Preferred Stock

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A preferred stock, also known as a preferred share or simply a preferred, is a share of stock carrying additional rights above and beyond those conferred by common stock.

Rights

Unlike common stock, preferred stock usually has several rights attached to it:

• The core right is that of preference in dividends. 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 in arrears.
• Preferred stock has a par value or liquidation 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. This claim is senior to that of common stock, which has only a residual claim.
• Almost all preferred shares have a 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. Unlike debt securities, however, a company is not legally required to pay preferred dividends and will not be in default for missing a preferred dividend payment.
• Variable preferreds are rare exceptions; their changing dividends depend on prevailing interest rates, or varying as a percentage of net income.
• 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.
• 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.

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 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 authorising 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.

Users

Preferred shares are more common in private companies, where it is more useful to distinguish between the control of and the economic interest in the company. Also, government regulations and the rules of stock exchanges discourage the issuance of publicly traded preferred shares. For example the Tel Aviv Stock Exchange prohibits listed companies from having more than one class of capital stock. ^{[citation needed]}

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.

United States

In the United States issuance of publicly listed preferred stock is generally limited to financial institutions, REITs and public utilities. Because in the US dividends on preferred stock are not tax deductible (like interest expense), the effective cost of capital raised by preferred stock is 35% greater than issuing the equivalent amount of debt at the same interest rate. This has lead to the development of TRuPS (Trust-preferred security) which are essentially debt instruments with the same properties as preferred stock.

However, with a dividend tax of 15% and a top marginal tax rate of 35%^[2], one dollar of dividend income taxed at these rates provides the same after-tax income as approximately $1.30 in interest.

The size of the preferred stock market in the United States has been estimated as USD 200-billion, as of August, 2006, compared to USD 16-trillion for equities and USD 5-trillion for bonds^[3].

Common types

There are various types of preferred stocks that are common to many corporations:

• Cumulative Preferred Stock - If the dividend is not paid, it will accumulate for future payment.
• Non-cumulative Preferred Stock - Dividend for this type of preferred stock will not accumulate if it is unpaid. This type is very rare, because the payment of dividends is always at the discretion of the board of directors.
• Convertible Preferred Stock - This type of preferred stock carries the option to convert into a common stock at a prescribed price.
• Exchangable Preferred Stock - This type of preferred stock carries the option to be exchanged for some other security upon certain conditions.
• Participating Preferred Stock - This type of preferred stock allows the possibility of additional dividend above the stated amount under certain conditions.
• Perpetual Preferred Stock - This type of preferred stock has no fixed date on which invested capital will be returned to the shareholder, although there will always be redemption privileges held by the corporation. Most preferred stock is issued without a set redemption date.
• Puttable Preferred Stock - These issues have a "put" privilege whereby the holder may, upon certain conditions, force the issuer to redeem shares.

Notes

1. ^ FSA Handbook, PRU 2.2 Capital resources Accessed July 31, 2006
2. ^ CCH Incorporated Marginal and Effective Tax Rates Accessed September 18, 2006
3. ^ Standard & Poors [http://www2.standardandpoors.com/spf/pdf/index/PreferredStock_whitepaper.pdf A Short Guide to Preferred Stocks and the S&P U.S. Preferred Stock Index] Accessed September 18, 2006