When rights go very wrong
Published 12 June 2008
The big banks' risky fundraising technique - offering bargain shares to private investors in "rights issues" - is a disaster for a City already in crisis
Over the next few days, millions of private investors will receive a fat wodge of documents from Bradford & Bingley (B&B), Halifax Bank of Scotland (HBOS) and others inviting them to buy new shares at bargain prices. Of course, there is no such thing.
The big banks have been foolish, investing too heavily in American trailer-park mortgages and over-lending at home, and they now need the shareholders to bail them out. What makes this round of fundraising (known as rights issues because existing investors have an entitlement to buy the shares) different is that the institutions raising the money have an unusually large number of private investors. Most of these people received shares for nothing when former building societies turned into banks, and watched happily as the share price soared. Since the credit crunch, they have become aware of a very different reality.
In the case of Northern Rock, the shares have been appropriated by the government. And at HBOS and B&B the shares have tumbled as professional investors recognised the enormity of the mistakes made. Now, if the companies wish to stay afloat they have no choice but to ask existing investors for new money. The Royal Bank of Scotland (RBS) has raised an astonishing £12bn (the biggest such issue ever on the London Stock Exchange), HBOS wants £4bn, and B&B - in grave danger of becoming Northern Rock Mark 2 - is asking for £250m. To tempt investors, the banks, behaving like barrow boys, have been offering the new shares at massive discounts of around 40 per cent.
A dangerous mechanism
This year is turning out to be a record-breaking one for rights issues. In less than six months, £22.8bn has been raised - more than the total volume of rights issues for every year since 1980. The apparent success of these offers is a retort to critics of the stock exchange who see it as just a super-charged casino where profits are made far too easily without notable contribution to the real economy of jobs and growth.
Yet not all has gone smoothly. There has been a storm of protest from big battalion investors such as the Association of British Insurers, smaller investment banks such as Collins Stewart, and private investors at the way in which the process works.
This debate was brought into sharp relief by the B&B rights offer. In the days between the announcement of fundraising and the circulation of documents to shareholders, there was a dramatic change of circumstances. The company discovered that it was making losses rather than profits. The chief executive, Steve Crawshaw, was forced to step down with heart disease and a small fraud, involving surveyors and unscrupulous developers, was discovered. The City underwriters of the issue, the people who have to take the shares onto their own books if current investors will not buy, got cold feet. It was argued that the circumstances had changed dramatically and the terms (but not their £37m fees) would have to be changed.
Over the final May bank holiday weekend the price of the rights issue was lowered, a new investor, the Texas Pacific Group, was brought in, and the government signed off on the agreement. But it left ordinary shareholders feeling bitter that they had been let down by the underwriters, Citigroup and UBS, who should have stood by their agreement.
As this episode demonstrated, the peculiar British mechanism of the rights issue is one of the few City institutions that remains unreformed. In an electronic age, rights issues move at a snail's pace. It can take at least six weeks between the announcement of the terms and the circulation of the documents. Even then another couple of weeks elapse while investors make up their minds. Meanwhile, the investment banks, lawyers and other hangers-on milk the process for fees. It looks like money for old rope.
The mechanism is the worst of all worlds. Banking is all about confidence and in the current circumstances investor opinion can change within hours. The uncertainty over financing at B&B came perilously close to giving Britain its second run on a bank in less than a year.
The Americans recognise the "rights" risks and organise the issue of new shares overnight, avoiding the months of uncertainty. This has been another factor which has protected America, which was far harder hit by the sub-prime fall-out, from the contagion seen in Britain.
Once again, at a time of financial crisis the City's architecture has been found seriously wanting. The amounts of new capital raised through issues to existing shareholders look impressive. But the process is so destabilising that it is almost counter-productive.
Alex Brummer is City editor of the Daily Mail. His book "The Crunch: the Scandal of Northern Rock and the Escalating Credit Crisis" will be published by Random House on 2 July
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