This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
Although preferred shares are entitled only to what is specifically granted to them, some customs have become fairly well established. In the United States nearly all industrial preferred shares bear cumulative dividends at the rates of 6%, 7%, and 8%, a great majority receiving 7%. Just why these percentages should have been chosen is somewhat difficult to say. Probably the best answer is to be found in the statement that high-grade preferred shares have been selling for several years on about a 7% basis; that is to say, if they are 6% shares they sell at about $86 for each $100 shares; if they are 7% shares they sell at about par; and if they are 8% shares they sell at about $114 for each $100 share. Inasmuch as shares, when they have a market value of or near par, are more convenient and more salable than would otherwise be the case, there is an advantage in making their preferential dividend 7%. There is, however, nothing fixed in this custom. If the general level of prices changes so that good industrial preferred shares begin to sell at par on a 6% basis, we may expect to see the customary rate changed to 6%.
The preferred dividend may be either "cumulative" or "non-cumulative." A cumulative dividend is one which carries over from year to year; that is to say, in case the profits are not sufficient to pay the full preferred rate in any given year, the unpaid dividends will remain as a prior claim to be paid in some succeeding year before dividends are declared on the common shares. Non-cumulative dividends give the preferred shares a prior claim for dividends each year; but in case these profits are not sufficient to meet the claims, or for other reasons dividends are not declared, no obligation rests upon the corporation to make up the deficiency in later years.
At one time most preferred shares were non-cumulative. But as such they have been found unsatisfactory because of the conflict of interest between the common and the preferred shareholders as to the payment of preferred dividends each year. It is obviously to the advantage of the common shareholders to defer dividends on the preferred shares as long as possible, since the cumulating profits inure directly to the benefit of the common stock. It is a simple matter of accounting procedure to use whatever profits accrue to the corporation to increase assets and to pass preferred dividends, until sufficient profits have accumulated to pay equal dividends to both preferred and common stock. There is plenty of opportunity not merely for unfair diversion of funds away from the preferred shareholders, but also for the expression of differences of opinion as to whether dividends are honestly withheld.
Non-cumulative preferred stock, is as stated, undesirable.
It is, in fact, a standing invitation to the directors, unless their ethical standards are high, to administer the corporate finances to the advantage of the common stockholder. Profits that might very properly have been applied to the preferred dividends are diverted into improvements or developments. These redound to the ultimate advantage of the company, but meanwhile stand in the way of dividends on the non-cumulative preferred stock until the company has reached a point where common and preferred stock dividends are both possible. The preferred stockholder's dividends for this period are absolutely lost as far as he is concerned. The company has profited at his expense. The directors might properly have paid them if they would, but decided in favor of the common stockholder.
If investors were wise there would be no sale for the non-cumulative stock, for there is no legal way for the holder of such stock to prevent the directors postponing dividends until the common stockholders can share equally or even receive more than do the holders of preferred stock.
It is to be noted that if the preferential dividend is to be non-cumulative, this fact must be clearly expressed in the charter provisions by which the stock is authorized. Where not so expressed the courts have held the preferential dividends to be cumulative and payable in full out of the first profits before anything is received by the common stock. The cumulative feature of preferred stock is, however, for the sake of security and definiteness usually covered by express provision.
On the other hand, cumulative dividends have an uncomfortable habit of piling up, and may become in the course of a few years so serious a burden as to leave no reasonable hope for dividends on the common shares. Such a situation might interfere with, or prevent entirely, additional financing were it needed. It is not at all uncommon in corporate experience for a company to go through several years of depression and limited income, and then, through good management or by some fortunate circumstance, suddenly enter upon a period of prosperity. Naturally, the common shareholders, having received no dividends through the "lean" years, feel that they are entitled to some recompense. If a large amount of unpaid dividends on cumulative preferred shares stands in the way, it is now customary to try to find some way, under the conditions stated, of "funding" these unpaid dividends, thus satisfying both the common and the preferred shareholders. The "funding" of the unpaid dividends is accomplished by issuing securities of some kind to the preferred shareholders in exchange for their dividend claims.
Shares may be preferred not only as to dividends, but also as to assets; that is, in case of dissolution or insolvency, the full par value of the preferred shares is to be paid before any payment is made on account of the common shares. We shall see, when we come to consider reorganization, that as a matter of fact going corporations are seldom sold or entirely liquidated and the assets distributed among the various security holders. It is usual to bring about a reorganization in which the claims of each class of securities are so readjusted that they may all be met by the corporation. Hence the prior claim of preferred shares upon assets is not to be taken too literally, but is to be regarded rather as a legal point of advantage in securing the best possible terms in case reorganization should become necessary. From this point of view, the preference as to assets is of considerable importance.
It is well to reiterate that the preferences granted to preferred shares are no more than are distinctly specified, and that these preferences may consist not only of prior claims as to dividends and assets, but of prior claims as to voting. For instance, the preferred shares of the Rock Island Company of New Jersey (the former holding company for the Chicago, Rock Island and Pacific Railway) were entitled to elect a majority of the directors of that company. It is more usual, however, for preferred shares to have no vote, on the theory that the responsibility for conducting the corporation should rest with the non-preferred shares, which take the greater part of the risk.
In every case in which preferred shares are under consideration, it is necessary to go to the charter or by-laws and find out exactly the nature of the preference. In 1901 there was a struggle between the Hill-Morgan party on the one side and the Harriman-Kuhn, Loeb party on the other, for control of the Northern Pacific Railroad Company, in the course of which the Hill-Morgan party secured a majority of the common shares, and the Harriman-Kuhn, Loeb party a majority of the preferred shares together with enough of the common shares to give them a majority of the entire outstanding stock. Inasmuch as both common and preferred shares had voting rights, it seemed clear that the victory remained with the Harriman-Kuhn, Loeb group. Unfortunately for their calculations, however, the charter of the company gave the common shareholders a right at any time to redeem the preferred shares at par. This right the Hill-Morgan party exercised and, through the control thus given them by a clause which had apparently been overlooked by their opponents, obtained the upper hand.