Preferred stock, also called preferred shares or preference shares, is typically a higher ranking stock than voting shares, and its terms are negotiated between the corporation and the investor.
Preferred stock usually carry no voting rights, but may carry superior 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 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”.
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.
- 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. 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.
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).