Control Expropriation Via Rights Offers

• Published date: 01 July 2023
• Author: Leeor Ofer
• Date: 01 July 2023
• DOI: http://doi.org/10.1111/ablj.12232

American Business Law Journal

Volume 60, Issue 3, 651–696, Fall 2023

Control Expropriation Via

Rights Offers

Leeor Ofer*

Rights offers are a relatively common capital-raising method. In a rights offer,

the company’s existing shareholders are given the opportunity to purchase

newly-issued shares in proportion to the amount of shares they already own for

a specific subscription price per share. Because all shareholders can participate

in the issuance under the same terms, rights offers are often regarded as fair

to all shareholders. However, this article demonstrates that rights offers do not

always place shareholders on equal footing. In particular, this article shows that

dominant, non-controlling shareholders (“insiders”) can utilize a rights offer to

expropriate control. By setting a deliberately high subscription price, insiders

can deter other shareholders from buying into the offer. Insiders can then pur-

chase a disproportionate amount of shares via the rights offer, thereby securing

absolute control. Once in control, insiders will be in a position to extract value

from the firm, and will be immune to future control challenges. These expected

benefits of control make the high subscription price worth paying from insiders’

perspective, so that the rights offer is effectively underpriced for insiders but

overpriced for other shareholders. When a rights offer acts as a change-

of-control tool, it should be governed by Delaware takeover law. Courts should

closely scrutinize such issuances, and require boards to maximize the premium

insiders pay for control. This article further suggests that stock exchanges adopt

a mandatory price-adjusting mechanism for rights offers, which will guarantee

*Leeor Ofer is a John M. Olin Fellow in Law and Economics, Harvard Law School; Pro-

gram on Corporate Governance Fellow, Harvard Law School; Editor of the Harvard Law

School Forum on Corporate Governance; and S.J.D. candidate, Harvard Law School. I am

indebted to Jesse Fried for his invaluable advice and continues support. I also thank Holger

Spamann, Kobi Kastiel, Guy Rubinstein, Tom Vos, and Dror Ofer for their insightful com-

ments and suggestions. All errors are my own. This article was selected as a Harvard John

M. Olin Law and Economics Working Paper.

©2023 The Author

American Business Law Journal ©2023 Academy of Legal Studies in Business.

651

that the subscription price is lower than or equal to the underlying share’s

trading price.

INTRODUCTION

In March 2013, the board of directors of Morgans Hotel Group Co.

(Morgans) approved a set of transactions (the Recapitalization) involving

The Yucaipa Companies, LLC (Yucaipa), an entity controlled by billion-

aire Ronald W. Burkle.

1

Prior to the Recapitalization, Yucaipa held a

combination of Morgans’ securities that, together with Burkle’s board

seat and close relationships with Morgans’ management, gave Yucaipa

significant influence over Morgans.

2

Yucaipa harnessed that influence to

push aggressively for a Recapitalization aimed at deepening Yucaipa’s

control over Morgans.

3

The Recapitalization included a $100 million rights offering—a share

issuance that provides existing shareholders the opportunity to purchase

additional shares in proportion to the amount of shares they already

own (pro rata).

4

The subscription price was set at $6 per share, a twenty-

six percent premium over Morgans’ then-current trading price

of $4.73.

5

The twenty-six percent premium appeared to be a deliberate attempt

to deter Morgans shareholders from buying into the rights offer. Indeed,

as Morgans stock traded on the Nasdaq Stock Exchange, shareholders

could simply purchase additional shares on the market, rather than

through the rights offer, for a much lower price. Yucaipa, on the other

hand, intended to fully subscribe to its part of the offer. Yucaipa further

committed to backstop the rights offer, i.e., to buy all shares not pur-

chased by other Morgans shareholders via the rights offer. By

1

OTK Assocs. v. Friedman,85 A.3d 696, 702 (Del. Ch. 2014).

2

Id.

3

Id. at 707; see also Liz Hoffman, Burkle Made “World War III”Threats, Morgans Investor Says,

L. 360 (May 24, 2013), https://www.law360.com/articles/444550/burkle-made-world-war-iii-

threats-morgans-investor-says.

4

OTK, 85 A.3d at 713.

5

Id. at 707.

652 Vol. 60 / American Business Law Journal

backstopping the rights offer, Yucaipa was expected to emerge with

thirty-five percent of Morgans common stock and exercise effective con-

trol over Morgans.

6

OTK Associates, LLC (OTK), a Morgans block-holder that opposed

Yucaipa, sought to replace all of Morgans’ existing directors by running

a competing slate of its own representatives at Morgans’ annual meet-

ing.

7

Despite Yucaipa’s dominant position, it was not immune to such a

threat. Yucaipa thus pressured Morgans’ board into delaying the annual

meeting, so that Yucaipa could complete the rights offer prior to the

meeting. Through the rights offer, Yucaipa planned to gain effective con-

trol and utilize its increased voting power to outvote OTK. Eventually,

the Delaware Court of Chancery granted a preliminary injunction to

enjoin the Recapitalization.

8

Later, at Morgans’ annual meeting, its share-

holders elected OTK’s entire slate of directors.

9

The Morgans overpriced rights offer was a clever attempt to expropri-

ate control. For Burkle, the subscription price (which he himself set) was

attractive. By backstopping the rights offer and buying a disproportion-

ate amount of shares, Burkle would be getting an asset—control—that

would act to offset the high subscription price. For most other Morgans’

shareholders, however, it made no sense to opt into purchasing

Morgans’ shares for more than their trading price. As minority share-

holders, they were not in a position to utilize the offer as a means to

cement control. Thus, from their perspective, the rights offer subscrip-

tion price was too high and not worth paying. In other words, because

Yucaipa and other Morgans shareholders were differently situated, their

equal treatment via the rights offer had an unequal effect. Indeed, by

designing a rights offer in which the subscription price is high for minor-

ity, non-insider shareholders (outsiders) but effectively cheap for

6

Id.(“Moelis, Yucaipa’s financial advisor, believed that few stockholders would participate in

a premium-priced [r]ights [o]ffering. Moelis advised Burkle that by backstopping a $100

million rights offering, Yucaipa would emerge with approximately 35% of the common

stock, and Burkle would be able to exercise effective control over Morgans. Moelis thought

that if the size of the [r]ights [o[ffering were increased to $160 million, Yucaipa would

emerge with a majority of the shares and Burkle would have hard control.”).

7

Id. at 709.

8

Id. at 714.

9

Id.

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