Overview
Preferred shares are equity securities that provide certain advantages over common shares, particularly in terms of dividend payments and asset entitlement. The features described below can be built into any type of preferred share to either strengthen the issuer’s position or protect the purchaser’s position.
Cumulative Feature
If a company’s board of directors opts not to pay one or more preferred dividends when due, these unpaid dividends accumulate in what is known as arrears. All arrears of cumulative preferred dividends must be settled before any common dividends are paid out or before the preferred shares are redeemed. This feature ensures that preferred shareholders receive all owed dividends before common shareholders.
Key points:
- Arrears: Unpaid dividends are accumulated.
- Priority: All arrears must be paid before common dividends or before redemption of shares.
Practical Tip: Before advising an investor to purchase preferred shares, it’s crucial to verify whether the shares have a cumulative feature.
Non-cumulative Feature
Non-cumulative preferred shares work differently. The shareholder is entitled to the payment of a specified dividend only when it is declared. Any unpaid dividends do not accumulate, and the shareholder will not receive any catch-up payments if dividends are resumed in the future.
Key points:
- No Arrears: Unpaid dividends do not accumulate.
- Weaker Position: Shareholders are not entitled to past unpaid dividends when dividends resume.
Callable Feature
Callable preferred shares can be redeemed by the issuer at a specified time and price. Typically, these shares provide for a premium over the per-share asset entitlement amount fixed by the company’s charter. This call feature permits companies to reacquire the shares, thereby providing some level of flexibility in managing their capital structure.
Key points:
- Issuer Right: The issuer can call back the shares.
- Premium: Usually, a small premium is paid above the per-share value.
- Regulation: Redemptions generally are subject to price limits and regulatory approval.
Non-callable Feature
Non-callable preferred shares cannot be called or redeemed for as long as the issuing company exists. This feature is restrictive from the issuer’s standpoint, as it effectively freezes a part of the capital structure for the life of the company.
Key points:
- Permanency: The shares remain unredeemed for the life of the company.
- Restriction: This feature is least common due to its restrictive nature.
Voting Privileges
Although most preferred shares do not come with voting privileges, it’s a common practice to assign voting rights to preferred shareholders if a certain number of preferred dividends are missed. This feature acts as an incentive for companies to meet their dividend obligations timely.
Key points:
- Non-voting: Typically, preferred shares do not have voting rights.
- Conditional Voting: Voting rights may be triggered after missing a specified number of dividend payments.
Purchase Fund
A purchase fund sets funds aside to buy back shares if their market price drops to or below a stipulated level. The fund is in place to ensure there is a measure of support for the stock’s market price, acting as a built-in stabilizer for preferred shareholders.
Key points:
- Market Support: The fund supports the share price by buying back shares.
- Stipulated Price: Purchases are typically made at or below a certain price threshold.
Sinking Fund
A sinking fund is an arrangement in which the issuing company sets money aside to retire/redeem a portion of the preferred stock. The goal is to systematically decrease the number of shares over time. It often tries to retire shares in the open market at or below a set price.
Key points:
- Regular Retirement: Funds dedicated to redeem shares incrementally over time.
- Market Purchase or Call: Shares may be purchased in the market or directly called from investors.
Glossary
- Arrears: Accumulated unpaid dividends that are overdue.
- Callable: Feature allowing the issuer to redeem shares before their maturity date, usually at a premium.
- Sinking Fund: A fund into which money is periodically deposited by a corporation for the purpose of repurchasing some of its preferred shares.
- Voting Privileges: Rights assigned to shareholders, allowing them to vote on company matters.
Key Takeaways
- Preferred shares can offer various features like cumulative dividends, callable options, and purchase funds to provide flexibility to issuers and protection to investors.
- It’s crucial to understand each feature’s implications before advising an investor or acquiring preferred shares.
- Terms like arrears, callable, non-callable, and sinking fund denote specific characteristics that can significantly impact the value and desirability of preferred shares.
Frequently Asked Questions
Q1: What happens to unpaid dividends in cumulative preferred shares?
A1: Unpaid dividends accumulate in arrears and must be paid off before any common dividends or redemption of preferred shares can occur.
Q2: Can a company never call non-callable preferred shares?
A2: Correct. Non-callable preferred shares cannot be called or redeemed as long as the issuing company is in existence.
Q3: What is the purpose of a sinking fund?
A3: A sinking fund ensures the gradual retirement of shares over time, providing a measure of security to investors and stabilizing the market value of the preferred stock.
Q4: Do preferred shares usually come with voting rights?
A4: Preferred shares typically do not have voting rights unless a specified number of preferred dividends are missed.
Feel free to refer back to this guide for a comprehensive understanding of preferred share features and their implications for both issuers and investors.
📚✨ Quiz Time! ✨📚
## Which feature of preferred shares allows unpaid dividends to accumulate in arrears until they are fully paid?
- [ ] Non-cumulative feature
- [x] Cumulative feature
- [ ] Callable feature
- [ ] Non-callable feature
> **Explanation:** The cumulative feature ensures that if dividends are not paid when due, they accumulate in arrears. These unpaid dividends must be paid before any common dividends can be paid or before the preferred shares can be redeemed.
## What type of preferred share does not allow arrears to accumulate, resulting in no catch-up payments if dividends are missed?
- [x] Non-cumulative feature
- [ ] Cumulative feature
- [ ] Callable feature
- [ ] Non-callable feature
> **Explanation:** Non-cumulative preferred shares entitle the shareholder to payment of specified dividends only when declared. If the dividends are missed, they do not accumulate and no catch-up payments are allowed.
## Which feature allows the issuer to redeem preferred shares at a stated time and price, providing a small premium to the investor?
- [ ] Non-cumulative feature
- [ ] Cumulative feature
- [x] Callable feature
- [ ] Non-callable feature
> **Explanation:** The callable feature allows the issuer to redeem the preferred shares at a specified time and price, often with a small premium as compensation to the investor for the call.
## Which feature is rarely used because it restricts the issuer by preventing the company from redeeming the preferreds?
- [ ] Cumulative feature
- [ ] Callable feature
- [ ] Purchase fund
- [x] Non-callable feature
> **Explanation:** Non-callable preferreds cannot be called or redeemed for the life of the company, which restricts the issuer's flexibility in managing their capital structure, making this feature rarely used.
## When do preferred shareholders typically gain voting rights?
- [x] After a specified number of dividends have been omitted
- [ ] When dividends are paid on schedule
- [ ] When the preferred shares are callable
- [ ] When they hold cumulative preferred shares
> **Explanation:** Preferred shareholders typically gain voting rights after a certain number of preferred dividends have been omitted, whereas normally preferreds are non-voting when dividends are paid on schedule.
## What does a purchase fund seek to achieve when the share price falls below a stipulated price?
- [ ] It calls the preferred shares
- [ ] It converts the preferred shares into common shares
- [x] It attempts to buy specified amounts of the security for redemption
- [ ] It changes the dividend rate
> **Explanation:** A purchase fund attempts to buy specified amounts of the preferred shares for redemption if the price falls to or below a stipulated value, providing market support.
## How does a sinking fund function in relation to preferred shares?
- [ ] It ensures dividends are paid on non-cumulative preferred shares
- [x] It attempts to retire shares in the open market or redeems them if necessary
- [ ] It converts preferred shares into common shares after a certain period
- [ ] It nullifies the callable feature
> **Explanation:** A sinking fund attempts to retire preferred shares in the open market at or below a stipulated price. If shares cannot be purchased, the issuer must call or redeem securities to meet the retirement requirement.
## Which feature provides compensation to investors whose shares are called by the issuer?
- [ ] Non-cumulative feature
- [x] Callable feature
- [ ] Purchase fund
- [ ] Voting privileges
> **Explanation:** The callable feature often includes a small premium as compensation to the investor when their shares are called by the issuer.
## What impact does a cumulative feature have on common dividend payments?
- [ ] It prioritizes payment of common dividends before preferred dividends
- [ ] It eliminates payment of preferred dividends
- [x] It requires all arrears of cumulative preferred dividends to be paid before common dividends
- [ ] It allows unpaid common dividends to accumulate
> **Explanation:** Before common dividends can be paid, all arrears of cumulative preferred dividends must be fully paid, thereby prioritizing preferred dividends.
## Which preferred share feature is considered advantageous because it provides potential built-in market support via purchasing?
- [ ] Cumulative feature
- [ ] Callable feature
- [x] Purchase fund
- [ ] Sinking fund
> **Explanation:** A purchase fund is advantageous as it offers potential built-in market support by making efforts to purchase preferred shares if their market price falls to or below a stipulated level.