* Regulation S: Potential Problems
Despite the benefits to both the issuers and investors, there are some concerns that must be addressed such as dilution of existing shareholders and potential near-term drops in the stock price.
Dilution: Issuing a large number of new shares at a discount causes dilution via two dimensions. The current level of earnings are shared by a greater number of shares. Thus, earnings per share immediately decline. In addition, the discount means that price to book value also drops and that more shares are issued per dollar of Market Value than existed before. However, assuming that the company's shares are fairly priced when the Regulation 'S' transaction takes place, the dilution effect is the percentage of the company being financed multiplied by the percentage of discount being offered. This result is often negligible.
For example, if an issuer wishes to raise capital, and is willing to discount its shares by 30%, and the amount of capital to be raised is 10% of the shares then outstanding, the dilution to existing shareholders is only 3% (30% x 10%). In most cases the influx of additional capital contributes significantly more to the ultimate value of the company than the relatively small dilution. This part of the story must be told and retold so that the marketplace understands and responds. By handling this well, the likelihood of a near-term drop in price can be significantly diminished.
Drop in Price: There are numerous Regulation 'S' stories where the issuer's stock price has been hammered, because the process was mishandled. Some of the problem is attributed to the Regulation 'S' community (brokers and buyers) but a great amount of the problem also rests with the issuers themselves, due to a wide dissemination of information regarding their desire to do a Regulation 'S' transaction.
The drop in price is generally the result of short selling. Taking short positions in the public float to offset a Regulation 'S' transaction is illegal under US securities laws. However, by definition, Regulation 'S' buyers are outside the US and many are unconcerned with the enforceability of US laws. As such, if the discount is sufficient, they can lock in a profit by shorting the stock and delivering against the short position after 40 days. As long as the short position is sufficiently greater than the purchase price and carrying costs, then the buyer is still richly rewarded and the stock drops considerably in the face of the extra selling pressure due to the short.
While it is illegal for the buyer (or a party related to the buyer) to take short positions in the stock, it is not illegal for other parties who learn of a planned Regulation 'S' transaction to do so (although it is illegal when a new issue is in registration we have submitted written recommendations to the SEC to adopt a similar rule for Regulation 'S'), thus when a company gathers information on Regulation 'S' or interviews two or more distributors (and especially tries to play them off against each other for lower discounts, commissions etc.) it is sowing the seeds for others to take a short position with assurance that cheaper stock might soon be available to cover the short position later on.
It is not unheard of for a distributor that lost the deal to take a short position or tip off his clients to do so. Thus, even if the distributor loses the deal in competition to another distributor, it still makes money on it. For market makers, knowledge of an impending Regulation 'S' deal is tantamount to a free lunch. Unlike the public, a market maker requires virtually no margin to take a short position (many will actually generate positive cashflow in the process) and does not need to sell on an uptick. When the shares are resold, the market maker covers its short in a continuing down market.
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