) is a form ofstockwhich may have any combination of features not possessed bycommon stockincluding properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior (i.e., higher ranking) to common stock, but subordinate tobondsin terms of claim (or rights to their share of the assets of the company)and may have priority over common stock (ordinary shares) in the payment of dividends and uponliquidation. Terms of the preferred stock are described in the issuing companysarticles of associationorarticles of incorporation.
Like bonds, preferred stocks are rated by the majorcredit rating companies. The rating for preferred stocks is generally lower than for bonds because preferred dividends do not carry the same guarantees as interest payments from bonds and because preferred-stock holders claims are junior to those of all creditors.
Preferred stock is a special class of shares which may have any combination of features not possessed by common stock. The following features are usually associated with preferred stock:2
Preference in assets, in the event ofliquidation.
Callability (ability to be redeemed before it matures), at the option of the corporation. Possibly subject to aspens clause.
In general, preferred stock haspreferencein dividend payments. The preference does not assure the payment of dividends, but the company must pay the stated dividends on preferred stock before or at the same time as any dividends on common stock.2
Preferred stock can becumulativeornoncumulative. A cumulative preferred requires that if a company fails to pay a dividend (or pays less than the stated rate), it must make up for it at a later time in order to ever pay common-stock dividends again. Dividends accumulate with each passed dividend period (which may be quarterly, semi-annually or annually). When a dividend is not paid in time, it has passed; all passed dividends on a cumulative stock make up a dividend inarrears. A stock without this feature is known as a noncumulative, orstraight,3preferred stock; any dividends passed are lost if not declared.4
Preferred stock may or may not have a fixedliquidation value(orpar value) associated with it. This represents the amount of capital which was contributed to the corporation when the shares were first issued.
Preferred stock has a claim onliquidationproceeds of astock corporationequal to its par (or liquidation) value, unless otherwise negotiated. This claim is senior to that of common stock, which has only aresidual 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
; they may change according to a benchmark interest-rate index (such asLIBOR).
Some preferred shares have special votingrightsto approve extraordinary events (such as the issuance of newsharesor approval of the acquisition of a company) or to elect directors, but most preferred shares have no voting rights associated with them; some preferred shares gain voting rights when the preferred dividends are in arrears for a substantial time. This is all variable on the rights assigned to the preferred shares at the time of incorporation.
The above list (which includes several customary rights) is not comprehensive; preferred shares (like other legal arrangements) may specify nearly any right conceivable. Preferred shares in the U.S. normally carry a call provision,6enabling the issuing corporation to repurchase the share at its (usually limited) discretion.
In addition to straight preferred stock, there is diversity in the preferred stock market. Additional types of preferred stock include:
Many companies have different issues of preferred stock outstanding at one time; one issue is usually designated highest-priority. If the company has only enough money to meet the dividend schedule on one of the preferred issues, it makes the payments on the prior preferred. Therefore, prior preferreds have less credit risk than other preferred stocks (but usually offer a lower yield).
Ranked behind a companys prior preferred stock (on a seniority basis) are its preference preferred issues. These issues receive preference over all other classes of the companys preferred (except for prior preferred). If the company issues more than one issue of preference preferred, the issues are ranked by seniority. One issue is designated first preference, the next-senior issue is the second and so on.
These are preferred issues which holders canexchangefor a predetermined number of the companys common-stock shares. This exchange may occur at any time the investor chooses, regardless of the market price of the common stock. It is a one-way deal; one cannot convert the common stock back to preferred stock. A variant of this is the
recently made popular by investment banker Stan Medley who structured several variants of these preferred for some forty plus public companies. In the variants used by Stan Medley the preferred share converts to either a percentage of the companys common shares or a fixed dollar amount of common shares rather than a set number of shares of common.
The intention is to ameliorate the bad effects investors suffer from rampant shorting and dilutive efforts on theOTCmarkets.
If the dividend is not paid, it will accumulate for future payment.
This type of preferred stock carries anembedded optionto be exchanged for some other security.
These preferred issues offer holders the opportunity to receive extra dividends if the company achieves predetermined financial goals. Investors who purchased these stocks receive their regular dividend regardless of company performance (assuming the company does well enough to make its annual dividend payments). If the company achieves predetermined sales, earnings or profitability goals, the investors receive an additional dividend.
This type of preferred stock has no fixed date on which invested capital will be returned to the shareholder (although there are redemption privileges held by the corporation); most preferred stock is issued without a redemption date.
These issues have aputprivilege, whereby the holder may (under certain conditions) force the issuer to redeem shares.
A combination of preferred stock andsubordinated debt.
Dividends for this type of preferred stock will not accumulate if they are unpaid; very common inTRuPSand bank preferred stock, since underBISrules preferred stock must be non-cumulative if it is to be included inTier 1 capital.
Preferred stocks offer a company an alternative form of financingfor example throughpension-led funding; in some cases, a company can defer dividends by going intoarrearswith little penalty or risk to its credit rating, however, such action could have a negative impact on the company meeting the terms of its financing contract.9With traditional debt, payments are required; a missed payment would put the company in default.
Occasionally companies use preferred shares as means of preventinghostile takeovers, creating preferred shares with apoison pill(or forced-exchange or conversion features) which are exercised upon a change in control. 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 checks are often used as a takeover defense; they may be assigned very high liquidation value (which must beredeemedin the event of a change of control), or may have great super-voting powers.
When a corporation goes bankrupt, there may be enough money to repay holders of preferred issues known asseniorbut not enough money forjuniorissues. Therefore, when preferred shares are first issued their governing document may contain protective provisions preventing the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior,pari-passu(equal), or junior relationship with other series issued by the same corporation.
Preferred shares are more common in private or pre-public companies, where it is useful to distinguish between the control of and the economic interest in the company. Government regulations and the rules of stock exchanges may either encourage or discourage the issuance of publicly traded preferred shares. In many countries, banks are encouraged to issue preferred stock as a source ofTier 1 capital. On the other hand, theTel Aviv Stock Exchangeprohibits listed companies from having more than one class of capital stock.citation needed
A company may issue several classes of preferred stock. It may undergo several rounds of financing, with each round receiving separate rights and having a separate class of preferred stock. Such a company might haveSeries APreferred,Series BPreferred, Series C Preferred and common stock.
In the United States there are two types of preferred stocks:straightpreferreds andconvertiblepreferreds. Straight preferreds are issued in perpetuity (although some are subject to call by the issuer, under certain conditions) and pay a stipulated dividend rate to the holder. Convertible preferredsin addition to the foregoing features of a straight preferredcontain 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 stock).
There are income-tax advantages generally available tocorporationsinvesting in preferred stocks in the United States. SeeDividends received deduction.
But forindividuals, astraightpreferred stock, a hybrid between a bond and a stock, bears some disadvantages of each type of securities without enjoying the advantages of either. Like a bond, a straight preferred does not participate in future earnings and dividend growth of the company, or growth in the price of the common stock. However, a 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. However, the potential increase in the market price of the common (and its dividends, paid from future growth of the company) is lacking for the preferred. One advantage of the preferred to its issuer is that the preferred receives better equity credit at rating agencies than straight debt (since it is usually perpetual). Also, certain types of preferred stock qualify as Tier 1 capital; this allows financial institutions to satisfy regulatory requirements without diluting common shareholders. Through preferred stock, financial institutions are able to gain leverage while receiving Tier 1 equity credit.
If an investor paid par ($100) today for a typical straight preferred, such an investment would give a current yield of just over six percent. If, in a few years, 10-year Treasuries were to yield more than 13 percent to maturity (as they did in 1981) these preferreds would yield at least 13 percent; since the rate of dividend is fixed, this would reduce their market price to $46, a 54-percent loss. The 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 approaches; however, the straight preferred (having no maturity date) might remain at these $40 levels (or lower) for a long time.
Advantages of straight preferreds may include higher yields andin the U.S. at leasttax advantages; they yield about 2 percent more than 10-year Treasuries, rank ahead of common stock in case of bankruptcy and dividends are taxable at a maximum rate of 15% rather than at ordinary-income rates (as with bond interest).
No obligation for dividends: A company is not bound to pay a dividend on preference shares if its profits in a particular year are insufficient. It can postpone the dividend in case of cumulative preference shares also. No fixed burden is created on its finances.
No interference: Generally, preference shares do not carry voting rights. Therefore, a company can raise capital without dilution of control. Equity shareholders retain exclusive control over the company.
Trading on equity: The rate of dividend on preference shares is fixed. Therefore, with the rise in its earnings, the company can provide the benefits of trading on equity to the equity shareholders.
No charge on assets: Preference shares do not create any mortgage or charge on the assets of the company. The company can keep its fixed assets free for raising loans in future
Variety: Different types of preference shares can be issued depending on the needs of investors. Participating preference shares or convertible preference shares may be issued to attract bold and enterprising investors.
Preferred shares represent a significant portion of Canadian capital markets, with over C$11.2billion in new preferred shares issued in 2016.10Many Canadian issuers are financial organizations which may count capital raised in the preferred-share market asTier 1 capital(provided that the shares issued are perpetual). Another class of issuer includessplit share corporations. 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 withbonds.
Preferred shares are often used by private corporations to achieve Canadian tax objectives. For instance, the use of preferred shares can allow a business to accomplish anestate freeze. By transferring common shares in exchange for fixed-value preferred shares, business owners can allow future gains in the value of the business to accrue to others (such as adiscretionary trust).
The rights of holders of preference shares in Germany are usually rather similar to those of ordinary shares, except for some dividend preference and no voting right in many topics of shareholders meetings. Preference shares in German stock exchanges are usually indicated withV,VAorVz(short forVorzugsaktie)for example, BMW Vz11in contrast toSt,StA(short forStammaktie) orNA(short forNamensaktie) for standard shares.12Preference shares with multiple voting rights, e.g. atRWEorSiemens, have been abolished.
Preferred stock may comprise up to half of total equity. It is convertible into common stock, but its conversion requires approval by a majority vote at the stockholders meeting. If the vote passes, German law requires consensus with preferred stockholders to convert their stock (which is usually encouraged by offering a one-time premium to preferred stockholders). The firms intention to do so may arise from its financial policy (i.e. its ranking in a specific index). Industry stock indices usually do not consider preferred stock in determining the daily trading volume of a companys stock; for example, they do not qualify the company for a listing due to a low trading volume in common stocks.12
Perpetual non-cumulative preference shares may be included asTier 1 capital. Perpetual cumulative preferred shares are UpperTier 2 capital. Dated preferred shares (normally having an original maturity of at least five years) may be included in LowerTier 2 capital.13
In the United States, the issuance of publicly listed preferred stock is generally limited to financial institutions,REITsand public utilities. Because in the U.S. 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 significantly greater than issuing the equivalent amount of debt at the same interest rate. This has led to the development ofTRuPS: debt instruments with the same properties as preferred stock. With the passage of theDodd-Frank Wall Street Reform and Consumer Protection Actin 2010, TRuPS will be phased out as a vehicle for raising Tier 1 capital by bankholding companies. Outstanding TRuPS issues will be phased out completely by 2015.14
However, with a qualifieddividend taxof 15 percent (compared to a top ordinarymarginal tax rateof 35 percent),15$1 of dividend income taxed at this rate provides the same after-tax income as approximately $1.30 ininterest. The size of the preferred stock market in the United States has been estimated as $100billion (as of early 2008update), compared to $9.5trillion for equities and US$4.0trillion for bonds.16The amount of new issuance in the United States was $34.1billion in 2016.17
InNigeriapreferred shares make up a small percentage of a companys stock with no voting rights except in cases were they are not paid dividends; owners of preferred shares are entitled to a greater percentage of company profits.
Preferred stock cannot be more than 50 percent of total equity.
By a law enacted in June 2004 France allows the creation of preferred shares.
Dividends from preference shares are not taxable as income when held by individuals.
In Brazil, up to 50 percent of the capital stock of a company may be composed of preferred stock. The preferred stock will have at least one less right than the common stock (normally voting power), but will have a preference in receiving dividends.
No more than 25% of capital may be preferred stock. Voting rights are limited, but if dividends are not fully paid, shareholders obtain full voting rights.
Kieso, Donald E.; Weygandt, Jerry J. & Warfield, Terry D. (2007),
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