Ch. 6: Security Offerings 289
(2)Stock liquidity and transaction costs of reselling rights. The resale of rights by
current shareholders takes place on organized exchanges, entailing dealer spreads and
brokerage fees. Since shareholders avoid these costs when the firm employs an under-
writer to sell its new shares, a rights offer carries an added transaction cost disadvantage
for shareholders uninterested in exercising their warrants.Kothare (1997)argues that
rights issuers have typically high ownership concentration, and a rights offering tends
to increase concentration. The result is a higher adverse selection effect associated with
buying the stock (or the rights), which Kothari finds raises the stock’s bid–ask spread
and this reduced liquidity is likely to lower the stock’s market price.
(3)Arbitrage activity and the risk of rights offer failure. Investors can use rights
as warrants to hedge their short sale positions in a firm’s stock. This encourages in-
creased short selling of the stock, but as additional short positions are opened, the stock
price will tend to be depressed as resulting sell orders rise (at least within the bid–ask
spread). Thus, between the announcement of rights offer terms and offer expiration, this
short-selling activity tends to keep the stock price down, reducing the attractiveness of
exercising rights for most stockholders. This creates additional uncertainty for issuers
as to the ultimate rights offer subscription level.
(4)Anti-dilution clauses and wealth transfers to convertible security holders.Ifafirm
has convertible securities or warrants outstanding with anti-dilution clauses in place,
then issuing rights at discounts can trigger automatic reductions in conversion rates of
these securities as discussed inKaplan (1965)andMyhal (1990). These anti-dilution
clauses are likely to result in improved positions for the convertible security holders,
shifting wealth away from the common stock holders who are the residual claimants.
As a result, there is an added incentive for firms with convertible securities outstanding
to avoid issuing rights at deep discounts.
3.10. Market microstructure effects
Seasoned public offers of common stock have important impacts on the secondary mar-
ket in which the common stock trades.^19 The typical firm commitment offer involves
a large increase in shares outstanding along with a large increase in the number of
stockholders and a reduction in management and blockholder percentage ownership.
As a result, one would anticipate that there would be major increases in trading vol-
ume, changes in bid–ask spread and depth, increased insider trading at the end of the
lock-up period, and possibly major changes in price volatility after the public offering.
One would also expect similar effects on secondary market trading of corporate bonds
following subsequent bond offerings of similar seniority and duration bonds.
Theories of bid–ask spread determination are based on adverse selection and inven-
tory cost considerations. These theories predict that if trading volume rises and price
(^19) Parts of this section are drawn fromEckbo and Masulis (1995).