Costly Self‐Insurance of Rights Offerings

• Author: Rajdeep Singh,Eng‐Joo Tan,Truong X. Duong
• Published date: 01 November 2015
• Date: 01 November 2015
• DOI: http://doi.org/10.1111/jbfa.12168

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(9) & (10), 1251–1281, November/December 2015, 0306-686X

doi: 10.1111/jbfa.12168

Costly Self-Insurance of Rights Offerings

TRUONG X. DUONG,RAJDEEP SINGH AND ENG-JOO TAN∗

Abstract: We study how the underwriting decision of an equity rights offering is affected by

the risk of offering failure. Firms can reduce failure risk by getting underwriting or by self-

insuring through subscription price discounts and subscription precommitments. Self-insurance

is generally regarded to be relatively costless, but we provide evidence from Singapore that

is consistent with the existence of implicit costs. In particular, the existence of self-insurance

costs implies that firms with better projects will have larger discounts and that firms with higher

ownership concentration will have more precommitments. Hence, our results support costly

self-insurance against issue failure as a factor in explaining the rights issue paradox.

Keywords: rights, paradox, failure, seasoned equity offerings

1. INTRODUCTION

Equity rights offers have presented a challenge to financial economists over the

past three decades. Smith (1977) describes a rights issue paradox, where corporate

managers prefer firm commitment offerings to rights offerings even though the

former are more costly, with direct flotation costs estimated to be 6.17% and 2.45%

of the proceeds, respectively.1Furthermore, Eckbo (2008) notes that the percentage

of rights issues among US seasoned equity offerings (SEOs henceforth) shrunk from

50% during 1935–1955 to 2% during 1980–2008; given that $730 billion were raised

during the latter period via firm commitment offerings, the direct cost differential

implies $27 billion have potentially been incurred due to suboptimal choices by firms.

In addition, a multitude of studies document an increasing reliance on underwriter-

intermediated SEOs in other parts of the world (e.g., in Canada (Ursel and Trepanier,

∗The first author is at the College of Business, Iowa State University. The second author is at the Carlson

School of Management, University of Minnesota. The third author is at the Lee Kong Chian School

of Business, Singapore Management University. The authors would like to thank Ren´

ee Adams, Sugato

Bhattacharyya, Clifford Holderness, Jennifer Huang, Stacey Jacobsen, Roger Loh, Ronald Masulis, Garry

Twite, Kazuo Yamada, as well as the participants of the 2010 Singapore Management University Finance

Summer Camp, 2011 Asian Finance Association Meeting, 2011 Financial Management Association Annual

Meeting, and 2013 European Financial Management Association Annual Conference for their helpful

comments. The authors are especially grateful to the Associate Editor, Norman Strong, and an anonymous

referee for their invaluable suggestions. Any remaining errors are, of course, the responsibility of the

authors. (Paper received December 2014, revised version accepted October 2015).

Address for correspondence: Truong X. Duong, College of Business, Iowa State University, 1200 Gerdin

Business Building, Ames, IA 50011, USA.

e-mail: tduong@iastate.edu

1 The most common equity flotation mechanisms are the firm commitment offering and the standby rights

offering, both of which are underwritten, and the uninsured rights offering, which is not underwritten.

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1252 DUONG, SINGH AND TAN

2001), Hong Kong (Wu et al., 2005), Japan (Eckbo et al., 2007), France (Gajewski and

Ginglinger, 2002), and Norway (Bøhren et al., 1997)).

Resolution of the paradox, unfortunately, remains elusive as it is challenging to

show that omitted costs (benefits) associated with non-underwritten (underwritten)

offers are sufficient to explain the direct cost differential, because to do so requires one

to estimate the economic significance of counterfactual elements. Moreover, countries

such as the United States for which the paradox is severe make undesirable test beds

because of their poor sample sizes, necessitating research on other countries in seeking

resolution. Studying the paradox in a setting where no paradox is observed is not, in

itself, inappropriate as long as there are common drivers of equity flotation mechanism

choice.

When an equity offering fails, the inability to raise the requisite proceeds imposes

a cost due to project opportunity loss or delay, which we refer to as failure cost

henceforth. For a firm commitment offering, the expected failure cost is trivial

because the offering is underwritten. For a non-underwritten rights offering, conven-

tional academic wisdom (e.g., Smith (1977)) suggests that self-insurance through a

sufficiently low subscription price is effectively costless, which implies an expected

failure cost that is close to zero. Yet, Bacon (1972), among others, notes corporate

managers appear averse to setting low subscription prices. Prior studies provide

reasonable bases for this puzzling behavior: Heinkel and Schwartz (1986) theorize

that undervalued firms set subscription prices at higher levels to signal their higher

quality while Holderness and Pontiff (2013) document that deeply discounted rights

offerings effect a substantial wealth transfer from non-participating to participating

shareholders.

Is self-insurance really costless? In this paper, we develop and test implications of

costly self-insurance. All else equal, corporate managers should choose equity flotation

methods with the lowest expected cost, which comprises not only direct costs but

also indirect costs such as failure costs and self-insurance costs (i.e., costs incurred

due to actions taken to avert offering failure). We argue that even though lowering

the subscription price of an offering reduces the failure cost, if subscription price

discounting is costly, managers are effectively trading off the cost of discounting

against the cost of failure.

In addition to subscription price discounting, an issuer can reduce expected failure

cost by obtaining precommitments from its shareholders to subscribe to its offering;

however, this form of self-insurance too is possibly not costless, as corporate managers

have to expend time and effort to procure sufficient subscription precommitments to

ensure the success of the offering. Thus, a firm that undertakes an uninsured rights

offering with subscription precommitments is trading off the cost of failure against

the opportunity cost of managerial time spent soliciting precommitments, where the

latter cost is likely a function of the firm’s ownership structure. Since failure cost is

relevant to the self-insurance decision only in the face of costly self-insurance mech-

anisms, we refer to our hypotheses collectively as the costly self-insurance hypothesis

(CSIH).

Although both non-underwritten and underwritten rights offerings are becoming

increasingly infrequent in the US, the paradox is really due to the dearth of

non-underwritten rights offerings, since underwritten rights and firm commitment

offerings have similar direct costs (see, e.g, Smith (1977)). Furthermore, as the

underwritten rights offering captures the salient features of the firm commitment

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