The proposed €1bn capital raising by Bank of Cyprus through a placing and open offer of 4,166,666,667 new ordinary shares in the capital of the bank has again raised the much debated topic of capital dilution and how shareholders can prevent share dilution. The issue is to be effected as a placement and open offer since:
a) In phase 1 a private placement is made with selected qualified investors1, and
b) In phase 2 an open offer is made to existing shareholders allowing for up to 20% of a clawback on the shares placed in private placement.
The issues of dilution are common and frequently hard fought issues in public and private companies alike.
Nature of Dilution
In simple terms dilution is a reduction in a shareholding which can be either of value (economic dilution) or of relative ownership (percentage dilution). The most frequent cause of dilution is when a company issues new shares. A percentage dilution occurs if an existing shareholder does not purchase in the new share issue a percentage of shares equal to its current holding – if for e.g. a shareholder holds 10% it must purchase 10% of the new issue in order to maintain its relative ownership. An economic dilution will reduce the value of an existing shareholders investment and occurs where the shares are issued at a price that changes the average value per share. The non-pre-emptive issue by Bank of Cyprus will result in both a percentage dilution and economic dilution for existing shareholders.
Companies Law, Cap. 113
Section 603 of the Companies Law, cap. 113 (as amended) provides some protection for existing shareholders of public companies where a new issue is being done for cash consideration by granting a statutory pre-emptive right. In such a case, the shares being issued must first be offered to existing shareholders on a pre-emptive basis pro-rata. The statutory pre-emptive right can only be excluded or restricted by a resolution of the shareholders passed by a majority of not less than two-thirds of the votes attaching to the securities or subscribed capital represented2. If the pre-emption rights are not excluded or waived by a requisite decision of the general meeting, then a non-pre-emptive share issue cannot take place.
The most effective and frequently used anti-dilution measure is the use of rights of pre-emption (or rights of first offer) – these can be contained in the articles of association in the case of private and public companies (in addition to the statutory pre-emption right in the case of public companies). The other measures frequently encountered are provisions usually contained in the articles of association and/or shareholder or investment agreements which provide for additional shares to be issued at a nominal price to existing shareholders or certain of the existing shareholders thus reducing the dilution suffered on a new share issue. These take the form of either:
(a) Full ratchet protection – where the shareholders benefiting from this provision will be issued such number of additional shares as will reduce the average price the shareholder has paid to the lower price that the shares are being issued on a new issue; or
(b) Weighted average ratchet protection3- the shareholders having this anti-dilution protection will receive such number of shares so as to reduce their average price to a weighted average of different issue prices.
These ratchets are commonly used when a company is taking in an institutional or venture capital investor who wants to safeguard the value of their investment and prevent or reduce any economic dilution in any future "round-down".
The issue that arises in the case of any new share issue is whether existing shareholders should be offered anti-dilution protection. One school of thought to which the authors subscribe is that giving existing shareholders full anti-dilution protection (both economic and percentage) both ignores commercial reality and is not in the best interests of the company. The very reason why a new share issue may be proposed is that the Company needs capital to survive or capital to expand or fund a new project or otherwise to raise regulatory capital, where relevant. In the current economic conditions where raising capital presents varying and varied difficulties, it may be the only way to raise capital is to carry out a new share issue and there is never any guarantee that the existing shareholders will meet the additional capital needs. Accordingly, the only commercial way to proceed is to attract new investment by excluding or restricting any pre-emptive rights or other anti-dilution mechanisms.
1 As defined in Article 2.1(e) of the EU Prospectus Directive, Directive 2003/71/EC and section 2 of the Public Offer and Prospectus Law, Law 114(I)/2005 (as amended).
2 Section 59A(1)(b). In the case of Bank of Cyprus the requirement is for a special resolution (75%).
3 There are two variants of this – either narrow based weighted average (taking account only of the total number of issued shares) or broad based weighted average (which takes account also of convertible securities).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.