than 5% of the issues involve the rights method. We find that the probability that a rights offer is underwritten is negatively related to expected shareholder takeup, as predicted by the Eckbo and Masulis (1992) adverse selection framework. Contrary to US evidence, but consistent with a growing number of studies on smaller capital markets, we also find that the two-day abnormal announcement return is significantly positive for uninsured rights issues (approximately 2%). Importantly, this announcement effect is significantly greater than the corresponding market reaction to standby rights issues (approximately 0%), which is

~. Bohren et al./Journal o f Financial Economics 46 (1997) 223-261

259

a further implication of the Eckbo-Masulis adverse selection model. Nonlinear cross-sectional regressions with announcement returns as the dependent variable also reveal that the market reaction to industrial issues decreases with the size of the offering and with the size of the pre-announcement runup in the issuers' stock price. Moreover, the price reaction is more favorable the higher the proportion of the voting stock held by board members and the CEO of the issuing firms prior to the issue. These results are consistent with adverse selection effects of managerial discretion as to the timing, form and size of the issue, and of the impact on managerial incentives of large insider stock holdings. Moreover, we find little evidence of managerial reluctance to issue rights with a deep discount, nor do we detect any evidence that a deep discount signals negative information about equity value. These results are consistent with our finding that firm-specific risk has no direct impact on the decision to underwrite once the expected level of current shareholder takeup is taken into account. In sum, our evidence supports the hypothesis that the growing international use of underwriting reflects value-maximizing behavior by the issuing firms' managers. An analysis based on direct flotation costs alone, which underlies the so-called 'rights offer paradox', misses important indirect costs of uninsured rights. These indirect costs, which arise when the issuer is better informed than outside investors about the true value of the stocks sold, are greater the lower the current shareholder takeup of the issue. Thus, a resolution of the rights offer paradox requires evidence on the role of shareholder takeup, which we present. This evidence is consistent with the model for rational flotation method choice developed by Eckbo and Masulis (1992) and, consequently, helps resolve the long-standing equity rights puzzle.

Acknowledgements We are grateful for the comments and suggestions of David Blackwell (the referee), Matti Keloharju, Ronald Masulis, Clifford Smith (the editor), and Karen Wruck. We would also like to thank seminar participants at London School of Economics, the Norwegian School of Economics and Business Administration, the Norwegian School of Management, Southern Methodist University, the Fifth Annual Finance Conference of Osaka University, and the meetings of the 1993 European Finance Association, the 1994 Northwest Finance Association, and the 1995 American Finance Association. This research was supported by a grant from the Norwegian Research Council (Norges Forskningsr/~d).

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