Forward Selling: A Crime Against Shareholders?

Roger has recently written about the censure of Cornhill Capital, in the matter of New World Oil & Gas. The full censure notice, setting out the gory details of the case has been published here: http://www.londonstockexchange.com/traders-and-brokers/rules-regulations/change-and-updates/stock-exchange-notices/2017/n0117.pdf

This case centres around the practice of “forward selling”, a practice which is not unusual at present. So, what is forward selling? Forward selling occurs when a company agrees to issue shares to a third party and that third party sells those shares in the market, prior  to actually receiving them.

What are the motivations behind this practice?

The motivations for the forward sellers are pretty obvious: they can make an almost* guaranteed profit by selling shares at market prices, when they know that they are going to acquire the shares at below market prices. By selling the shares before they receive them, they are taking no risk that the price might decline after the issue process has completed. The practice also benefits brokers and advisers, who generate fees or commissions from the share issuance.

From directors’ point of view, permitting forward sales may make it easier for them to issue shares, thus raising finance which supports the business (and supports the payment of their salaries). This is a particular issue for businesses that are not generating profits, including early stage businesses and pre-production natural resource companies – many of which regularly need to raise fresh capital.

*I say “almost guaranteed”, because the New World case illustrates what can go wrong: it is possible that for some reason the company isn’t able to fulfill its commitment to issue the shares the forward seller is expecting to receive.

Under what circumstances can forward selling occur?

When we start to consider the circumstances under which forward selling can occur, the problems with the practice start to become evident. Firstly, in order for forward selling to be profitable the shares must be issued at below market prices. In the case of New World, the shares had been trading around 0.1p before the massively dilutive placing at 0.055p was announced. They still traded (in volume) at around 0.075p in the days immediately after the placing announcement, meaning an instant & substantial profit for the forward sellers.

Another circumstance where I have learnt forward selling takes place is when companies enter into agreements such as “Equity Financing Facilities” (EFFs). See this example in the case of Nighthawk Energy, another case that I am intimately familiar with. These and similar agreements are even more iniquitous from shareholders’ point of view (and investors should regard the existence of such an agreement to be a “red flag”). They allow the subject company to periodically issue tranches of shares, at prices that are to be determined by reference to market prices, upon issue of a “subscription notice” to the EFF provider by the company.

What happened in practice is that the EFF provider forward sold the shares it was procuring under the subscription notice during the period when the discounted subscription price was being determined, thus guaranteeing a profit, as described above.

What is the problem for shareholders?

There are two evident problems with this practice:

1. The forward sellers make their profits at the expense of pre-existing (and often long-term) shareholders, who’s stakes are diluted and hence devalued.
2. The buyers of the forward sellers’ shares may not be aware of what is going on (that was certainly the case in the Nighthawk example) and are purchasing shares that the company is issuing at a price that is inflated relative to the issue price. In the New World case, anyone buying shares from the forward seller at 0.075p was paying 36% more than they could have paid, had the company made the shares directly available to investors.

A less obvious problem is that for this practice to succeed, there needs to be a strong market for the shares that the company is issuing to the forward sellers. In my experience, one often finds very bullish comments about the worth of the company at such times, which can mislead investors and encourage them to overpay. In the case of New World, investors ultimately found themselves with worthless shares, as the company subsequently delisted.

There is obviously a strong incentive for the company or the forward seller to promote such commentary which misleads investors.

In the Nighthawk case, I believed that there was a clear instance of market abuse, which I evidenced and explained to the FCA in this letter – but never received anything other than an acknowledgement of my complaint, and a refusal to discuss it. Watch this space for ShareSoc’s response to the FCA’s recent consultation on their mission!

For these reasons, I believe the practice of forward selling should be banned and companies seeking to raise equity finance should instead be encouraged to do so from existing shareholders, and new investors, on equal terms, with preference being given to the former where demand exceeds supply.

What do you think?

Mark Bentley