Chapter 8. Equity Securities: Common and Preferred Shares CSI GLOBAL EDUCATION INC. (2013) 8 1

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1 Chapter 8 Equity Securities: Common and Preferred Shares 8 1

2 8 Equity Securities: Common and Preferred Shares CHAPTER OUTLINE What are Common Shares? Benefi ts of Common Share Ownership Capital Appreciation Dividends Voting Privileges Tax Treatment Stock Splits and Consolidations Reading Stock Quotations What are Preferred Shares? The Preferred s Position Why Companies Issue Preferred Shares Why Investors Buy Preferred Shares Preferred Share Features Straight Preferreds Convertible Preferreds Retractable Preferreds Floating-Rate Preferreds Foreign-Pay Preferreds Other Types of Preferreds 8 2

3 What are Stock Indexes and Averages? Canadian Market Indexes U.S. Stock Market Indexes International Market Indexes and Averages Summary LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Discuss the benefi ts of common share ownership, describe how dividends are taxed, declared and claimed, and describe the impact of stock splits and consolidations on shareholders. 2. Discuss the position, advantages, disadvantages and special provisions of preferred shares, differentiate among the types of preferred shares, describe their features, and perform related calculations. 3. Differentiate between a stock market index and an average, and summarize the important stock market indexes and averages. INVESTING IN EQUITIES Equity securities, particularly common stocks, are an important part of most investors portfolios. History has shown that the return on stocks has exceeded the return on bonds over the long term. In addition, long-term common stock returns have consistently outpaced infl ation, providing long-term protection from a loss of purchasing power. At the close of trading each day, investors and advisors want to know how the markets performed. To measure performance, market participants look to the various stock market indexes that have developed over time. For the most part, these indexes track the performance of a basket of common shares that represents the most visible and easily accessible of investments. Common shares form the backbone of many investment portfolios and are a major component of pension funds, mutual funds and hedge funds. Unlike many other types of investments, there are a number of inherent rights, advantages and disadvantages of common share ownership with which investors must be familiar. 8 3

4 Closely related, but with some key differences, are preferred shares. Preferred shares are a staple investment in the Canadian market largely because of the fi xed-income stream that the investment generates. With an investment in common shares, what you see is mostly what you get an ownership position in a company. Preferred shares are a little different in that there is a variety of features and structures, characteristics that make them appeal to different investors for various reasons. You will fi nd that you are familiar with many of the preferred share features discussed in this chapter because they are very similar to the different features available in bonds. In this fi rst chapter on equity securities, we look at some of the basic features, advantages and disadvantages of investing in common and preferred shares before introducing the important role played by Canadian, U.S. and global stock market indexes. KEY TERMS Arrears Callable preferreds Canadian Depository for Securities Limited (CDS) Capital gain Capital loss Consolidations Convertible preferreds Cum dividend Deferred preferred Delayed fl oaters Dividend record date Dividend reinvestment plan Dividend tax credit Dividends Dollar cost averaging Dow Jones Industrial Average (DJIA) Ex-dividend Ex-dividend date Floating-rate preferreds Foreign-pay preferreds Non-callable preferreds Odd lot Participating preferred Retained earnings Restricted shares Retractable preferred S&P/TSX Composite Index Soft retractable preferred Standard Trading Unit Stock dividends Stock split Street certifi cates Variable rate preferreds Voting rights 8 4

5 EIGHT EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 5 WHAT ARE COMMON SHARES? Common shareholders are the owners of a company and initially provide the equity capital to start the business. If the venture prospers, the shareholders benefit from the growth in value of their original investment and the flow of dividend income. The prospect of a small investment growing to many times its original value attracts investors to common shares. On the other hand, if the business fails, the common shareholders may lose their entire investment. This possibility of total loss explains why common share capital is sometimes referred to as venture or risk capital. SUMMARY OF COMMON SHARES Position on asset claims in case of bankruptcy Dividends Evidence of Ownership Clearing and Settlement Trading Units Senior creditors (such as banks), bond and debenture holders and preferred shareholders all have prior claims on the company s assets in case of bankruptcy. Common shares, therefore, have a relatively weak position on asset claims. Unlike debt interest, common share dividends are payable at the discretion of the Board of Directors. There is no guarantee of dividend income. Shares are most often registered in street certificate form, meaning they are registered in the name of the securities fi rm rather than the benefi cial owner. This increases the negotiability of the shares, making them more readily transferable to a new owner. CDS Clearing and Depository Services Inc (CDS) offers computerbased systems to replace certifi cates as evidence of ownership in securities transactions. This system almost eliminates the need to handle securities physically. Stocks trade in uniform lot sizes on stock exchanges. A standard trading unit is a regular trading unit which has uniformly been decided upon by the exchanges. The usual unit of trading for most stocks is 100 shares. A group of shares traded in less than a standard trading unit is called an odd lot. Benefits of Common Share Ownership The right to buy or sell common shares in the open market at any time is an attractive feature and a relatively simple matter with few legal formalities. When a company first sells its shares to investors, the proceeds from the sale go to the company. When these outstanding shares are subsequently sold by their holders, the selling price is paid to the seller of the shares and not to the corporation. Shares, therefore, may be transferred from

6 8 6 CANADIAN SECURITIES COURSE VOLUME 1 one owner to another without affecting the operations of the company or its finances. From the company s point of view, the effect of a sale is simply that a new name appears on its list of shareholders. The following are some of the benefits of common share ownership: Potential for capital appreciation The right to receive any common share dividends paid by the company Voting privileges, including the right to elect directors, to approve financial statements and auditor s reports, and vote on other important issues Favourable tax treatment in Canada of dividend income and capital gains Marketability shareholdings can easily be increased, decreased or sold, for most public companies The right to receive copies of the annual and quarterly reports, and other mandatory information pertaining to the company s affairs The right to examine certain company documents such as the by-laws and register of shareholders at specified times The right to question management at shareholders meetings Limited liability Capital Appreciation For many investors, the prospect of capital appreciation is the main attraction of common shares. Common shares may increase in value as retained earnings (earnings kept within the company rather than paid out to shareholders) increase the size of shareholder s equity, making the stock more attractive to investors. Increasing profits and increasing dividend payments can also result in a higher demand for the stock, thereby leading to the stock s capital appreciation. It is important to keep in mind that not all common shares fulfill these expectations, and even those that increase shareholder equity, earn profits and increase dividend payments will not necessarily increase in value every year. There are many other factors that can affect a company s stock price, and careful analysis is required to ensure a profitable investment. Stock price analysis is the focus of Chapter 13. Dividends A company s net earnings are available for distribution as dividends, or may be retained within the company and reinvested in the business, or a combination of the two. Dividend policy is determined by the Board of Directors, who are guided primarily by the goals of the company, the size of the company, the industry in which it participates, and the financial position of the company. For example, mature companies, such as banks, may pay out a substantial percentage of their earnings as dividends to shareholders, while growing companies such as those in the technology field may need to keep a high proportion of earnings within the company to fund the large amount of research and development that are crucial to their success. To maintain its operations and finance future growth opportunities, most companies will retain a portion of earnings each year. In the long run, this policy may work to the benefit of shareholders if it results in increased earnings.

7 EIGHT EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 7 Reductions or omissions of dividends do occur, particularly in poor economic times, and although they may be temporary, they do emphasize the risks of common share investment. REGULAR AND EXTRA DIVIDENDS Some companies paying common share dividends designate a specified amount that will be paid each year as a regular dividend. The term regular indicates to investors that payments will be maintained, barring a major collapse in earnings. Some companies may also pay an extra dividend on the common shares, usually at the end of the company s fiscal year. The extra is a bonus paid in addition to the regular payout but the term extra cautions investors not to assume that the payment will be repeated the following year. DECLARING AND CLAIMING DIVIDENDS Companies may pay dividends quarterly, semi-annually or annually. But, unlike interest on debt, dividends on common shares are not a contractual obligation. The Board of Directors decides whether to pay a dividend, the amount and the payment date. An announcement is made in advance of the payment date. If the shares are registered in the name of the owner, dividend payment cheques are mailed directly to the owner. For shares registered in street certificate form, dividend payments are made to the securities firm whose name appears on the certificate. The dividends are then credited to the accounts of the firm s clients who own the shares. EX-DIVIDEND AND CUM DIVIDEND Many companies place advertisements in financial newspapers announcing the declaration of a dividend. Following is an example of a typical dividend announcement. EXAMPLE NOTICE OF DIVIDEND The Board of Directors of ABC Inc. voted to pay on July 2, 20XX to shareholders of record at the close of business on June 13, 20XX a dividend of $0.75 per each share of common stock. The transfer books will not be closed. Payment will be made in Canadian funds. The purpose of the interval between June 13 and July 2 is to give the company time to prepare the dividend cheques for mailing to recorded shareholders. During this interval, a purchaser of these shares will not receive the dividend that has just been declared and the stock is said to be ex-dividend. When a stock is actively traded, the record of shareholders is continually changing. For convenience, the company names a date known as the dividend record date. All shareholders recorded as of this date will be entitled to the dividend. The dividend record date is usually two to four weeks in advance of the payment date in order to allow time for cheque preparation. To determine whether the seller or the buyer is entitled to the dividend when a sale takes place around the time of the dividend payment, the stock exchange names an ex-dividend date. On and after this date, the stock sells ex-dividend; that is, the seller retains the dividend and the buyer is not entitled to it. The ex-dividend date is set at the second business day before the dividend record date. Since trades settle on the third business day after a trade, a purchaser of shares two

8 8 8 CANADIAN SECURITIES COURSE VOLUME 1 days before the record date would not have the trade settle until the day after the record date, and would therefore not be a shareholder of record for purposes of receiving the dividend. The following example shows how the shares trade. EXAMPLE TRADING EX- AND CUM DIVIDEND Using the dates in the previous example, and assuming that all are business days, the shares would trade as follows: Date Traded Date Settled Ex- or Cum Dividend Monday June 9 Thursday June 12 Cum Dividend Tuesday June 10 Friday June 13 Cum Dividend Wednesday June 11 Monday June 16 Ex-dividend Thursday June 12 Tuesday June 17 Ex-dividend Friday June 13 Wednesday June 18 Ex-dividend Monday June 16 Thursday June 19 Ex-dividend The major Canadian stock exchanges publish dividend announcements in their daily releases to securities firms in the following form: Payment When Payable Shareholder s of Record* Ex-Dividend Date A Company.25 June 15 May 14 May 12 B Company.50 August 5 July 15 July 13 * or Shareholders of Record Date The person who buys the stock on the day that it goes ex-dividend does not get the declared dividend, but will of course receive subsequent dividends as long as the shares are held. The person who buys the stock the day before it goes ex-dividend, however, does receive the dividend, and in this case the stock is said to be cum dividend (meaning with dividend). The last day a stock trades cum dividend is the third business day before the dividend record date; in other words, it is the day before the first ex-dividend date. DIVIDEND REINVESTMENT PLANS Some major companies give their preferred and common shareholders the option of participating in an automatic dividend reinvestment plan. In such a plan, the company diverts the shareholders dividends to the purchase of additional shares of the company. Reinvested dividends are taxable to the shareholder as ordinary cash dividends even though the dividends are not received as cash.

9 EIGHT EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 9 Share purchases in most dividend reinvestment plans are made on the open market under the direction of a trustee. Participating shareholders are periodically sent a statement showing the number of shares, including fractional shares in some cases, bought under the plan and at what price. The provision in some plans for crediting participating shareholders with applicable fractions of shares is unique. Normally fractions of shares cannot be purchased in the market by a shareholder. Since under a reinvestment plan the company uses authorized dividends to purchase additional shares in bulk, a saving in commission is achieved. An individual shareholder trying to buy the same small number of shares would normally pay a higher commission, particularly if odd lots were involved. In effect, a dividend reinvestment plan is an automatic savings plan which solves the problem of reinvesting small amounts of cash. Participating shareholders acquire a gradually increasing share position in the company, and because purchases by the plan are made regularly, shareholders can reduce the average cost paid per unit, a process known as dollar cost averaging. STOCK DIVIDENDS Sometimes the dividend may be in the form of additional stock rather than cash. Stock dividends are typically paid by a rapidly growing company that needs to retain a high degree of earnings to finance future growth. The advantage to the company is that cash is conserved for expansion purposes while shareholders receive additional shares, which can be sold if they require the cash. These stock dividends would be recorded on the Statement of Retained Earnings in the same fashion as cash dividends. Since stock dividends are treated as regular cash dividends for tax purposes, many investors, given the option, elect to receive dividends in cash. Voting Privileges Voting rights are an important feature of common shares. Through the right to vote at the annual meeting and at special or general meetings, shareholders exercise their rights as owners to control the destiny of the corporation. They elect the directors who guide and control the business operations of the corporation through its officers. Many matters of an unusual, nonrecurring nature, such as the sale, merger or liquidation of the business and the amendment of the charter, must receive shareholder approval before action is taken. However, many companies have two or even three different types of shares, often designated as Class A or B. Because all classes may not have voting rights and may differ in other respects such as dividend entitlement, it is important to know their respective features. RESTRICTED SHARES Restricted shares are shares which give the shareholder the right to participate to an unlimited degree in the earnings of a company and in its assets on liquidation, but do not have full voting rights. There are three categories of restricted or special shares: Non-voting shares which have no right to vote, except perhaps in certain limited circumstances;

10 8 10 CANADIAN SECURITIES COURSE VOLUME 1 Subordinate voting shares which carry a right to vote, where there is another class of shares outstanding that carry a greater voting right on a per share basis; and Restricted voting shares which carry a right to vote, subject to a limit or restriction on the number or percentage of shares that may be voted by a person, company or group. In recent years, the number of companies issuing restricted shares has increased substantially. Some investors have become concerned and have resisted reorganizations which involve the creation of restricted shares. Canadian securities regulators have introduced policies regarding these shares. In Ontario, for example, the details of these policies are set out in Ontario Securities Commission Policy 1.3. Investment advisors should be able to identify restricted shares and understand the implications of the differences in the voting rights of such shares in order to advise their clients properly. STOCK EXCHANGE REGULATIONS OF RESTRICTED SHARES The stock exchanges have urged companies having or issuing restricted shares to put in place provisions to ensure that the holders of restricted shares are treated fairly. Some of the regulations published by the stock exchanges and securities commissions are: Restricted shares must be identified by the appropriate restricted share term Disclosure documents such as information circulars, annual reports and financial statements which are sent to voting shareholders must be sent to holders of restricted shares and must describe the restrictions on the voting rights of the restricted shares Restricted shares must be identified in the financial press with a code Dealer and advisor literature must properly describe restricted shares Trade confirmations must identify restricted shares as such Holders of restricted shares must be given notice of, be invited to attend and be permitted to speak at shareholders meetings Minority approval is required for any corporate action which would result in the creation of new restricted shares Advisors should be aware of the protection offered to restricted shareholders, as the extent of such protection may vary. Tax Treatment The tax system in Canada provides some benefits to investors holding common shares: A dividend tax credit is available that makes the purchase of dividend-paying shares of taxable Canadian companies relatively attractive compared to interest paying securities. The current exemption from tax of 50% of capital gains provides investors with a tax inducement to buy shares.

11 EIGHT EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 11 Stock savings plans entitle residents of some provinces to deduct up to specified annual amounts from (or obtain a tax credit for) the cost of certain stocks purchased in their respective provinces during the year. DIVIDENDS FROM TAXABLE CANADIAN CORPORATIONS The pre-tax yield from common and preferred shares is normally below the yields available from debt investments. This is due to the tax treatment of interest received versus dividends received. When a company pays interest on its debt, the interest is paid with the company s pre-tax dollars because interest is considered a tax-deductible cost of doing business. When bond or debenture holders receive interest, it is treated as taxable income in their hands. When a company pays dividends on its shares, the dividends are paid with after-tax dollars because dividends, being a share of a company s profits, are not considered a tax-deductible cost of doing business. When shareholders receive dividends, the dollars involved have already been subject to tax in the company s hands prior to payout. To alleviate double taxation, the federal government allows shareholders of Canadian companies to receive tax relief through the dividend tax credit. The dividend tax credit results in a lower tax payable on dividend income compared to tax payable on interest income. This procedure is applicable to dividends received from resident taxable Canadian corporations. No similar preferential treatment is applicable to interest income, foreign dividends or dividends from non-taxable Canadian corporations. TAX ON FOREIGN DIVIDENDS Individuals who receive dividends from non-canadian sources usually receive a net amount from these sources, as taxes are usually deducted at source. Such investors may be allowed a deduction from the Canadian income tax otherwise payable. The allowable credit is essentially the lesser of the foreign tax paid and the Canadian tax payable on the foreign income, subject to certain adjustments. Details on foreign tax deductions are available from the Canada Revenue Agency (CRA). CAPITAL GAINS AND LOSSES Investors are taxed on any capital gains or losses earned from their investments. Basically, a capital gain arises from the sale (or the deemed sale) of a capital property for more than its cost. A capital loss arises from the sale of a capital property for less than its cost. Any capital gains earned must be reported, and 50% of the gains must be included in income for that year and taxed at the investor s marginal tax rate (the tax rate that would have to be paid on any additional dollars of taxable income earned). Capital losses can be used to reduce any capital gains that have been earned, but generally cannot be used to reduce any other income.

12 8 12 CANADIAN SECURITIES COURSE VOLUME 1 FOR INFORMATION PURPOSES ONLY An investor buys 1,000 ABC common shares at a market price of $10 a share and then sells them fi ve years later at a price of $15 a share. Cost of the shares 1,000 $10 = $10,000 Proceeds from the sale 1,000 $15 = $15,000 Capital Gain on the sale = $ 5,000 Taxable Capital Gain 50% $5,000 = $ 2,500 The investor would then pay tax at his personal tax rate on the $2,500 and not on the full $5,000 gain. Note that we have excluded commissions on this transaction. Stock Splits and Consolidations Most companies believe it is good corporate strategy to keep the market price of their shares in a popular price range, say $10 to $20, and may use a stock split or subdivision to bring a highpriced stock into this range or a consolidation, to bring a low-priced stock more attractive. STOCK SPLITS When a split becomes effective, the market price of the new shares reflects the basis of the split. Example: In a four-for-one split, the market price of shares selling at $100 (pre-split basis) will sell somewhere in the $25 range after the split. An investor who owned 1,000 shares of the company would now own 4,000 shares. The split itself does not affect the dollar value of a company s equity, nor the proportion and value of a shareholder s stake (from the example above, note that the investment value of the investor s holding remains unchanged: $100 1,000 shares pre split = $25 4,000 shares after the split). Equity per share would be reduced, as the total number of shares outstanding would increase, but the equity section of the statement of financial position would remain unchanged. REVERSE SPLIT OR CONSOLIDATION When the market price of shares are too low, reverse stock splits or consolidations can occur with the result that market price rises to reflects the basis of the consolidation, and each shareholder s total shareholdings in a company are reduced accordingly. Example: If a reverse split of one new share for ten old were implemented, a shareholder owning 100 shares of stock would own only 10 new shares after the reverse split. If the shares were selling at $0.25 before the reverse split, the new shares would probably trade near $2.50 per share. The total dollar value of the holdings would not be affected: $ shares pre consolidation = $ shares after the consolidation. Reverse splits occur most frequently when a company s shares have fallen in value to a level that is unattractive to investors with large amounts of capital. They are utilized when a company is in danger of being delisted by a stock exchange as the company s share price has fallen below the exchange s minimum share price rule. A reverse split raises the market price of the new shares and can put the company in a better position to raise new capital.

13 EIGHT EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 13 Reading Stock Quotations There are two kinds of stocks traded during the day under review: those that are listed and thus traded on the stock exchanges, and the unlisted stocks that trade on the over-the-counter market. A typical quotation for stocks traded in Canada during the day under review is shown here: 52 Weeks High Low Stock Div. High Low Close Change Volume BEC ,000 This type of quotation is complex but very useful and may vary in format depending on the media source. This quotation means that: BEC common has traded as high as $12.55 per share and as low as $9.25 during the last 52 weeks. BEC common has paid dividends totalling $0.50 per share during the last 52 weeks (sometimes an indicated dividend rate may be shown if the company pays regular dividends and has recently increased a dividend payment). During the day under review, BEC common shares traded as high as $10.65 and as low as $ The last trade of the day in this stock was made at $ The closing trade price was $0.50 higher than the previous trading day s closing trade price. (Therefore, BEC shares closed at $9.85 on the previous trading day.) A total of 6,000 BEC common shares traded that day. Market prices used in stock quotations apply to standard trading units and exclude commission expense for trades in listed stocks. Complete the following Online Learning Activity Common Shares In this activity you will review the key features and benefi ts of common shares from the point of view of both the issuer and the investor. Features and benefi ts include, among others, voting privileges, tax implications and dividend payments. Understanding the features and benefi ts of these types of shares will help you decide if a particular common share is a good investment. Complete the Common Shares activity.

14 8 14 CANADIAN SECURITIES COURSE VOLUME 1 WHAT ARE PREFERRED SHARES? Shares can have a number of designations including common, ordinary, subordinated, Class A and preferred. In recent years the name given to shares has become less helpful in determining the attributes attached to the shares. It is necessary to go beyond the name to determine the true characteristics of a company s shares. The notes to a company s audited financial statements can be useful in this regard. In this chapter, references to preferred shares apply to all shares not classified as common or restricted shares. The Preferred s Position It is important to keep in mind that bond and debenture holders are creditors, while preferred shareholders rank afterwards and are part owners along with common shareholders. Preferred shareholders are usually entitled to a fixed dividend payment subject to the discretion of the Board of Directors. Some companies issue more than one class of preferred stock, and when this occurs, each class is separately identified. (Note that in this example, and the ones that follow, reference is sometimes made to preference shares. These shares generally hold the same meaning as preferred shares, but can rank ahead of the different classes of preferred shares that a company has outstanding.) Example: ABC Corporation Limited has three preference share issues outstanding: a $2.50 Series Class A Preference; a $2.60 Series Class A Preference; and a $2.70 Series Class B Preference. If various outstanding preferred share issues rank equally as to asset and dividend entitlement, the shares are described as ranking pari passu. PREFERENCE AS TO ASSETS Preferred shares are usually given a prior claim to assets ahead of the common shares in the event of bankruptcy or dissolution of a company. Claims of creditors and debtholders rank ahead of preferred shareholder claims. The preferred share investor is therefore better protected than the common shareholders but junior to the claims of creditors and debtholders. The common shareholder has to be content with anything that is left after all creditor, debtholder and preferred shareholder claims have been met. This preference as to assets clause is found in most preferred share issues. Since preferred shareholders usually have no claim on earnings beyond the fixed dividend, it is fair that their position is buttressed by a prior claim on assets ahead of the common shares. PREFERENCE AS TO DIVIDENDS Preferred shares are usually entitled to a fixed dividend expressed either as a percentage of the par or stated value, or as a stated amount of dollars and cents. Example: DEF Limited s $50 par value 5.6% First Preferred Series U shares pay a fi xed annual dividend of $2.80 per share ($50 par value x 5.6% = $2.80 annual dividend).

15 EIGHT EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 15 Dividends are paid from earnings current or past. However, unlike interest on a debt security, dividends are not obligatory and are payable only if declared by the Board of Directors. If the Board omits the payment of a preferred dividend, there is very little the preferred shareholders can do about it. However, the charters of some companies provide that no dividends are paid to common shareholders until preferred shareholders have received full payment of dividends to which they are entitled. While directors have the right to defer the declaration of preferred dividends indefinitely, in practice dividends are paid if justified by earnings. Failure to declare an anticipated preferred dividend has unfavourable repercussions. Besides weakening investor confidence, the general credit and future borrowing power of the company suffer. Since most preferred shares can be considered fixed-income securities, they do not offer, from an investment standpoint, the same potential for capital appreciation that common shares provide. Should interest rates decline, the preferred will increase in price, much like a bond; but good corporate earnings will have no effect on the dividend rate or equity allocation. Thus, the dividend rate is of prime importance to the preferred shareholder. Why Companies Issue Preferred Shares In comparison with debt, preferred shares are usually more expensive for a company because dividends paid are not a tax-deductible expense. However, when all considerations are weighed, there may be sufficient advantages to justify a new preferred share issue. PREFERRED ISSUE VERSUS DEBT ISSUE From a company s viewpoint, preferreds do not create the demands that a debt issue creates. Preferreds do not usually have a maturity date, although some may have a purchase fund. If a preferred dividend payment is omitted, no assets are seized by preferred shareholders. The company has flexibility in deciding whether or not to declare a preferred dividend. Dividends are never omitted without good reason. But to preserve working capital in an emergency, a company s directors may decide to omit a preferred dividend without jeopardizing the company s solvency. A corporation will choose to issue preferreds rather than debt if: It is not feasible for it to market a new debt issue. Existing assets may already be heavily mortgaged Market conditions are temporarily unreceptive to new debt issues The company has enough short- and long-term debt outstanding, i.e., its debt/equity ratio is high. Preferreds will increase the equity component The directors are reluctant to assume the legal obligations to pay interest and principal The directors decide that paying preferred dividends will not be onerously expensive. PREFERRED SHARES VERSUS COMMON SHARES When a company has decided it will not or cannot issue bonds or debentures, it may find conditions are not favourable for selling common shares either. The stock market may be falling or inactive, or business prospects may be uncertain. However, in such circumstances, preferred

16 8 16 CANADIAN SECURITIES COURSE VOLUME 1 shares might be marketed as a compromise acceptable to both the issuing company and investors. Preferreds also offer the advantage of avoiding the dilution of equity that results from a new issue of common shares. Since preferred shares typically do not have any claim on shareholder s equity beyond the par value of the preferred shares, the issuance of preferred shares does not affect the common shareholders equity claims and therefore does not reduce the proportional ownership of common shareholders. Why Investors Buy Preferred Shares Preferred shares are bought largely by income-oriented investors. Today, conservative individual investors, seeking income, purchase preferred shares to take advantage of the previously mentioned dividend tax credit. Institutional investors who may be concerned with taxes are attracted to the preferential tax treatment of preferreds as well. Canadian companies also purchase preferred shares as an income investment. Dividends paid by one resident taxable Canadian company to a similar company are not taxable in the hands of the receiving company. This is not the case with debt interest. Preferred Share Features Table 8.1 describes the features that could be built into any of the types of preferred shares just described. Some features strengthen the issuer s position, others protect the purchaser s position. TABLE 8.1 PREFERRED SHARE FEATURES Type of Feature Cumulative Non-cumulative Definition If a company s Board of Directors votes not to pay one or more preferred dividends when due, the unpaid dividends accumulate or pile up in what is known as arrears. All arrears of cumulative preferred dividends must be paid before common dividends are paid or before the preferred shares are redeemed Investors should determine if a cumulative feature is present before buying preferred shares. On non-cumulative preferreds, the shareholder is entitled to payment of a specifi ed dividend in any year, only when declared. Arrears do not accrue and the preferred shareholder is not entitled to catch-up payments if dividends resume. For this reason, the dividend position of non-cumulative preferred shares is very weak.

17 EIGHT EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 17 TABLE 8.1 PREFERRED SHARE FEATURES Cont d Type of Feature Callable Non-callable Voting Privileges Purchase Fund Sinking Fund Definition Callable preferreds can be called or redeemed by the issuer at a stated time and at a stated price. Callable preferreds usually provide for payment of a small premium above the amount of per share asset entitlement fi xed by the charter, as compensation to the investor whose shares are being called in. The company will typically try to buy shares for cancellation on the open market or through invitations for tenders addressed to all holders. The price paid under these circumstances generally must not exceed the par value of the preferred shares plus the premium provided for redemption by call. Non-callable preferred shares cannot be called or redeemed as long as the issuing company is in existence. This feature is restrictive from the issuer s standpoint, in that it freezes a part of the capital structure for the life of the company. This feature is, therefore, rare. Virtually all preferred shares are non-voting so long as preferred dividends are paid on schedule. However, once a stated number of preferred dividends have been omitted, it is common practice to assign voting privileges to the preferred. A purchase fund is advantageous to preferred shareholders because it means that if the price of shares declines in the market to or below a stipulated price, the fund will make every effort to buy specifi ed amounts of the security for redemption. Preferred shares with a purchase fund have a potential built-in market support through the fund s purchasing efforts. A sinking fund will often attempt to retire shares in the open market when the shares trade at or below a stipulated price, much like a purchase fund. If the shares cannot be purchased in the open market, the issuer is required to call or redeem the securities from investors to ensure the stipulated amount of securities are retired each year. Straight Preferreds These are preferred shares with normal preferences as to asset and dividend entitlement ahead of the common shares. Straight preferreds may have any of the features described previously. They pay a fixed dividend for as long as they remain outstanding and the shares trade in the market on a yield basis. As with the market price of bonds and debentures, if interest rates rise, the fixed dividend payment becomes less valuable and the market price of straight preferreds will fall, and if interest rates decline, the fixed dividend payment becomes more valuable and the market price of straight preferreds will rise.

18 8 18 CANADIAN SECURITIES COURSE VOLUME 1 Example: A company issues preferred shares with a par value of $50 and a fi xed dividend rate of 3% (i.e., an annual fi xed dividend payment of $1.50 per share). If interest rates then rise, new fi xed income issuers will issue securities that pay higher yields to compensate for higher market interest rates. As a result, the yield of 3% on the previously issued preferred share is now seen to be too low. To compensate, the price of the preferred share will fall below $50. The drop in price of the previously existing preferred share will provide interested buyers a higher yield, since yield is calculated as dividend divided by current market price. The reverse is true when interest rates fall. From the standpoint of the purchaser, straight preferred shares provide: Greater safety than common shares through preference to dividend and asset entitlements A tax advantage to individuals through the dividend tax credit and to corporations which receive preferred dividends from taxable Canadian companies on a tax-exempt basis Less safety than a debt investment since dividends are not a legal obligation No voting privileges (unless a stated number of dividend payments are in arrears) No maturity date Poorer marketability than common shares because there are usually fewer preferred shares than common outstanding Limited appreciation potential compared to common shares. The price at which the preferred could be redeemed by the issuer will limit any appreciation that might occur as a result of a decline in interest rates. Convertible Preferreds Convertible preferreds are similar to convertible bonds and debentures because they enable the holder to convert the preferred into some other class of shares (usually common) at a predetermined price(s) and for a stated period of time. More recently, preferred shares have been issued where both the holder and the issuer have conversion privileges. Conversion terms are set when the preferred is created and normally specify the number of common shares into which each preferred is convertible. The preferred price is set at a modest premium (perhaps 10% to 15%) above its converted value. The purpose of the premium is to discourage an early conversion, which would defeat the purpose of the convertible offering. Virtually all conversion privileges expire after a stated period of time, usually five to twelve years from the date of issue. Example: GHI Inc., 4.70% Non-Cumulative Preferred Shares, Series J are convertible by the holder on a minimum of 65 days notice beginning July 31, 2021, and on the last day of January, April, July and October of each year into common shares. The conversion rate is determined by using a formula that considers the conversion date, declared and unpaid dividends, and the weighted average trading price of the common shares on the TSX over a specifi ed period. These shares are also convertible by the company beginning April 30, 2015 under various terms. Usually the convertible preferred will sell at a premium above the price it might be expected to sell at, based on the conversion terms. This premium can be expressed as a dollar amount or as a percentage. Expressing the premium as a percentage makes comparisons between preferreds easier. The premium on the preferred shares is usually offset by their higher yield compared to the underlying common shares. Over a period of years, the preferred s higher yield will pay back to the investor the premium required to purchase it.

19 EIGHT EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 19 Exhibit 8.1 illustrates a hypothetical example of a convertible preferred share payback. EXHIBIT 8.1 CONVERSION COST PREMIUM AND PAYBACK For information purposes only Preferred Issue Market Price Pre-tax Yield Preferred Common Preferred Common Difference Conversion Cost Premium Years to Repay Premium ABC Corp. Cumulative Redeemable Convertible $62.50 $ % 1.5% % 7.42 ($2/$62.5) ($0.2775/$18.50) Class A Preferred, Series 2 Preferred dividend = $2.00 Common dividend = $ (Each Series 2 preferred is convertible into three common shares at any time.) Sample calculation (excluding commission) of a conversion cost premium using ABC Corp. 1. To buy one ABC Corp. Series 2 preferred share that could be converted into 3 common shares costs $ To buy 3 common shares would cost $55.50 (3 $18.50). 3. Therefore, the conversion cost dollar premium is $62.50 $55.50 = $7.00. In other words, if you decided to obtain the common shares by purchasing preferred shares that convert into common shares, you would end up paying $7.00 more than if you had simply purchased the common shares directly from the market. As a per cent of the common share price, the premium is: $ % $55.50 = 4. Since you paid in theory 12.61% more for the common shares by purchasing the convertible preferred shares (as opposed to directly purchasing common shares from the market), the question now is how long will it take for you to pay back that premium from the additional income you receive from the convertible preferred share purchase. Years to pay back the premium from the convertible s higher dividend stream: % Premium = = = 7.42 years Convertible yield -Common yield Convertible preferreds are issued either in markets where a straight preferred is difficult to sell or in a situation where a high level of dividend coverage is lacking. Because of the added benefit of a conversion feature, the dividend on a convertible is often less than that of a comparable straight preferred.

20 8 20 CANADIAN SECURITIES COURSE VOLUME 1 From the standpoint of the purchaser, convertible preferred shares: Provide a two-way security: the holder is in a more secure position than the common shareholder and yet can realize a capital gain if the market price of the common rises sufficiently Usually provide a higher yield than the underlying common shares Provide the right to obtain common shares through conversion without paying a commission Usually provide a lower yield than a comparable straight preferred Sometimes convert into less (or more) than a standard trading unit of common shares which in turn may be a little more difficult to sell than a standard trading unit Revert to a straight preferred when the conversion period expires if conversion has not taken place Exhibit 8.2 demonstrates how common share prices affect the price of convertible preferred shares. EXHIBIT 8.2 HOW COMMON SHARE PRICES AFFECT CONVERTIBLE PREFERREDS For information purposes only When the price of the common shares rises above the conversion price, the market action of the preferred mirrors the market action of the common shares. Investors should also be aware that convertible preferred shares are vulnerable to a decline in price if the price of the common shares is above the conversion price and then declines. ABC Corp. issues a convertible preferred share with a par value of $50 that can be converted into 2 common shares, resulting in a conversion price of $25 per common share. At the time of issue, the common shares trade at $15 per share. (i) Common share price trades at $15 Convertible Price The price of the common share is below the conversion price of the preferred share ($15 per common share x 2 = $30, which is below $50). Changes in the common share price does not impact the price of the convertible preferred as long as the price of the common share remains below the convertible price. $50 (ii) Common share price drops from $15 to $10 per share Since the price of the common share is lower than the conversion price of the convertible preferred, there is little to no change in the price of the convertible preferred based on the change to the common shares. $50

21 EIGHT EQUITY SECURITIES: COMMON AND PREFERRED SHARES 8 21 EXHIBIT 8.2 HOW COMMON SHARE PRICES AFFECT CONVERTIBLE PREFERREDS For information purposes only Cont d Convertible Price (iii) Common share price increases to $35 per share As soon as the common share price reaches the conversion price, the price of the preferred starts to mirror the price of the common share and rise to $70 ($35 per common share x 2 shares = at least $70 convertible preferred share price). $70 (iv) Common share price drops from $35 to $30 The preferred share is directly affected by the $5 drop in price of the common shares and drops $5 per common share ($30 per common share x 2 shares = at least $60 convertible preferred share price). $60 An investor who purchased the convertible preferred share at $70 when the common share price was above the conversion price would have suffered a loss of approximately 14% when the underlying common share dropped by $5 per share. An investor who purchased the convertible preferred share at $50 when the common share was trading at only $15 would see little to no change in the price of the convertible preferred share when the common shares dropped by $5 per share. Retractable Preferreds A retractable preferred shareholder can force the company to buy back the retractable preferred for cash on a specified date(s) and at a specified price(s). Some are issued with two or more retraction dates. The principle of retraction, or pulling back, is identical to that described in Chapter 6 for retractable bonds and debentures. The holder of a retractable preferred can create a maturity date for the preferred by exercising the retraction privilege and tendering the shares to the issuer for redemption. The term soft retractable preferred refers to those retractables where the redemption value may be paid in cash or in common shares, generally at the election of the issuer. Example: JKL Inc., Series 14, Cumulate Class A Preference Shares are retractable on the fi rst of each March, June, September and December at $100 per share. From the standpoint of the purchaser, retractable preferred shares: Provide a predetermined date(s) and price(s) to tender shares for retraction. The shorter the time interval to the retraction date, the less vulnerable is the stock s market price to increases in interest rates. Whereas a straight preferred will decline in price if interest rates rise, a retractable preferred will not fall significantly below its retraction price as the retraction date approaches Provide a capital gain if purchased at a discount from the retraction price and subsequently tendered at the retraction price

22 8 22 CANADIAN SECURITIES COURSE VOLUME 1 Will sell above the retraction price and at least as high as the call price if interest rates decline sufficiently Do not retract automatically. The retraction privilege will expire, if no action is taken by the holder during the election period(s) Become straight preferred shares if not retracted when the election period(s) expires. If this occurs in a period of high or rising interest rates, the stock s market value will decline. The shares will sell on a straight yield basis after the retraction privilege expires. Floating-Rate Preferreds Identical in concept to variable or floating rate debentures, floating- or variable-rate preferreds pay dividends in amounts that fluctuate to reflect changes in interest rates. If interest rates rise, so will dividend payments, and vice versa. Floating-rate preferreds are issued: During periods in the market when a straight preferred is hard to sell and the issuer has rejected making the issue convertible (because of potential dilution of equity) or retractable (because holders could force redemption on a specified date); and When the issuer believes interest rates will not go much higher than they are at the date of issuance of the new issue. The company, in any event, is prepared to pay a higher dividend if interest rates rise. Of course, if interest rates decline, the issuer will pay a smaller dividend (subject in most cases to a guaranteed minimum rate). Example: MNO Corp. Floating Rate Cumulative Series II shares are entitled to cumulative preferential cash dividends. The quarterly dividend rate is one quarter of 70% of the prime rate times $25. The dividend rate is set on the last business day of the preceding month. Some preferred shares may have delayed floating-rate features. Known as delayed floaters, fixedreset or fixed floaters, these shares entitle the holder to a fixed dividend for a predetermined period of time after which the dividend becomes variable. From the standpoint of the purchaser, variable rate preferreds provide: Higher income if interest rates rise, but lower income if interest rates fall A variable amount of annual income that is difficult to predict accurately but which will reflect prevailing interest rate levels An investment with a market price less responsive to changes in interest rates compared to the market prices of straight preferred shares. The dividend payout of a variable rate preferred is tied to changes in interest rates on a predetermined basis. Accordingly, the preferred s market price is less sensitive to changes in interest rates.