Introduction

Firms seeking new equity funds have several alternatives: a fully underwritten general cash offer, an uninsured rights offer or a standby rights offer, among others. In practice we observe all alternatives being used; some firms, however, constrain their financing choice to a preemptive rights offer with a charter provision. One possible explanation for this precommitment is the concern for control by a large shareholder. Hanson and Pinkerton (1982) offer empirical evidence for this explanation.

In the absence of concerns about control it is unclear as to why firms would voluntarily constrain future equity financing choices by precommiting to the use of rights offers. The issue is further complicated by the empirical findings of Bhagat (1983), who reports a significant negative price reaction to the elimination of the preemptive rights charter provision. In this paper we develop a model based on asymmetric information with rational, value maximizing behavior that offers a possible justification for the precommitment to rights offers and is consistent with Bhagat's (1983) empirical findings.

In our model firms are assumed to have better information about future prospects (quality) than do investors. The act of precommiting to the use of rights offers serves as a signal to investors about firm quality: only higher quality firms are willing to sacrifice flexibility in their future equity financing choices. In this world removal of the charter provision requiring preemptive rights is a negative signal, resulting in a negative price reaction at the announcement.