The Wealth Effects of Reducing Private Placement Resale Restrictions Elizabeth Maynes* J. Ari Pandes† Current Version: December 2009 Abstract Recently, the U.S. Securities and Exchange Commission reduced resale restrictions on Rule 144 private placements from 12 months to 6 months with the intention of lowering the cost of equity capital for issuing firms. In Canada, similar regulatory changes were adopted several years ago, providing a unique opportunity to test the wealth effects of reducing private placement resale restrictions. We find that shortening resale restrictions reduces the liquidity portion of offer price discounts and thus lowers the cost of equity capital for issuing firms, but has a larger negative effect of reducing existing shareholder wealth measured by announcement-period abnormal returns. Moreover, we show that the legislation-induced easing of resale restrictions reduces the costly signal that helps to overcome the Myers and Majluf (1984) underinvestment problem, causing smaller firms with greater information asymmetry to choose not to issue equity and thus potentially passing up positive net present value investment opportunities. JEL Classification: G32; G28; G14 Keywords: private placements, special warrants, offer price discount, announcement effects * Associate Professor of Finance, Schulich School of Business, York University, 4700 Keele Street, Toronto, Ontario M3J 1P3, Canada. E-mail: [email protected]. Phone: (416) 736-2100 ext 77944. Fax: (416) 736- 5687. † Corresponding Author: Assistant Professor of Finance, Haskayne School of Business, University of Calgary, 2500 University Drive NW, Calgary, Alberta T2N 1N4, Canada. E-mail: [email protected]. Phone: (403) 220-4350. Fax: (403) 770-8104. We thank Douglas Cumming, B. Espen Eckbo, Debarshi Nandy, Pauline Shum and Ed Waitzer for very valuable feedback. Comments and suggestions from conference participants at the 2008 European Finance Association meetings, the 2008 Financial Management Association meetings, the 2008 Northern Finance Association meetings, and seminar participants at the Office of Economic Analysis, U.S. Securities and Exchange Commission, University of Calgary (Haskayne), Erasmus University, ESSEC, HEC Montreal, University of Toronto (Rotman), VU Amsterdam, University of Warwick, University of Waterloo, and York University (Schulich), are gratefully acknowledged. This paper was awarded the 2008 Bank of Canada Best Paper Award on Canadian Financial Markets. 1. Introduction Private placements are an important source of raising equity capital for smaller firms with high information asymmetry (Chemmanur and Fulghieri, 1999; Wu, 2004; Cronqvist and Nilsson, 2005). Unlike public equity offerings, private placements of common stock by publicly listed companies are typically associated with positive announcement effects and are issued at considerable discounts from the issuing firm’s stock market price.1 The monitoring and certification hypotheses are the most widely cited explanations for these findings. According to the monitoring hypothesis (Wruck, 1989), the positive announcement effects are a consequence of reduced agency costs motivated by the private placement induced increase in ownership concentration. Private placement discounts reflect compensation for monitoring services provided by private investors. Under the certification hypothesis, Hertzel and Smith (1993) extend the Myers and Majluf (1984) model of information asymmetry between managers and outside investors regarding the firm’s true value and show that private placement discounts and the positive stock price effects reflect the resolution of this asymmetry. An alternative hypothesis is managerial entrenchment (Barclay et al., 2007). According to this hypothesis, management places stock with friendly investors at a discount so that they will not “rock the boat”; positive announcement effects are mainly driven by private investors that become active investors in firm affairs. Another factor in the determination of private placement discounts is the existence of restrictions on the resale of the shares, imposing illiquidity on the investors (Silber, 1991). Recently, securities regulators in various jurisdictions have been easing private placement resale restrictions with the intention of making private placements more attractive to investors and also 1 We use the pairs of terms “common share” and “common stock”, and “discount” and “offer price discount” interchangeably throughout the paper. 1 to reduce the cost of equity capital for issuers by reducing the liquidity discount. For example, the U.S. Securities and Exchange Commission (SEC) on February 15, 2008 amended resale restrictions associated with Rule 144 private placements effectively reducing the resale restriction period from 12 months to 6 months.2 In Canada, similar regulatory changes were adopted several years earlier, on November 30, 2001, providing a unique opportunity to test the wealth effects associated with legislation-induced reductions in private placement resale restrictions. Using a unique sample of 1,173 private placements of equity from Canada, this paper provides evidence that although shortening resale restrictions reduces the liquidity portion of offer price discounts, it has a larger negative effect of reducing existing shareholder wealth measured by announcement-period abnormal returns. Moreover, we show that the easing of resale restrictions reduces the costly signal that helps to overcome the Myers and Majluf (1984) underinvestment problem, causing smaller firms with greater information asymmetry to choose not to issue equity and thus potentially passing up positive net present value investment opportunities. The Canadian experience with past institutional and regulatory changes provides insights into what regulators, firms, and investors can potentially expect in the U.S., and other markets that are considering adopting similar rule changes. The rules governing private placements of equity by Canadian publicly listed companies are similar to U.S. equity private placements issued under Regulation D of Rule 144. In both countries, privately placed equity issues can only be sold to qualified investors and those investors face restrictions on the resale of the shares. 2 The Securities and Exchange Commission in their final report on making the change in resale restrictions effective, state: “We believe that the amendments will increase the liquidity of privately sold securities, make capital investment more attractive, and decrease the cost of capital for all issuers without compromising investor protection.” (Release No. 33-8869; File No. S7-11-07) 2 In addition to privately placing common stock, Canadian public companies also issue a second type of privately placed equity, known as special warrants. As with all Canadian private placements of equity, special warrants are issued without a prospectus and sold only to qualified investors. Unlike regular stock warrants, special warrants have an exercise price of zero, making them exchangeable for common stock of the issuer at no additional cost. However, the issuer promises to file a prospectus so that when the special warrants are exercised, the newly issued common stock are freely tradable. In a typical special warrant offering, the issuer promises that the warrants will be exercisable into freely traded common stock within 4 months. A special warrant deal offers the speed of a private placement to the issuer and at the same time offers investors the promise that they are buying stock with a shorter restricted period than a regular private placement of common stock.3 Special warrants are in effect hybrid private/public offerings. The Canadian regulations governing the resale of private placements of equity by publicly listed companies have undergone significant change.4 At the start of the sample period, Jan 1, 1993, until Nov 29, 2001, any privately placed equity of Canadian publicly listed companies was subject to a 12 month restricted period, unless issuers circumvented the restricted period with a special warrant offering. Therefore, investors were prohibited from reselling the privately placed common stock in the public market for 12 months after their issuance. On Nov 30, 2001, Multilateral Instrument 45-102 (MI, henceforth) was implemented, shortening the resale restriction period from 12 months to 4 months for private placements of common stock by public companies. 3 In effect, these are like Regulation D issues in the U.S. with a guaranteed registration. 4 To avoid confusion we define “private placements of equity” as the broad sample of private placements which includes “private placements of common stock” and “special warrants”, the latter two being the sub-groups of private placements we examine. 3 We document a major decrease in the issuance of special warrants after resale restrictions were reduced on Nov 30, 2001. Special warrants, which comprised approximately 82% of total private equity placements to passive investors from Jan 1, 1993 to Nov 29, 2001, became almost nonexistent after MI came into effect on Nov 30, 2001, reflecting a strong desire for liquid shares by investors.5 We also find that issuers making special warrant offerings, similar to issuers making public offerings, are larger firms with less information asymmetry than common stock private placement issuers. Since MI came into effect, issuers making common stock private placements are also larger firms with less information asymmetry than issuers making common stock private placements in the pre-MI period, implying that the legislation-induced reduction in resale restrictions changed the types of firms making private placements. We first examine the wealth effects of having private placements associated with different resale restriction lengths in the marketplace. We find substantially higher offer price discounts for private placements of common stock than special warrants before MI came into effect by about 6% to 7%, reflecting the longer resale restrictions on the privately placed common stock than the effective restricted period for special warrants. However, existing shareholder wealth as measured by announcement-period abnormal returns are significantly more positive for private placements of common stock than special warrants, reflecting the more costly signal associated with longer resale restrictions. These differences are similar to prior U.S. studies comparing unregistered and registered private placements (Wruck, 1989; Hertzel and Smith, 1993). Importantly, the pre-MI results imply that private placements with different resale restriction lengths provide issuing firms an important signaling mechanism. 5 We categorize the buyers of private placements as passive, strategic, active, insiders and venture/private capital in the spirit of Barclay et al. (2007). This paper focuses on passive investors. 4 Next, we examine the wealth effects of the regulatory easing of resale restrictions. We find higher discounts for common stock private placements in the period Jan 1, 1993-Nov 29, 2001, before the legislative change, when resale restrictions were 12 months, compared to the period after, for which resale restrictions are only 4 months, by about 6.5% to 9.0%. The regulatory change in resale restrictions therefore reduced the cost of capital for private placements, in part, by reducing the liquidity discount. However, we also document significantly less positive announcement-period abnormal returns for common stock private placements in the post-MI period than in the pre-MI period. Taken together, these results show that the easing of resale restrictions implies negative wealth effects for existing shareholders of issuing firms. Private placements with longer resale restrictions serve an important purpose. In particular, they provide smaller firms with greater asymmetric information a mechanism by which to provide more costly signaling. By reducing private placement resale restrictions and ultimately driving special warrants out of the market, firms that previously relied on the costlier signal choose not to issue equity. Our evidence provides strong support for this; firms making common stock private placements in the post-MI period are larger firms with less information asymmetry, much like firms making special warrant issues in the pre-MI period. In the final section of the paper we formally test this conjecture by implying probabilities in the post-MI period based on the parameter estimates from a logistic regression that determines the choice of offering type in the pre-MI period, special warrant or private placement of common stock. We show that the majority of firms would be special warrant issuers in the post-MI period had the legislation-induced shortening of resale restrictions not come into effect. Therefore, the easing of resale restrictions augments the Myers and Majluf (1984) underinvestment problem that the private placement market had partially circumvented (Hertzel and Smith, 1993). 5 The remainder of the paper is organized into the following sections. Section 2 describes the Canadian private placement market. Section 3 discusses the information hypothesis. Section 4 describes the data and presents descriptive statistics. Section 5 presents our empirical tests and findings. Section 6 discusses the implications of MI 45-102. Conclusions are drawn in Section 7. 2. A Brief Background on Canadian Private Placements Private placements are an alternative to public equity offerings. They are offerings made through certain statutory exemptions which allow the securities to be sold without a prospectus. Under Canadian securities law the sales of private placements are limited to various prescribed accredited purchasers. The definition of such purchasers generally refers to sophisticated and knowledgeable investors with substantial funds, including financial institutions, corporations and wealthy individuals. Limiting prospectus-exempt offers to accredited investors is intended to protect unsuspecting investors from being taken advantage of by unscrupulous issuers. In addition, in order to prevent the use of private placements as “backdoor public offerings”, bypassing the more costly prospectus offering, private placements are subject to restrictions on resale. Consequently, until the end of the statutory restricted period, privately placed shares can only be sold to other accredited investors. After the elapse of the restricted period, the privately placed equity can be resold to any and all investors in the marketplace. The restricted period for privately placed securities of publicly listed companies (also known as “reporting issuers”) has experienced substantial change in Canada. Prior to Nov 30, 2001, the restricted period for a private placement of equity by a publicly listed company was 12 months. On Nov 30, 2001, the restricted period for private placements of all stocks that were 6 listed for trading on a recognized stock exchange was cut to 4 months. The change was implemented through Multilateral Instrument 45-102 (MI). Special warrants are a type of equity private placement unique to Canada. They are private/public hybrid transactions, designed to provide an issuer with the quick access to funds normally associated with private placements, while providing purchasers with freely tradable securities sooner than the 12 month restricted period associated with regular private placements. Special warrants are also sold for cash under an exemption from the prospectus requirements. The special warrants are convertible into common stock and the conversion is qualified pursuant to a prospectus being filed. The proceeds from the sale of the special warrants are either received on the closing date of the special warrants or may be held in escrow pending clearance of the prospectus. The special warrants are usually refundable to the purchasers of the special warrants if a receipt for the prospectus is not obtained from the securities regulator by a stated deadline (usually 120 days or 4 months following the purchase of the special warrants). Alternatively, interest may be charged for each day that a receipt for the prospectus is not obtained following the agreed upon deadline. Therefore, under a special warrant transaction the restricted period associated with the underlying shares is the length of time necessary to prepare and obtain a receipt for a prospectus.6 Prior to Nov 30, 2001, when the restricted period for common stock private placements was 12 months, the effective restricted period for special warrants was substantially shorter (up to 4 months).7 One might ask why a prospectus cannot be filed to qualify securities previously issued in a private placement, thereby eliminating the need to use special warrants to allow for the shares to become freely tradable. Unlike in the United States where the regulatory system requires the 6 See Insight Education Services seminar papers (1990) for a more complete discussion of the structure of special warrant private placements. 7 See Insight Education Services seminar papers, 1990. 7 registration or qualification of actual securities, the Canadian system requires qualification by prospectus of distributions.8 Therefore, under the various securities laws in Canada it is not possible to issue securities on a private placement and then subsequently file a prospectus to qualify its resale prior to the expiration of the applicable restricted period.9 Securities commissions forcefully point out that once a private placement offering takes place, there is no distribution to be qualified by a prospectus, since the distribution was already completed in the initial placement. In the special warrant transaction, the issuance of the underlying shares upon the exercise of the special warrant is considered to be a first trade and a distribution which a prospectus may qualify. As a result, the shares obtained through the exercising of the special warrants are freely tradable.10 3. Resale Restrictions and the Information Hypothesis Myers and Majluf (1984) demonstrate that equity issues convey management’s belief that the firm is overvalued. Therefore, managers of undervalued firms with profitable investment opportunities but lacking financial slack will choose not to issue equity whenever the share of existing assets transferred to new stockholders exceeds the share of increased firm value retained by existing stockholders. By not issuing, managers are choosing to forego the investment opportunities. This "underinvestment problem" disappears if managers can costlessly convey their private information to the market. Hertzel and Smith (1993) extend the Myers and Majluf (1984) framework and show that private placements mitigate the underinvestment problem and even signals undervaluation. They show that private placement discounts reflect information costs borne by private investors and 8 This simply means the first trade of securities. 9 As noted securities laws are provincially regulated in Canada. Therefore, no one law covers all of Canada but the provincial laws share some similarities and in some cases have adopted national standards. 10 See Insight Education Services seminar papers, 1987, for a more complete discussion. 8 positive announcement-day abnormal returns reflect the willingness of private placement investors to commit funds to the firm, thereby signaling management’s belief that the firm is undervalued. In order for the signal of undervaluation to be credible the prospect of false signaling must be precluded so that overvalued firms cannot benefit by placing shares with private investors who then resell these shares in the public market before the true state of nature is revealed. The resale restrictions in private placements provide one such guarantee by making the signal costly. Given the costly signal implied by resale restrictions raises an interesting question: is the recent easing of resale restrictions by securities regulators beneficial or harmful to issuing firms? On the one hand, easing resale restrictions may reduce the cost of capital by providing more liquid shares. On the other hand, certain firms may be forced to pass up positive net present value (NPV) investment opportunities because of the loss of costly signaling. The recent experience in Canada provides a unique setting to test the value impact of reduced resale restrictions on private placements for shareholders. Special warrants were created to bypass the 12 month restricted period for private placements of equity. They are in effect like U.S. registered private placements. Special warrants are associated with resale restrictions of up to 4 months while private placements of common stock were associated with resale restrictions of 12 months prior to Nov 30, 2001. Therefore, the discount should be higher for common stock private placements than special warrants in the pre-MI period, since a longer required holding period provides an incentive for private placement investors to incur additional costs to assess firm prospects and also because of a larger liquidity discount. However, as noted above, longer resale restrictions make signaling more costly because of the lower likelihood of opportunistic 9