It is generally understood that shares represent ownership in a company. Provided that any applicable laws and the articles of the company so permit, a company may issue shares of different classes conferring particular rights. So, for example, it is a common practice in Jamaica to class shares as either ordinary shares or preference shares.
The distinction between ordinary shares and preference shares is usually evident in the rights attached to the shares, including in relation to whether the shares are redeemable, whether there is any priority for payment of dividends and return of capital in a winding up, and whether the shares confer voting rights.
As the name suggests, preference shares carry preferential rights. The terms on which preference shares are issued usually provide that dividends, a distribution of the company’s earnings, are to be paid at a fixed rate, and the shares are to be cumulative and redeemable. It is important to note, however, that preference shares are not fixed creatures and may reflect many differences.
Dividends at a fixed rate
The preferential treatment that a holder of preference shares is entitled to may include a right to a dividend of a fixed amount from the profits determined to be distributed before any dividend is paid to holders of ordinary shares. The terms of issue of shares may also provide that the preference shares shall rank in priority of ordinary shares in a winding up as regards return of capital, or the amount that would be distributed to shareholders proportionate to their percentage of ownership in the company, provided that the company has any assets remaining after paying its expenses and settling its liabilities. The right to dividends at a fixed rate does not automatically translate to a right of priority in a winding up so the terms of issue of the preference shares must provide for that right of priority if such right should exist. Additionally, if the rights conferred by preference shares are limited to receiving a fixed amount of the profits determined to be distributed to shareholders, the preference shareholders will not be entitled to receive any dividend in excess of that fixed amount. If the preference shares are issued on terms that provide for a right to participate in surplus or residual profits, they are sometimes referred to as participating preference shares.
Preference dividends may be cumulative or non-cumulative, but they are presumed to be cumulative unless the terms upon which they were issued state or suggest otherwise. In the case of cumulative preference dividends, if the profits declared to be available for dividend in one year are insufficient to pay the fixed rate preference dividend in full, the unpaid amount of the dividend is carried forward and is payable out of the profits of subsequent years, and no dividend may be paid on the ordinary shares until the preference dividends for all previous years and the current year are paid in full. However, if the company is being wound up, the holders of preference shares will not be entitled to be paid any of the unpaid preference dividends out of the company’s assets unless the articles of the company or the terms of issue of the preference shares so provide. A non-cumulative preferential dividend, on the other hand, is not carried forward into subsequent years, and as such, if profits are in sufficient in one year, the right to the unpaid amount is extinguished. In practice, preference shares are usually cumulative.
Preference shares are usually issued on the condition that they are redeemable shares, which is like the company buying back the shares from the shareholders, except that when shares are redeemed, they cease to exist. If preference shares are issued on the condition that they a redeemable unconditionally, and not just on the option of the company, they are likely to be treated as loan capital rather than “equity”. The terms of issue of the preference shares may specify when or the period within which the shares may be redeemed and may provide that the shares may be converted to ordinary shares if not redeemed at or within the time specified.
Ordinary shares are generally considered equity shares and therefore, unlike capital paid on some preference shares, are not treated as a loan. While a preference dividend may be fixed and unalterable even if the company makes a large profit, the holder of ordinary shares can be paid all the surplus profits of the company. Additionally, the holder of preference shares may have limited or no voting rights. The holders of ordinary shares usually have unrestricted voting rights and are usually authorized to participate in the appointment of directors who manage the company, although companies may issue for example, “A” Ordinary Shares and “B” Ordinary Shares with varying rights.
Reasons for issuing both ordinary and preference shares
A company may be incorporated with both ordinary and preference shares, or ordinary shares only but have in its articles, a provision that allows the company to issue by the passing of a resolution, shares of different classes to which may be attached rights or restrictions related to dividend, voting, return of capital, transfer or otherwise. The original ordinary shareholders of the company may choose to have the company issue preference shares in order to raise capital without losing voting and financial control over the company. On the other hand, a person may prefer to own preference shares instead of ordinary shares as the person might be interested in making an investment in a company and earning dividends from that investment, without getting involved in the decision-making and the greater risk that shareholders of ordinary shares typically take on.
It is important that the terms of issue of shares are consistent with the company’s objectives so that any inequality in the rights conferred on shares is exactly what was intended.
Kimberley Brown is an attorney at Myers, Fletcher and Gordon and a member of the firm’s Commercial Department. She may be contacted at firstname.lastname@example.org or through the firm’s website www.myersfletcher.com. This article is for general information purposes only and does not constitute legal advice.