Preferred stock, also called
preferred
shares or
preference shares, is typically
a 'higher ranking' stock than
common
stock, and its terms are negotiated between the corporation and
the investor.
Preferred stock usually carries no voting rights, but may carry
priority over
common stock in the
payment of dividends and upon
liquidation. Preferred stock may carry a
dividend that is paid out prior to any
dividends being paid to common stock holders. Preferred stock may
have a convertibility feature into common stock. Preferred
stockholders will be paid out in assets before common stockholders
and after debt holders in
bankruptcy.
Terms of the preferred stock are stated in a "Certificate of
Designation".
Rights
Unlike common stock, preferred stock usually has several rights
attached to it:
- The core right is that of preference in the payment of
dividends and upon liquidation of the company. Before a dividend can be declared on the common shares, any
dividend obligation to the preferred shares must be satisfied.
- The dividend rights are often cumulative, such that if the
dividend is not paid it accumulates from year to year. However, the
directors must declare a dividend before the preferred shareholder
has any right to it. In case of non-cumulative, the dividend right
for the year is extinguished if it is not declared for that
year.
- Preferred stock may or may not have a fixed liquidation value, or par value, associated with it. This represents the
amount of capital that was contributed to the corporation when the
shares were first issued.
- Preferred stock has a claim on liquidation proceeds of a stock corporation, equivalent to its par
or liquidation value unless otherwise negotiated. This claim is
senior to that of common stock, which has only a residual claim.
- Almost all preferred shares have a negotiated fixed dividend amount. The dividend is usually specified
as a percentage of the par value or as a fixed amount. For example
Pacific Gas & Electric 6% Series A preferred. Sometimes,
dividends on preferred shares may be negotiated as floating i.e.
may change according to a benchmark interest rate index such as
LIBOR.
- Some preferred shares have special voting rights to approve certain extraordinary events (such
as the issuance of new shares or the approval
of the acquisition of the company) or to elect directors, but most
preferred shares provide no voting rights associated with them.
Some preferred shares only gain voting rights when the preferred
dividends are in arrears for a substantial time.
- Usually preferred shares contain protective provisions which
prevent the issuance of new preferred shares with a senior claim.
Individual series of preferred shares may have a senior, pari-passu or junior relationship with other
series issued by the same corporation.
- Occasionally companies use preferred shares as means of
preventing hostile takeovers,
creating preferred shares with a poison pill or forced
exchange/conversion features that exercise upon a change in
control.
The above list, although including several customary rights, is far
from comprehensive. Preferred shares, like other legal
arrangements, may specify nearly any right conceivable. Preferred
shares in the U.S. normally carry a call provision, enabling the
issuing corporation to repurchase the share at its (usually
limited) discretion.
Some corporations contain provisions in their charters authorizing
the issuance of preferred stock whose terms and conditions may be
determined by the board of directors when issued. These "blank
check" preferred shares are often used as takeover defense (see
also
poison pill). These shares may be
assigned very high liquidation value that must be
redeemed in the event of a change of
control or may have enormous supervoting powers.
Types of Preferred Stock
In addition to the straight preferred, as just described, there is
great diversity in the preferred stock market. Additional types of
preferred stock include:
Prior Preferred Stock: Many companies have
different issues of preferred stock outstanding at the same time
and one of them is usually designated to be the one with the
highest priority. If the company has only enough money to meet the
dividend schedule on one of the preferred issues, it makes the
dividend payments on the prior preferred. Therefore, prior
preferred have less credit risk than the other preferred stocks but
it usually offers a lower yield than the others.
Preference Preferred Stock: Ranked behind the
company's prior preferred stock (on a seniority basis), are the
company's preference preferred issues. These issues receive
preference over all other classes of the company's preferred except
for the prior preferred. If the company issues more than one issue
of preference preferred, then the various issues are ranked by
their relative seniority. One issue is designated first preference,
the next senior issue is the second and so on.
Convertible Preferred Stock: These are preferred
issues that the holders can exchange for a predetermined number of
the company's common stock. This exchange can occur at any time the
investor chooses regardless of the current market price of the
common stock. It is a one way deal so you cannot convert the common
stock back to preferred stock.
Participating Preferred Stock: These preferred
issues offer the holders the opportunity to receive extra dividends
if the company achieves some predetermined financial goals. The
investors who purchased these stocks receive their regular dividend
regardless of how well or how poorly the company performs, assuming
of course, the company does well enough to make the annual dividend
payments. If the company achieves predetermined sales, earnings or
profitability goals, the investors receive an additional
dividend.
Users
Preferred shares are more common in private or pre-public
companies, where it is more useful to distinguish between the
control of and the economic interest in the company. Government
regulations and the rules of stock exchanges may discourage or
encourage the issuance of publicly traded preferred shares. In many
countries
banks are encouraged to issue
preferred stock as a source of
Tier 1
capital. On the other hand, the
Tel Aviv Stock Exchange prohibits
listed companies from having more than one class of capital
stock.
A single company may issue several classes of preferred stock. For
example, a company may undergo several rounds of financing, with
each round receiving separate rights and having a separate class of
preferred stock; such a company might have "Series A Preferred,"
"Series B Preferred," "Series C Preferred" and common stock.
In the United States there are two types of preferred stocks:
straight preferreds and
convertible preferreds.
Straight preferreds are issued in perpetuity (although some are
subject to call by the issuer under certain conditions) and pay the
stipulated rate of interest to the holder. Convertible
preferreds—in addition to the foregoing features of a straight
preferred—contain a provision by which the holder may convert the
preferred into the common stock of the company (or, sometimes, into
the common stock of an affiliated company) under certain
conditions, among which may be the specification of a future date
when conversion may begin, a certain number of common shares per
preferred share, or a certain price per share for the common.
There are income tax advantages generally available to
corporations that invest in preferred stocks in the United
States that are not available to
individuals.
Some argue that a
straight preferred stock, being a hybrid
between a bond and a stock, bears the disadvantages of each of
those types of securities without enjoying the advantages of
either. Like a bond, a straight preferred does not participate in
any future earnings and dividend growth of the company and any
resulting growth of the price of the common. But the bond has
greater security than the preferred and has a maturity date at
which the principal is to be repaid. Like the common, the preferred
has less security protection than the bond. But the potential of
increases of market price of the common and its dividends paid from
future growth of the company is lacking for the preferred. One big
advantage that the preferred provides its issuer is that the
preferred gets better equity credit at rating agencies than
straight debt, since it is usually perpetual. Also, as pointed out
above, certain types of preferred stock qualifies as Tier 1
capital. This allows financial institutions to satisfy regulatory
requirements without diluting common shareholders. Said another
way, through preferred stock, financial institutions are able to
put on leverage while getting Tier 1 equity credit.
Suppose that an investor paid par ($100) today for a typical
straight preferred. Such an investment would give a current yield
of just over 6%. Now suppose that in a few years 10-year Treasuries
were to yield 13+% to maturity, as they did in 1981; these
preferreds would yield at least 13%, which would knock their market
price down to $46, for a 54% loss. (In all probability, they would
yield some 2% more than the Treasuries—or something like 15%, which
would take the market price down to $40, for a 60% loss.)
The important difference between straight preferreds and Treasuries
(or any investment-grade Federal agency or corporate bond) is that
the bonds would move up to par as their maturity date is
approached, whereas the straight preferred, having no maturity
date, might remain at these $40 levels (or lower) for a very long
time.
Advantages of straight preferreds posited by some advisers include
higher yields and tax advantages (currently yield some 2% more than
10-year Treasuries, rank ahead of common stock in the case of
bankruptcy, dividends are taxable at a maximum 15% rather than at
ordinary income rates, as in the case of bond interest).
Canada
Preferred shares represent a significant portion of Canadian
capital markets, with over CAD 5-billion in new preferred shares
issued in 2005.
[59608]
Canadian issuers
Many issuers are financial organizations that may count capital
raised in the preferred share market as
Tier 1 capital, provided that the shares
issued are perpetual. Another class of issuer are "
split share corporations."
Canadian investors
Investors in Canadian preferred shares are generally those who wish
to hold fixed-income investments in a taxable portfolio.
Preferential tax treatment of dividend income, as opposed to
interest income, may in many cases result in a greater after-tax
return than might be achieved with
bonds.
Czech Republic
Preferred stock cannot be more than 50% of total equity.
France
By a law that dates from June 2004, France allows the creation of
preferred shares.
Germany
Preferred stock may amount to up to half of the total equity.
Preferred stock is convertible into common stock, but conversion
needs approval by majority vote in the stockholders' meeting. If
the vote passes, German law requires consensus with preferred stock
holders to convert their stock, which is usually encouraged
offering a one-time premium to preferred stock holders. The firm's
intention to do so may arise from its finance policy i.e. ranking
in a specific index. Industry stock exchange indices usually do not
consider preferred stock in determining daily trading volume of a
company's stock e.g. do not qualify the company for a listing due
to the low trading volume in (just common) stocks.
United Kingdom
United Kingdom issuers
Perpetual non-cumulative preference shares may be included as
Tier 1 capital. Perpetual cumulative
preferred shares are Upper
Tier 2
capital. Dated preferred shares (normally having an original
maturity of at least five years) may be included in Lower
Tier 2 capital.
United States
In the United States issuance of publicly listed preferred stock is
generally limited to financial institutions,
REITs and public utilities. Because in the US dividends
on preferred stock are not tax deductible at the corporate level
(in contrast to interest expense), the effective cost of capital
raised by preferred stock is 35% greater than issuing the
equivalent amount of debt at the same interest rate. This has led
to the development of TRuPS (
Trust-preferred security) which are
essentially debt instruments with the same properties as preferred
stock.
However, with a qualified
dividend tax
of 15% compared to a top ordinary
marginal tax rate of 35%, $1 of dividend
income taxed at these rates provides the same after-tax income as
approximately $1.30 in
interest.
The size of the preferred stock market in the United States has
been estimated as USD$100-billion, as of early 2008, compared to
USD$9.5 trillion for equities and USD$4.0 trillion for bonds.
South Africa
Dividends from preference shares are not taxable as income in the
hands of individuals.
Common types
There are various types of preferred stocks that are common to many
corporations:
- Cumulative preferred stock - If the dividend is not paid, it
will accumulate for future payment.
- Non-cumulative preferred stock - Dividend for this type of
preferred stock will not accumulate if it is unpaid. Very common in TRuPS
and bank preferred stock, since under BIS
rules, preferred stock must be non-cumulative if it
is to be included in Tier 1
capital.
- Convertible preferred stock - This type of preferred stock
carries the option to convert into a common stock at a prescribed
price.
- Exchangeable preferred stock - This type of preferred stock
carries the option to be exchanged for some other security upon
certain conditions.
- Monthly income
preferred stock - A combination of preferred stock and subordinated debt.
- Participating
preferred stock - This type of preferred stock allows the
possibility of additional dividend above the stated amount under
certain conditions.
- Perpetual preferred stock - This type of preferred stock has no
fixed date on which invested capital will be returned to the
shareholder, although there will always be redemption privileges
held by the corporation. Most preferred stock is issued without a
set redemption date.
- Putable preferred stock - These issues have a "put" privilege whereby the holder may, upon
certain conditions, force the issuer to redeem shares.
Notes
- This Google search contains examples of voting
preferred stock.
- "Preferred Stock...generally carries no voting rights unless
scheduled dividends have been omitted." [1]
- Harvard Business Services, Inc. Accessed February 23,
2007
- According to a Quantum Online table
- FSA Handbook, PRU 2.2 Capital resources Accessed July 31, 2006
- CCH Incorporated Marginal and Effective Tax Rates Accessed September
18, 2006
- Standard & Poor's [2] 2009-08-27
- Basel Committee on Banking Supervision [Minimum Capital
Requirements http://www.bis.org/publ/bcbs128b.pdf] Accessed
2007-1-12
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