Preferred Stock

General Terms of Preferred stock contract.

1. Cumulative / Noncumulative 2. Redemption 3. Dividend Preference 4. Liquidation Preference 5. # of shares and price per share 6. Yield 7. Subordination 8. Voting Rights 9. Conversion Rights 10. Exchange Rights 11. Participating Rights 12. Affirmative & Negative Covenants

Types of Preferred Stock

1. Fixed Preferred 2. Participating Preferred 3. Pay in Kind (PIK) Preferred 4. Auction Rate Preferred 5. Normal + Auxilliary Dividend 6. Poison Pill Preferred 7. Angel Preferred

Dividend Preference

A corporation is required to pay prefered dividend before it can pay any dividend to the common stock. But dividends are payable at the board's discretion and only out of the funds legally available for the payment of dividends.

PIK Preferred

A financial instrument that pays dividends with additional debt or equity instead of cash. Payment-in-kind securities are attractive to companies who would prefer not to make cash outlays. They are often used in leveraged buyouts.

Contract establishing the rights of preferred stock.

Articles of Incorporation or Charter Amendment.

Liquidation Preference

Corporation must pay preferred stockholders their contractual liquidation preference (specified dollar amount = par value of series) plus any accrued but unpaid dividends before it can distribute any assets to the common stock.

Posion Pill Preferred

Never issued, used as a tactic to force hostile bidder to the negotiation table.

Conversion Rights

PS may be convertible into shares of common stock at a specified conversion price. In most cases, conversion is at the option of each preferred stock holder. It has the downside protetion of preferred stock and the upside potential of common stock. Conversion right is normally set at 20 to 30% above current trading price.

Voting Rights

PS typically receives limited voting rights. Some of these rights are statutory while others are contractual. 1. Statutorily, preferred and common must vote together as a single class to approve amendments to the charter, or as a single class if the amendment affects them negatively. DGLC §242(b)(1)-(2). 2. Contractually, PS may have a right to elect a specified number of directors (2) if company misses (6) quarterly cumulative dividends (after payment of arrierages they must resign). In the alternative, PS may elect specific directors in addition to existing directors.

Optional Redemption

Peferred stock may be callable or redeemable if contract grants company with the option to redeem it in whole or in part at a specified redemption price (liquidation value + premium + accrued unpaid dividends if applicable). This option allows companies to refinance their existing preferred stock when interest rates decline through the issuance of a new series of preferred. at the company's discretion or otherwise. It may also be perpetual.

Cumulative Preferred

Preferred stock preference extends to any preivous dividends (known as dividends arrierages) the board did not declare.

Fiduciary Duties to Preferred

Protections of preferred stockholders are set forth by contract. But preferred stockholders are still stockholders with more rights than a mere contract claimant. In Jedwab v. MGM, the Court of Chancery found that directors had a fiduciary duty towards PS reasoning that the rights of preferred not associated with preferences are shared equally with the common stock (i.e. intrinsic fairness standard). Yet, in L.P. v. Marriott, the court explained that in most instances a review of preferred will exhaust the judicial review. Directors don't owe general duties, but specific duties in specific factual contexts.

Blank Check Preferred Stock Provision.

Provision granting the board authority to issue a new series of preferred stock when the board believes doing so is desirable (no need of shareholder's approval). When utilizing the Blank Check provision, the board will set forth the rights, preferences and other terms of a new series of preferred stock in board resolutions known as Certificates of Designation.

Tax incentives of using Preferred Stock.

S is tax-favored form of investment. IRC §243 provides that if stock is owned by another corporation, 70% of dividends received are deductible by recipient. If recipient owns 20% or more of the stock, 80% of the dividends are deductible. They are 100% deductible if the recipient corporation owns 80% or more of the stock. [Is it only for corporations or also investors?]. Insurance companies are major investors in preferred stock. Company should look at net cost of capital (even if same rate cost, the tax treatment is different).

Noncumulative Preferred

When preferred in noncumulative, its contract states that preferred stock dividends that were not paid did not accrue. In Guttman v. Illinois Central (2d Cir 1951) the court held that board may not declare dividends of noncumulative preferred so long as there is no abuse of discretion.

Redemption Rights

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(Venture) Angel Preferred

1. Noncumulative 2. Convertible into common stock in case of liquidity event (company sold or IPO). 3. Demand Rights/ Piggy Back Rights 4. Voting Rights (elect directors)

Exchange Rights

Company may have the ability to exchange shares of an existing series of preferred stock for debt securities (debentures) with comparable attributes.

Mandatory Redemption

Company must redeem some or all of its preferred at specified price upon the occurrence of certain events or on specified dates. Mandatory redemption may also be required in cases of change of control.

Perpetual Preferred

No Redemption date.

Covenants

Protections to Preferred stock requiring or prohibiting certain action by the company.

Preferred Stock

Shares which pay fixed dividends and have dividend preference and liquidation preference over common stock.

Participating Preferred

Participation rights entitle PS to receive in addition to their preferred stock dividends, dividends payable on common stock as if each share of preferred stock were a share of common stock.

Yield

Preferred is riskier than debt, so the dividend rate is higher than market interest rate. Yield may be expressly given (% YLD) or implied (dividend/price).

Sham Preferred

Preferred stock has to have a real dividend and liquidation preference to differentiate it from Common Stock. (El Paso Company / Telvest v. Olson).

Certificate of Designation

A certificate which contains a copy of the board resolution setting out the powers, designations, preferences or rights of a class or series of a class of stock of a corporation (typically a series of preferred stock) if they are not already contained in the certificate of incorporation of the corporation (pursuant to Blank Check Provision). The certificate of designation is filed as an amendment to the certificate of incorporation with the secretary of state of the corporation's state of organization.

Floating Rate Preferred

A preferred stock paying a dividend that varies from time to time. Usually, the dividend rate is the same as the interest rate on a Treasury security + X basis points.

What triggers liquidation rights?

Bankruptcy, substantial change in the company's business (merger), sale of substantially all of the company's assets, etc.

Fixed Preferred

Fixed dividend rate (majority of preferred stock).

Auction Rate Preferred

Floating rate preferred stock, whose dividend is adjusted every seven weeks (45 days) through a Dutch auction.

Subordination

When company has more than one series of preferred, it typically labels them A, B, C, D, E, etc. Subordination among outstanding series of preferred is strictly a matter of contract.