Preferred Shares Overview:

What kind of investors purchase preferred shares?

Preferred shares appeal to investors who prefer long-term dividend yields and greater
stability than common shares—preferred shares tend to be considerably less volatile and
aren’t subject to market pressures to the same degree common shares are.

What are some characteristics of preferred shares?

- have preference in dividends

- have preference in assets in the event of a company liquidation
- may be convertible into common stock
- may be callable at the option of the corporation
- usually non-voting, but may have voting rights in special circumstances (such as
acquisitions or new issuances)
- may or may not have par value associated to them
- usually do not have a merely residual claim to liquidated assets
- may have a fixed or variable dividend amount

Additional preferred characteristics and types:

- Prior preferred: lower-yield but gets dividend first (lower credit risk)
- Preference preferred: second to Prior preferred in receiving dividend. Can be ranked in
priority order (first preference, second, third, etc.)
- Convertible preferred: can be exchanged for a predetermined number of common shares
at the holder’s discretion. One-way…cannot be converted back from common
- Cumulative preferred: if the dividend isn’t paid, it accumulates for future payment
(unlike other types of shares, which may lose their dividend claim entirely)
- Exchangeable: can be exchanged for another type of security upon certain conditions
- Participating preferred: holders can receive an additional dividend if the company meets
or exceeds performance goals (receive normal dividend no matter what)
- Perpetual preferred: no set redemption date upon which capital will be returned
- Putable preferred: Put privilege allowing holder to force issuer to redeem shares
- Monthly income preferred: a combination of preferred stock and subordinated debt
- Non-cumulative preferred: dividend doesn’t accumulate (very rare)
- Blank Check preferred: grants shareholders enormous voting powers in order to
maintain control in the event of an attempted hostile takeover

Strategic Considerations:
- Allow companies to pay dividends in arrears without losing credit rating
- Can be used to guard against hostile takeovers- exercise upon a change in control,
giving the holder enormous voting power or a high value that must be redeemed
 - May contain provisions preventing the issuance of new preferred shares senior to
existing
- Issued in lieu of bonds when companies have the cash flow to pay dividends but don’t
want the debt on their books.
- Prevent dilution of voting rights and allows for creation of very specific terms
- Payment (dividend) can be suspended due to financial constraints (unlike bonds, where
default occurs upon a halt in payments
- Do not reflect added debt on company financial statements, allowing for more
advantageous borrowing conditions

Tax Considerations:
- Preferred shares offer little tax advantage to the issuing corporation because the
preferred dividends are paid from after-tax dollars—therefore, they are considered
a more expensive means of financing than bonds, which are payed pre-tax
- The main tax advantage goes to the corporate buyers of preferred shares, allowing them
to exclude 70% of preferred dividend earnings from federal income tax. This is
known as an inter-corporate dividends received deduction (DRD)
- Indirectly, this saves the issuing company money by allowing it to lower the interest
rate while keeping the same net yield to investors

Regulatory and Rating Considerations:

- Rated by credit agencies (Moody’s, Standard and Poors, etc.) according to the issue, not
the issuer. Rated similarly to bonds, but the rating varies based upon the likelihood of
payment. A company’s bond issues will be rated higher than its preferred
offerings because the bonds have a preferential claim to payment.
- According to historic SEC regulations, redeemable preferred shares have been listed
between equity and liabilities on a company’s balance sheet, with characteristics
considered significantly different from both permanent capital and cash flow.
- However, new regulations aim to classify redeemable preferred shares with liabilities in
order to reflect the company’s obligation to redeem them at a future date. This
shift in accounting would cause an increase in the debt to equity ratio, providing
more of the ‘whole picture’ of the company’s financial obligations to investors,
where previously this issued preferred debt would have been off-balance sheet.