It Pays to Know Your Rights

Beleaguered and cash-strapped companies have hit upon an old tactic for raising some badly needed capital: rights offerings.

In recent months, Ericsson (ERICY Quote), Allied Capital (ALD Quote) and Chartered Semiconductor (CHRT Quote) have all gained approval from the Securities and Exchange Commission to implement their rights plan.

If the past few years have taught us anything, it's that nothing comes easy on Wall Street. Investors need to understand the tax implications of these rights, particularly how any profits will be taxed. Let's work through a few scenarios resulting from a rights grant.

But first, a few basics. A rights offering is when a company offers current shareholders the "right" to buy a fixed number of additional shares for a fixed price within a fixed period. The number of rights is based on how many the investor currently owns, and the rights generally enable the investor to purchase the additional shares at a discount to where they're currently trading.

When rights are transferable -- as they frequently are -- a secondary market often develops in which the rights themselves can be bought and sold on the open market. Investors frequently see these offerings as a boondoggle. Indeed, sometimes they are.

Companies, such as Allied Capital, often position rights offerings as a "reward" for long-term investors. But that reward can backfire -- as was the case with Ericsson -- if the market reprices all shares to reflect the discount.

The bottom line is that companies issue these rights for their own benefit; it's frequently an easy way to raise cash that requires less effort, and disclosure, than a secondary offering. Duke Energy (DUK Quote) recently took the latter route, selling 54 million shares in a secondary offering expected to raise $1 billion for debt repayment. Both secondary and rights offerings dilute existing shares, although rights offerings can actually serve as something of a boon to existing investors able to pick up additional shares at a discount (or sell the rights).