The Illusory Promise of Pre-emptive Rights

Abstract: Corporate law has long relied on pre-emptive rights to prevent a controlling shareholder from engaging in “cheap-stock” tunneling: selling itself cheap stock at the expense of minority shareholders. The underlying theory is simple and appealing: a controlling shareholder should not be able to expropriate value from minority shareholders via an equity issuance if minority shareholders can participate pro rata, thereby getting the same deal as the controlling shareholder. Unfortunately, I show, the theory is wrong. Pre-emptive rights cannot prevent cheap-stock tunneling, as long as any other tunneling channels remain open to the controlling shareholder. I also offer two simple proposals for improving the functioning of pre-emptive right arrangements. However, even if these proposals were adopted, pre-emptive rights would still need to be supplemented by additional measures to control cheap-stock tunneling.