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.
It has already been noted that in modern corporations the distinction between owned capital and borrowed capital is sometimes shadowy. Preferred shares, for instance, are sometimes protected and subject to redemption in such a way as to bring them almost, if not wholly, into the same class as junior bonds. It is very common practice for a company to reserve the right to redeem preferred shares, usually at a premium varying from 5% to 20% or more. The decision of the matter, however, rests with the corporation. Further than this, many companies make redemption obligatory and even provide for the building up of sinking funds for this purpose, just as in the case of sinking fund bonds. The California Petroleum Corporation, for example, sets aside five cents on each barrel of petroleum sold, to redeem its preferred shares. The May Department Stores, the Studebaker Company, and the Underwood Typewriter Company all have sinking funds for this purpose. The provision in the charter of the Underwood Typewriter Company reads as follows:
There shall be set apart from the net profits of the Company at the rate of not less than $100,000 per annum, a fund to be known as "Special Surplus Capital Reserve Account," which shall be made and kept going at the rate of $100,000 per annum for each year before any dividend shall be paid on the common stock, and after the expiration of three years from the date of incorporation of the Company said Special Surplus Capital Reserve Account shall be used annually in the purchase and retirement of said preferred stock at the lowest price at which the same may be obtainable, but in no event exceeding a premium of 25% over and above the par value thereof. Such purchases may be made at the option of the Company either at a public or private sale, and all preferred stock so acquired shall be cancelled.
It is also becoming a more and more prevalent custom to protect preferred stock by specific provisions as to percentages of current liabilities to current assets, of net surplus to capital, of dividends to current surplus, and the like. The Canadian Inter-Lake Line is required by its charter to establish a cumulative reserve fund equal to 50% of the outstanding preferred stock, and to maintain the fund by setting aside out of earnings an amount equal to at least 3% par value on the outstanding preferred stock. In the case of the Moline Plow Company, the net quick assets must always equal at least $140 per share of first preferred. Montgomery, Ward and Company provide that no additional preferred beyond the present issue can be put out unless, after such issue, the net quick assets shall equal at least 120% of the outstanding preferred. The Griffin Wheel Company has a number of detailed provisions. Additional issues (after the original issue) of its preferred stock cannot be put out up to more than 66 2/3% of the cost of improvements, extensions, or increased working capital. Common dividends may not be increased to more than 7% unless the net tangible assets are at least 50% of the preferred shares; even then, the common may get only one-half the surplus earnings above the preferred and previous common dividends. When the tangible assets rise to 200%, the net quick assets being 50% of the preferred, the directors of this company may declare such dividends on the common "as may be deemed prudent".
A form of protection given by many companies is the proviso that the preferred shareholders shall automatically obtain control, or partial control, over the directorate of the corporation in case their claims are not met. It is customary to give the preferred the power to veto an increase of bonds or of preferred stock. The Wisconsin Central Railroad Company provides that in case of failure for two successive years to pay 4% dividends on its preferred, the preferred shareholders shall have the right to elect a majority of the directors. In the American Smelters Securities Company, the preferred shareholders are permitted to vote if dividends for one year remain unpaid. The William Carter Company gives both the preferred and the common shares equal voting power, except that if there is default in four successive quarterly dividends on the preferred, or if the net quick assets for one year remain at less than the. par value of the preferred shares outstanding, the preferred becomes the sole voting stock. The American Sumatra Tobacco Company provides that if unpaid dividends accumulate above 14%, the preferred shareholders shall have the right to elect a majority of the board. The International Motor Company provides that if the preferred stock fails to receive dividends, it shall obtain the sole voting power. The American Rolling Mill Company gives its 6% preferred stock the right to vote only when three successive dividend periods have been passed.
All of these provisions appear to be equitable, although the mere grant of voting power to preferred shareholders, if the common shares still retain control of a corporation, may prove to be a concession of only slight importance. If it is expected and seriously intended that the dividends on preferred shares shall be paid regularly year after year, then it would seem only fair that the common shareholders, if they should fail to live up to this expectation, should forfeit control and give the preferred shareholders a chance to see what they can accomplish. It may be objected that an arrangement of this kind would involve the possibility of shifting the control from one set of shareholders to another from year to year, a practice which would be fatal to the interests of both classes. The answer to this objection is to be found in the fact that whatever minor conflicts of interest may exist between the preferred and the common shareholders, both are likely to do all they can to build up the corporation, and this tendency would probably not prove serious. It may be further suggested that preferred shareholders, after all, bear a considerable part of the risk in most corporations, and ought from the beginning to have at least a small share in the management; they could be given complete control in the event of default in the payment of preferred dividends.
In Canada it is unusual to deprive preference shareholders of their customary right to vote upon their shares. The Companies Act of the Dominion states that:
Holders of shares of preference stock shall in all respects possess the rights, and be subject to the liabilities, of shareholders within the meaning of this Act, provided that in respect of dividends and in any other respect declared in by-laws as authorized by this Act, they shall, as against the ordinary shareholder, be entitled to preferences and rights given by such by-laws.
It is plainly implied here that preferred shareholders are entitled, unless there is some clear agreement to the contrary, to vote on an equality with common shareholders.