Whenever an existing company wants to issue new equity shares, the existing shareholders will be potential buyers of these shares. Generally the Articles or Memorandum of Association of the Company gives the right to existing shareholders to participate in the new equity issues of the company. This right is known as ‘pre-emptive right’ and such offered shares are called ‘Right shares‘ or ‘Rights issue‘.
A rights issue involves selling securities in the primary market by issuing rights to the existing shareholders. When a company issues additional share capital, it has to be offered in the first instance to the existing shareholders on a pro-rata basis. This is required in India under section 81 of the Companies Act, 1956. However, the shareholders may by a special resolution forfeit this right, partially or fully, to enable the company to issue additional capital to public.
Under section 81 of the Companies Act 1956, where at any time after the expiry of two years from the formation of a company or at any time after the expiry of one year from the allotment of shares being made for the first time after its formation, whichever is earlier, it is proposed to increase the subscribed capital of the company by allotment of further shares, then such further shares shall be offered to the persons who, at the date of the offer, are holders of the equity shares of the company, in proportion as nearly as circumstances admit, to the capital paid on those shares at that date. Thus the existing shareholders have a pre-emptive right to subscribe to the new issues made by a company. This right has at its root in the doctrine that each shareholder is entitled to participate in any further issue of capital by the company equally, so that his interest in the company is not diluted.
Significance of Rights Offering
- The number of rights that a shareholder gets is equal to the number of shares held by him.
- The number rights required to subscribe to an additional share is determined by the issuing company.
- Rights are negotiable. The holder of rights can sell them fully or partially.
- Rights can be exercised only during a fixed period which is usually less than thirty days.
- The price of rights issues is generally quite lower than market price and that a capital gain is quite certain for the share holders.
- Rights issue gives the existing shareholders an opportunity for the protection of their pro-rata share in the earning and surplus of the company.
- There is more certainty of the shares being sold to the existing shareholders. If a rights issue is successful it is equal to favorable image and evaluation of the company’s goodwill in the minds of the existing shareholders.