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Preferred Shares vs Common Shares: Legal Implications that must be understood before investing.

Thursday, November 29, 2007

Preferred Shares vs Common Shares: Legal Implications that must be understood before investing.

I recently read a news article written by an investment advisor about the benefits of investing in preferred shares. At first glance this article seems to be extremely accurate, at least from a financial perspective. For example, I presented the ‘bare bones’ of this case to some of my colleagues (investment professionals) and none seemed to have any major quarrels with any aspect of this article. It seems the legal implications of many of the statements made throughout this article are not held as common knowledge by the majority of investment professionals, which is unnerving as these are the people whom are though to have specialized knowledge with regards to all aspects of investing.

Discussing the investment terms presented in this article seemed basic and at first I was uninterested. Financial professionals distinguish between two kinds of shares on a daily basis: preferred shares and common shares, but is it really that plain and simple?
Preferred shares are thought of more as a debt security as the article suggests. The general consensus is exactly the position of the article: a regular fixed dividend, a chance of share appreciation, leading position over common shareholders when a company is wound up, and no voting privileges. After income taxes, preferred shareholders are though to collect their dividends ahead of the common shareholders and these dividends are also thought to accumulate if not paid.

The article goes on to discuss different terms that are very regular with preferred shares. Preferred shares tend to be bought for their regular cash flows and as a result, like debt, their price appreciates when interest rates fall and vice versa. Common features of preferred shares are presented in the article: retractable / callable, the shares may be bought back by the company at the company’s or unit holders option…they may participate in profits through extra dividends…some have variable dividends with a floating rate…and they may have warrants attached or be convertible to Common Shares.

Common Shares on the other hand are though to carry the right to vote to elect the board and the right to receive dividends when they are declared; upon windup they are thought to receive the last ‘pick at the pie’.

Even a seasoned investment professional would not appeal the presentation of preferred shares provided in the article; however, from a legal perspective there are many incongruent statements produced that should be understood by all professionals in the investment industry, especially if they want to avoid any potential law suits.

The first thing to notice is what kinds of securities the law distinguishes. The consensus is wrong to automatically think common and preferred shares. These are not kinds of shares, only marketing jargon. Within the law in British Columbia there are two kinds of shares according to S.52 of the Business Corporations Act (BCA): par and non par. Par shares meaning they have a stated value on the books, while non-par shares have no underlying value. This distinction comes from old law that sought to keep previous owners and new share owners on equal grounds when purchasing shares; however, the majority of Provinces today no longer allow for par shares, and instead require all shares to be of the non-par variety.

The second thing to notice is what a share actually is. From a financial perspective, even many professionals still believe that a share is a part ownership in the underlying business. This is incorrect however. The legal definition of a share is a ‘choses in action’ or ‘the right to sue’. What shares really are is a bundle of rights produced by the constitutional documents of a company according to S.56 of the BCA; the name preferred and common have no legal distinction within the BCA.

Some other key features of shares may be clarified by discussing major sections of the BCA with regards to the legal nature of shares. S.107 provides that a share certificate is produced when shares are created; these days it is uncommon for the certificate to be transferred to a share owner, instead the certificates are held in trust. S.111 provides that a central list of the share owners is kept by the corporation, which includes the number and class of shares held and the amount held by each share holder.

The next major sections to notice are S.113 and S173. S.113 states that a share is transferable as provided by the articles of the company. This may affect the liquidity of the shares and should be known before purchasing. S.173 provides that unless the articles state otherwise, all shares carry one vote per share. This could have major implications on the actions taken by the company since without restriction, common and preferred shares will have the same vote.
One of the more interesting sections of the BCA governing shares includes S. 64, which states that a share must not be issued until it is fully paid; however, a share can be paid in a number of ways: money, property, or past services actually performed.

Now that some of the more prominent sections of the BCA have been discussed it may help to clarify the distinction of classes of shares by looking at some case law. From International Power v. McMaster for example, the judge makes it clear that calling a share common versus preferred does not determine which shareholders participate in the residue of a company when it is wound up. The distinction is made through the articles of incorporation and if there is no distinction or restriction made then all classes of shares will participate equally in any residue.

A further application that we learn from the case of Devall v. Wainright Gas Co. Ltd is that dividends, even if stated in the articles as cumulative are not payable unless and until the board declares them. If the board deems it more beneficial to the company to setup a reserve fund then the board is not incorrect in doing so as long as it is in the company’s best interest.

Common and preferred shares are not as easily distinguishable and generic as I once thought. The most important thing to remember is that the constitutional documents will determine the exact rights and restrictions on the different classes of shares. Understanding the exact details provided from these documents can dramatically affect the liquidity (ease of share transfer), and value of a security. It is very surprising that the legal implications of share rights and restrictions are not even discussed within the Canadian Securities Course or Canadian Practices Handbook—the financial industry licensing requirements. Hopefully the Canadian Securities Institute, investment licensing body, will update their training materials to include such important lessons in the near future.

Here is a Google Earth link to some Canadian Companies my Investment Advisor has recommended for me.
Investment Opportunities in Canada

Before making any investment decisions you should always consult with a professional to see whether the investments would be a good match for your risk preferences and overall portfolio

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