Abstract Capital raising in the offshore market (forthcoming Journal of Banking and Finance

Capital raising in the offshore market

(forthcoming Journal of Banking and Finance)

Reena Aggarwal a,*, Ian Gray b, Hal Singer b

a McDonough School of Business, Georgetown University, Washington, D.C. 20057

b The Johns Hopkins University, Baltimore, MD

Received; accepted

Abstract

U.S. corporations can raise capital in the offshore market using Regulation S, adopted by the Securities and Exchange Commission (SEC) in 1990 and modified in 1996. We examine how offshore offerings are done under Regulation S, what types of companies use this market, the discount companies offer investors to compensate for illiquidity in the market, and the impact of the new disclosure requirements on capital raising in the offshore market. We find that small firms tend to raise capital in this market. During our sample period before the 1996 rule change the median market capitalization of reporting firms was $16.82 million with a median stock price of $1.13. The mean and median discount offered to foreign investors was 32.84 percent and 40.53 percent respectively. Offerings during this period resulted in average share dilution of 11.97 percent. We find that before the disclosure requirements, firms were A gaming the system@ by giving foreign investors just enough time to resell the securities back into the United States before the initial sale became public information. After the rule changes, Regulation S offerings are not perceived to be A shady@, and larger firms are now using the market, resulting in lower average discount and dilution.

JEL classification: G14, G15, G24, G32, K22

Keywords: Securities markets regulation; Capital raising; Stock issuance, Offshore markets

*Corresponding author. Tel.: 1 202 687 3784; fax: 1 202 687 4031 e-mail: aggarwal@https://www.360docs.net/doc/e78229895.html,

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1. Introduction

The 1990s have seen considerable growth in the globalization of securities markets. Advances in technology, development of the Internet, and competition for lower cost of capital have all been catalysts in the globalization process. Corporations can raise capital in the domestic market or in foreign markets. Debt can be sold in the offshore market in the form of Eurobonds or foreign bonds. During the 1980s a global Euroequity market also emerged. Issuers also have the option to sell securities privately or publicly. There are significant differences in the costs of raising capital using different methods. Historically, the Securities and Exchange Commission (SEC) has held the view that U.S. securities laws apply to U.S. citizens, residents, and corporations both within and outside the United States. In 1990, the Commission adopted rules that provide a legal safe harbor for U.S. corporations to issue unregistered securities in the offshore market.

Regulation S clarifies the SEC=s position on the extraterritorial application of the U.S. securities laws. This paper analyzes the capital raising process in the Regulation S market. We examine how offshore offerings are done under Regulation S, what types of companies use this market, the amount of discount companies offer to compensate for the illiquidity in the market, and the impact of the 1996 disclosure requirements on capital raising in the offshore market. The Securities Act of 1933 mandates that issuers who offer or sell securities must comply with the SEC=s registration process unless a valid exemption from registration is obtained. However, Regulation S and private placement offerings are exempt from the registration. We find that it is mostly small firms who tend to use this market. They offer stock at substantial discounts to foreign investors. We also find evidence to suggest that these firms were A gaming the system@ by providing buyers an option to

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resell the securities before the transaction had the potential to become public knowledge via a quarterly 10-Q filing.

There have been articles in the financial press discussing the capital raising activities of U.S. corporations in the offshore markets and some of the controversies surrounding them. For example, on April 5, 1993 Barron=s reported:

Seven minutes before Thursday noon, the news ticker reported that Primerica couldn=t explain why its stock was sharply down on triple its average volume for the whole day .... the shares had touched 50 two weeks before, on enthusiasm for the insurer=s purchase of Shearson to complement its ownership of Smith Barney.@ The article continued, A Twenty minutes after it professed puzzlement, Primerica announced that Morgan Stanley would lead a group of brokers selling seven million of its shares, but only outside the U.S. The price 42.75-43.25. That was a sharp discount to Wednesday=s close at

46.125, and Thursday=s 46.375. An option specialist commented, A We had huge call sellers and huge

put buyers down here all morning. We had European customers trying to buy the June 45 puts. Smaller companies have often used Regulation S to raise capital offshore and have been the focus of abusive practices.1 However, we are not aware of any empirical studies in the finance literature examining offerings made in the offshore market under Regulation S. There is considerable interest among regulators and issuers to better understand the functioning of this market.

There have been some studies done to analyze the private placement market. Wruck (1989) and Silber (1991) both report substantial discounts for restricted stock offered in private placements.

A partial explanation for the discounts is the illiquidity of unregistered stock. Hertzel and Smith (1993) find that the discounts are related to resale restrictions, placement size, and type of investor. In contrast to the negative price reaction observed for announcements of public equity issuance Wruck (1989) reports positive price reaction to private placement announcements. Regulation S

1 For example, see Lowry, A SEC tightens restrictions on offshore stock issues,@USA Today, February 11, 1998.

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offerings are exempt from registration because they are sold offshore. Private placements are sold directly to a single investor or a small group of investors. Rule 144A placement is a type of private placement that is exempt because the securities are sold only to qualified institutional buyers (QIBs). Blackwell and Kidwell (1988) find two types of issuers in the private placement market: small, risky firms for whom floatation costs and agency costs is very high and large less risky firms with fewer agency problems who sell large issues and therefore benefit from the economies of scale in floatation costs.

One of the main advantages of the exemption from registration is that offerings can be put together in days or weeks because there is no registration requirement. The literature has also documented that the sale of regular secondary offerings is associated, on average, with negative stock price reaction.2 Regulation S offerings do not need to be announced at the time of the offering and therefore the negative A announcement effect@ can be avoided. However, a big disadvantage of such offerings is the illiquidity, due to restrictions on resale as discussed below.

On November 18, 1996 the SEC changed the disclosure requirements for Regulation S offerings. Prior to this change, U.S. firms issuing unregistered equity securities under Regulation S to non-U.S. entities were not required to report such activities on the quarterly 10-Q form to the SEC although they could report such sales on a voluntary basis. Since November 18, 1996, firms are required to disclose Regulation S offerings in an 8-K report filed with the SEC within 15 days after the date of sale. We examine the use of Regulation S to issue stock in the period before and after this change.3

2 For example, see Masulis and Korwar (1986) and Mikkelson and Partch (1985).

3 The SEC has made further amendments to Regulation S in 1998 and this paper does not

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The rest of the paper is organized as follows: section II describes the original Regulation S of 1990 and the changes adopted by the SEC in 1996 to stop abusive practices in the market; section III discusses the data; empirical findings are reported in section IV; and section V provides a summary and conclusions.

2. Regulation S

Regulation S was adopted by the SEC on April 24, 1990 and went into effect on May 2, 1990 in order to allow U.S. corporations to compete in the global market and offer securities offshore.4 It made it easier and less expensive for U.S. corporations to raise capital offshore. The SEC adopted a A territorial approach@ in Regulation S. The Regulation mandates that issuance of unregistered securities must take place in an offshore transaction. The definition of offshore transactions is based on the location of the buyer. No directed selling efforts are allowed in the United States.

Prior to April 27, 1998 the Commission defined three categories of securities on the basis of factors such as, nationality and whether the issuer is a reporting company in the U.S. and therefore files periodic reports with the SEC under the Exchange Act. Category One consists of securities of non-U.S. issuers with A no substantial U.S. market interest"; Category Two consists of equity and debt securities of domestic and foreign reporting issuers, and debt securities of non-reporting foreign issuers with A substantial U.S. market interest;" and Category Three consists of securities of non-reporting U.S. issuers and equity securities of non-reporting foreign issuers with A substantial U.S.

discuss details of those issues.

4 See SEC Adopting Release 33-6863, April 24, 1990.

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market interest." Further revisions to these categories have been made in 1998.5 The Regulation places less restrictions on debt securities as compared to equity securities, and on offerings made by reporting issuers (those who already report to the SEC) than those made by non-reporting U.S. issuers. Securities issued by companies with little or no connection to the U.S. markets are subject to the least restrictive requirements because their securities are less likely to flow back to the U.S. after an offshore offering.

The U.S. federal securities laws apply to any offer or sale of securities that involves interstate commerce or the mail. Historically, the SEC has taken the position that offerings with minimal jurisdictional contacts with the United States did not need to be registered. Regulation S was adopted in 1990 to codify that position. Regulation S opened up the offshore market, but at the same time the flowback of unregistered, non-exempt securities into the United States also increased. It turned out that many small companies, whose shares were not being traded in the U.S., intentionally started using this arrangement to distribute securities into the United States and avoid the registration requirements of the Securities Act. Any resale of Regulation S shares must be made pursuant to registration or an exemption therefrom. To make matters worse, their securities were resold in the United States to U.S. investors. The flowback can occur if international investors resell their securities to U.S. investors before the A restricted period@ is over. Under Regulation S, foreign buyers of Category 2 and 3 securities are required to hold the stock for a certain period of time, in some cases it is 40 days. Abuses of Regulation S defeated the purpose of having long-term offshore

5 Refer to Securities and Exchange Commission Release No. 33-7505 and 34-39668 for further details.

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investors in U.S. companies. The SEC=s ability to monitor offshore transactions became somewhat limited due to lack of reporting requirements. This resulted in an increase in the abusive uses of Regulation S offerings and was of concern to the SEC.

The use of Regulation S to raise capital in the unregistered offshore markets certainly helps to reduce the cost of capital for U.S. corporations. However, international investors who purchase Regulation S offerings do so at a considerable discount to compensate them for the illiquidity. These discounts have been documented to be 9 percent for companies such as Primerica (earlier part of The Travelers Inc. and now part of Citigroup) to more than 40 percent for small, unknown companies.6 Deep discounting of Regulation S issues enables offshore investors to use Regulation S shares to cover short sales of stock traded on the U.S. markets and turn in immediate profits. Some of these activities are not legal and in some ways international investors were at an advantage relative to U.S. investors.

On November 18, 1996 the SEC started requiring firms to disclose Regulation S offerings in an 8-K report filed with the SEC within 15 days of the sale. The rule attempted to alleviate the secretive dilution of existing shareholders= value. Previously, issuing firms could time a Regulation S offering to give foreign investors enough time to resell the stock in the U.S. market before public disclosure of the offering via a 10-Q filing. Figure 1 shows how if the Regulation S offering is made at least 40 days before the next 10-Q then foreign investors have basically been given a valuable A option@. They have the opportunity to sell the securities after the restricted period of 40 days but before the news of the offering and its dilution effects become public knowledge. The new rule

6 See Muglia and Tierney (1998).

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requiring an 8-K filing increases the disclosure requirements for U.S. firms. The possibility to resell Regulation S securities in the U.S. markets before the public disclosure of the information is eliminated. In 1998 the Commission has increased the restricted period (now called distribution compliance period) from 40 days to one year for equity securities of reporting U.S. issuers and is requiring reporting on 10-Q. Purchasers of equity securities issued by U.S. firms are required to certify that they are non-U.S. persons. The issued securities are also required to carry a legend indicating that these are restrictive securities.

3. Data

For the purpose of our analysis, we gather data on Regulation S offerings during the nine-month period before November 18, 1996, when the rule change took affect, and the nine-month period after the rule change. We refer to the former period as the Pre-rule change period and the latter as the Post-rule change period in our analysis.

In the Pre-rule change period, the only source of information on Regulation S offerings was 10-Q filings. We did a Lexis/Nexis search to examine all 10-Q filings that had a mention of Regulation S.7 It is important to keep in mind that disclosure of a Registration S offering on the 10-Q was not required, so we pick up only those offerings where the firm voluntarily disclosed the information. It raises the question that if firms were trying to A game the system@ then why would they voluntarily disclose information. However, our conversations with securities lawyers revealed that generally lawyers will advise firms to disclose the information. If the issuer believes the information

7 Lexis/Nexis is an online service that provides a database of company and business information.

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is A material@ then they tend to disclose it. By reporting it they are covering their basis, particularly if they get into trouble.8

A total of 359 filings were identified, many of which had to be eliminated for several reasons. We analyze only equity offerings so all debt offerings were not included. In some cases the 10-Q identified in our search was an amendment and therefore it was a repetition of an offering already in the sample. In addition, offerings that were the result of the exercise of an option, warrant, or employee benefits program were not included because current shareholders were already aware of these sales. Finally, offerings of convertible debentures, preferred stock, units (consisting of stock along with options or warrants) or stock for acquiring another company were not included in the data set. The final sample consists of 78 Regulation S equity transactions in the nine-month period before the rule change which we refer to as the Pre-rule change period.

After November 18, 1996 Regulation S offerings needed to be filed with the SEC on form 8-K. Therefore, for the nine-month period after the rule change the data are gathered from 8-K reports filed with the SEC. We started with 332 filings with A Item 9" entries (where Regulation S offerings are reported on form 8-K). After applying the same criteria as above to this period there are 114 Regulation S transactions.

4. Empirical Analysis

8 We thank the reviewer for helping us to clarify this issue.

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It is not possible to know the exact size of the Regulation S market because it is largely unregulated. There is no source to determine the number of debt and equity transactions under Regulation S. Some investment bankers and securities lawyers believe that the Regulation S market constitutes almost 5 percent of all U.S. issues since 1990. It is also estimated that the number of transactions has increased over the years.

4.1. Issuer Characteristics and Discounts

In Table 1, we provide some descriptive statistics on Regulation S offerings done during the nine-month period before the rule change and the nine-month period after the rule change. While comparing the Pre and Post-rule change periods, it is important to keep in mind that in the Pre-rule change period the reporting was voluntary but in the Post-rule change period it was required and therefore some biases may arise. We find that 1) the Regulation S market is being used by small firms; 2) the stock is being sold to foreign buyers at substantial discounts; and 3) the extent of share dilution is quite large. The use of the market mostly by small firms and not by large reporting firms continues to be a problem. It is evident from SEC Release No. 33-7505 and 34-39668 that the regulators are continuing to work on stopping the abusive practices in this market so that a broader range of firms will use it. The substantial discounts imply large losses for existing U.S. investors who may not even have been aware of these offerings before the rule change and this has also been a cause for concern.

Before November 1996, the mean and median market capitalization of firms doing Regulation S offerings was $57.71 million and $16.82 million respectively. On average, 1.56 million shares (median of 0.61 million) were offered, resulting in an average dilution of 11. 97 percent (median of 6.03 percent). The mean closing price was $3.59 on the day of the offering while the shares were

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offered under Regulation S offering at an average price of $2.81. The median values show similar results.

After the rule change, disclosure requirements increased and we find the average market capitalization of firms jumps almost 400 percent to $248.83 million. The median also increases but not as dramatically. In addition, while the average size of the transaction increased, the average share dilution decreased. This could mean either of two things. First, some of the smaller firms have been discouraged from using the market because of more stringent disclosure requirements. If these firms wanted to provide foreign investors with the A option value@ discussed earlier and shown in Figure 1, they can no longer do that. After November 1996, they have to file the 8-K within 15 days and the restricted period was still 40 days. The other factor that may have caused the average market capitalization to increase can be that more of the larger firms are reporting now. Conversations with industry officials suggest that larger firms are using the Regulation S market more now because it is not seen as A shady@ anymore. We cannot directly test for this hypothesis but some of our results, including the dilution numbers, suggest this might be true.

If larger firms start using the Regulation S market more than the smaller firms after the rule change then we would expect the average discount to decrease. Larger firms tend to have less dilution and they are also more liquid. However, with the new reporting requirements there is no A option value@ for investors of Regulation S offerings, therefore they should demand higher discounts. We find the average discounts decreases from a mean of 32.84 percent (median of 40.53 percent) to 21.67 percent (median of 25.65 percent). If larger firms are using the Regulation S market more after the rule change then the discount would be expected to go down. Also, if the percentage dilution is small then the discount would be expected to be lower. Silber (1991) examines 69 private

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placements and finds the average discount to be 34 percent, Hertzel and Smith (1993) report discounts of 20.14 percent for their sample of 106 private placements. These private placements tend to be larger than our sample of Regulation S offerings.

In order to shed further light on discounts offered, we examine changes in the discount rate along size categories as shown in Table 2. The most dramatic change occurred in the large capitalization sector. The mean discount decreased from 31.59 percent in the Pre-rule change period to 25.57 percent in the Post-rule change period for small firms. The discount changes from 47.80 percent to 6.23 percent for large firms. Also the number of large capitalization firms went up by a large margin. Even more telling, in the Pre-rule change period, only one of the 78 (1.3%) firms had

a market capitalization greater than $300 million. In the Post-rule change period, 15 of the 114 firms

(13.2%) are greater than $300 million. This is evidence that the rule change has encouraged larger firms to participate in the Regulation S market (or at least to report their transactions). Perhaps with a new pool of Regulation S firms, participation in this market no longer sends a negative signal about a firm=s financial integrity. Even in the small size category the mean and median discounts are less. If A shady@ firms were not disclosing information during the voluntary period then we would expect the drop in the discounts to be even more dramatic.

4.2. Timing of Regulation S offering Prior to the Rule Change

Before the rule change of November 18, 1996, it was possible for U.S. firms to give foreign investors enough lead time to resell the securities into the United States market before the announcement of the Regulation S offering. The announcement of the offering was generally reported on the next 10-Q filing. These sales gave the foreign investors an inherent option. Figure 2 depicts the timing decision of when to issue shares pursuant to Regulation S before the new rules.

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The sale can occur any time during the 90-day period between the filing of two consecutive 10-Qs. Foreign buyers were required to hold the securities only for 40 days. By selling the Regulation S securities more than 40 days before the next 10-Q filing, U.S. firms offer the foreign buyer an option to resell the securities before the transaction has the potential to become public knowledge.

We find evidence that supports the idea that issuing firms were A gaming the system@ by selling Regulation S securities with just enough lead-time so as to guarantee the arbitrage opportunity to foreign investors. Of all the transactions in the Pre-rule change period, 33 percent were consummated within 14 days before the option value would expire as shown in Figure 2. Many firms gave their investors just enough days to resell the securities back into the U.S. market before the initial sale became public information. This can be seen by the large spike in the 41-54 day lead time range. The average discount and market capitalization for the 62 issues in the Pre-rule change period where investors had an A option@ were35.77 percent and $53.23 million respectively compared to 20.00 percent and $75.09 million for the 16 issues where such an option was not available because there were less than 40 days before the next 10-Q filing date. This suggests that it was the smaller firms that were providing foreign investors the possibility of selling their securities back into the United States before the information about the offering became public. However the difference in the average discount between the two groups is not statistically significant. Again, it has to be kept in mind that issuers were not required to file this information even on a 10-Q.

4.3. Determinants of the Discount in the Pre- and Post-Rule Change Periods

A regression is estimated to examine what variables are important in determining the amount of the discount. It would be expected that larger offerings would have lower discounts, more dilution should result in a higher discount, and low-priced stock should also have a higher discount. As seen

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in Table 3, for the Pre-rule change period, the coefficient of the offering price is positive and significant, the coefficient of the dilution variable is also positive and significant, and the coefficient of lnvalue (natural log of size of the offering in dollars) is negative and significant. In the Post-rule change period, the dilution and lnvalue variables are significant with the correct sign but the price variable is not significant. The price variable also did not have the appropriate sign in the Pre-rule change period.

4.4. Price Reaction When Information is Disclosed

The objective of this section is to examine the price reaction when information about the Regulation S offering becomes available via the 10-Q filing. The date on which the 10-Q is filed is our Filedate. (Filedate -1) and (Filedate +1) are obtained by finding the sale price on the day before and after the filing date respectively. The results in Table 4 suggest that disclosure of Regulation S sales on Form 10-Q had a small, if any, impact on the market price of equity. Investors either do not seem to pay attention to this piece of information or it is possible that there is information leakage prior to the 10-Q filing. None of the means are significantly different from zero. Worth noting is the fact that in each period the median is zero, implying that exactly half of all events were met with increases while half were met with decreases in stock price.

In order to test whether A amount of bad news,@ as measured by shareholder dilution, influenced price reaction, we also regress price reaction on shares dilution and the price movements of the Wilshire 5000.9 The coefficient of the dilution variable is not statistically significant. The results are not reported here.

9 The Wilshire 5000 index is used as a proxy for the performance of small capitalization stocks.

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5. Conclusions and Summary

The adoption of Regulation S by the SEC was expected to make it easier for U.S. corporations to raise capital in the offshore market. However the market has been plagued by abusive practices. We document that it is mostly small firms who tend to use the market. The regulation has not resulted in attracting large reporting companies to raise capital offshore. We also find that substantial dilution occurs with these offshore offerings. The stock is issued to foreign issuers at a large discount to the current market price. Existing shareholders are generally not aware of the offering or the discount.

We also find evidence to suggest that the issuing firms tended to A game the system@ by timing the issue appropriately. During the nine-month period before the new disclosure requirements of November 1996, we find that issuers were timing the Regulation S offering. Offerings were being timed so that foreign investors got just enough time to resell the securities into the United States market before the initial sale became public information. Even though reporting was voluntary before November 1996 it seemed that many firms were being advised by their lawyers to A play it safe@ and report the transaction. The abusive practices in this market continue to be cause for concern. The SEC has recently made further amendments to the regulation and continues to keep a close eye on the various issues.

Acknowledgements

We thank Bill Atkinson, Cynthia Campbell, Felicia Kung, Cathy Niden, Erik Sirri, and two anonymous referees for helpful comments. Domenica Eisenstein Noronha and Maria Partch provided

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excellent research assistance. Part of this work was done while Aggarwal was an Academic Fellow at the U.S. Securities and Exchange Commission and both Gray and Singer were research assistants. The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.

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References

Blackwell, David W. and David S. Kidwell, 1988. An Investigation of Cost Differences Between Public Sales and Private Placement of Debt, Journal of Financial Economics 22, 253-278. Hertzel, M. and R. L. Smith, 1993. Market Discounts and Shareholder Gains for Placing Equity Privately, Journal of Finance 48, 459-485.

Masulis, Ronald W. and Ashok N. Korwar, 1986. Seasoned Equity Offerings: An Empirical Investigation, Journal of Financial Economics 15(2), 91-118.

Mikkelson, W. H. and M. M. Partch, 1985. Stock Price Effects and Costs of Secondary Distributions, Journal of Financial Economics 14, 165-194.

Muglia, Richard and Annemarie Tierney, May 1998. SEC Tightens Regulation S Rules for US Issuers, International Financial Review, 27-29.

Securities and Exchange Commission Release No. 33-6863, 33-7505 and 34-39668, Offshore Offers and Sales.

Silber, W. L., 1991. Discounts of Restricted Stock: The Impact of Illiquidity on Stock Prices, Financial Analysts Journal 47, 60-64.

Wruck, Karen, 1989. Equity Ownership Concentration and Firm Value: Evidence from Private Equity Financings, Journal of Financial Economics 23, 3-28.

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Timing of Regulation S Offerings Prior to the Rule Change

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Distribution of Lead Time Prior to Rule Change

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Descriptive Statistics on Offerings Pre and Post Rule Change

On November 18, 1996 the SEC adopted new rules which require issuers to file Regulation S offerings on form 8-K within 15 days of the sale. The Pre-Rule change period covers the nine-month period before the rule change and the Post-rule change period covers the nine-month period after the rule change. Our sample consists of 78 offerings which were reported on 10-Q forms in the nine-month before the rule change and 114 offerings in the nine-month after the offering. Market capitalization is based on the closing market price on the day of the Regulation S offering, market price is the closing price on the day of the offering, shares offered are the number of shares offered in the offering, offering price is the price at which the Regulation S shares are sold, dilution is shares offered as a percent of total shares outstanding, and discount is the offering price relative to the closing price. The discount is reported both as equally-weighted and also as value-weighted.Value-weighted discount is calculated by weighting the discount by the size of the offer relative to the total amount of capital raised by Regulation S in the sample.

Pre-Rule Change Offerings

(N = 78)Post-Rule Change Offerings

(N = 114)

Mean Median Mean Median Market Cap.$57,712,813$16,815,245$248,828,457$21,738,788 Shares Offered1,559,082605,4431,072,609500,000 Size of Offering$2,021,929$598,629$4,202,396$477,519 Share Dilution11.97% 6.03%8.64% 4.10% Offering Price$2.81$1.13$5.99$1.70 Market Price$3.59$2.38$6.77$2.52 Equally-weighted

Discount

32.84%40.53%21.67%25.65%

Value-weighted

Discount

17.54%-8.66%-

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