Ethiopian share market is undergoing a profound transformation, by and large, for the better. Hundreds of thousands of equity holders in various companies are beginning to see hope that what they have in their hands is a property that can be exchanged. Except that the hope doesn’t seem to be realizable soon enough.
For the moment, there is a lot of work to be done before the market heats up. Reportedly, a great deal of work remains on the part of companies to complete registration of their shares. Meanwhile, holders of securities seem to be stuck in the process rendering their shares effectively as if they are under freezing order.
Few of the companies that have come on the other side of the share registration tunnel are publicizing rights offers at premiums, apparently under pressure from the ECMA (the Authority). The question is why premiums on rights issues?
Before delving into the question, let us see what rights issue means, in the first place. Rights issue means sale of new shares by a company to existing shareholders in return for new cash injection by the shareholders in proportion to their existing shareholdings.
To put it simply, it is a call for cash. In this, it is different from bonus issues which are, likewise, new shares issued by the company to existing shareholders in proportion to their respective shareholdings but at no cost to the shareholders.
To be precise, bonus shares are paid from reserves maintained by a company- the shareholder doesn’t bring anything from her pocket. Another variant of bonus issue is dividend reinvestment, in some countries known as scrip issue.
In the latter case, the shareholder can opt for cash dividend, instead of the new shares. The distinction of each of these types of issues is not just a pedantic matter. Rights issues and dividend conversions can be refused by a shareholder.
If a shareholder refuses a rights issue, it goes to other shareholders that applied for more shares. If a shareholder refuses dividend conversion into shares, such a shareholder gets cash dividend. On the other hand, a bonus share cannot be refused, but can be transferred to others.
From the accounting point of view bonus shares do not change the net worth of the company unlike rights issues. ECMA’s public offer directive does not clearly distinguish these three types of issues. Nor does the practice especially in the financial companies.
In this brief note, I question the wisdom of applying premium on rights issues for the following reasons: First, it is contrary to the market practice in Ethiopia; second, it doesn’t serve any particular purpose other than potentially harming capital raising efforts of companies; and finally, forcing premium without shareholder consent is in violation of the Commercial Code.
In Ethiopia, companies issue new shares by way of dividend reinvestment, almost always, at zero premium. The logic is simple: why charge premium on the very owners of the company? The natural justification of premium is that it is compensation paid by new comers to old shareholders who took greater risk during the earlier years of the company and got it where it is.
It is hence conventional wisdom that late comers pay premium to join a successful enterprise, or else they start their own. This makes the concept of premium on rights issue unconventional, especially where there is no liquid market for the shares.
Coupled with the inherent preferred right of shareholders to purchase new shares, the idea of issuing shares to existing shareholders at premium is a rare practice. Even for that matter, true rights issues are rare in Ethiopia.
What we call rights issue is in practice a combination of bonus issue and dividend re-investment. True rights issues call for fresh capital from members which is unusual. Thus, in Ethiopia, rights issues are settled through dividends.
Given the market reality in Ethiopia, premium on rights issue serves no purpose other than harming capital raising efforts of companies. Investors who are used to buying rights offers at no premium may ignore the offer at premium.
That in itself may kill any appetite from outside public for the shares, eventually defeating the very purpose of the capital market. ECMA should seriously reconsider its stance on this matter. This doesn’t mean that premium on rights issues has no logic.
Where the shares are on demand in the market, there may be reason to apply premium on rights issues. Fairness to non-participating members may justify applying discounted premium. While, one may always contend that non-participating shareholders can assign their rights to others for value, because, rights (to purchase new shares) are transferable for value, the absence of liquid market means such an exercise will be futile.
In developed markets, there is even an arrangement whereby a shareholder who cannot afford the rights issue can sale part of the rights and buy as many of the new shares as the proceeds for the partial rights sale allows. But all this requires a developed market. Hence, the requirement of premium on rights offering will disenfranchise existing shareholders.
Another reason to worry about premium on rights issue is the lack of clarity over its tax treatment. The Commercial Code tells that proceeds from premium are distributable only to old shareholders who were present when the premium was paid- somewhat equating it with income/reserve. In a way this position of the code tends to favor the interpretation of premium as income over capital-resolving the age old debate.
The Commercial Code thus assumes that premium is paid only by new coming investors, not existing shareholders. The practice in Ethiopian courts and tax authorities is mixed. There were times when premium from sale of shares was regarded as capital and nontaxable. But there are also cases in which the tax authorities claimed taxes over premium income.
A recent regulation for example exempts premium income generated by sale of shares to foreign investors from income tax- implying that it is taxable otherwise. All this implies that imposing premium on rights issues can have further ramifications for the shareholders.
Forcing premium without shareholder consent is contrary to the Commercial Code. Ethiopian law gives complete discretion to the general meeting of shareholders to decide whether to increase capital and on what terms and conditions.
While it is forbidden to issue shares below par value, it is within the complete discretion of the shareholders meeting whether or not to levy premium. In fact, the general meeting may delegate the board to determine the detailed terms and conditions of increase (including premium)- an authorization which is time limited to five years.
Hence, whether to charge premium is the power of the general meeting, at least under Ethiopian law. In other countries, such in the USA the board can increase capital, and determine the terms and conditions of the increase at its complete discretion. It can sidestep the preferred rights of shareholders, and apply premium on new issues. Ethiopian law has none of this, unless the general meeting expressly delegates its power to the board. I am not sure whether any regulator can change this.
As Samuel Jonson once famously said in The Rambler, “almost all absurdity of conduct arises from the imitation of those whom we cannot resemble.” Our market does not resemble those where premium is applied on rights issues.
In other markets where the share market is advanced, issuing rights offers at premium might be workable, though the premium is still a significant discount from the market price. Thus, premium on rights issue does not make sense where the shares are not selling on an exchange or on OTC.
Because, existing shareholders cannot know whether the premium is at a discount or at the market rate, or above the market for that matter. Therefore, at least before the share are listed or available on the OTC market, it will not be appropriate to force premium on rights. Once the shares trade on a public market, companies and their shareholders will know for themselves.
Fekadu Petros is Managing Partner at Fekadu Petros & Partners LLP
