What are preference shares and why do companies create them?
As the name suggests, preference shares are separate classes of shares that carry better – or preferential – rights than ordinary shares. There are no specific requirements for what types or levels of preferential rights should be attached to preference shares. The rights can vary in each case. The most common types of preferential rights are rights that:
allow preference shares to rank ahead of ordinary shares regarding payment of dividends and/or capital on a winding up; and
create fixed dividend entitlements attached to preference shares, such that the dividends payable are not based on the success and profits of the company but rather calculated at a fixed rate (similar to interest).
Preference shares with such types of rights are considered to be a less risky form of investment than ordinary shares. Consequently, companies may wish to issue preference shares for such reasons or purposes as:
Giving preferential treatment to the original shareholders of the company over later investors.
Providing consideration for the acquisition of another business where the company does not have enough readily available cash to pay the purchase price in full and does not want to (or cannot) issue more ordinary shares.
Providing a means of raising additional unsecured finance from investors, potentially at cheaper rates than would be paid for borrowing cash from a bank.
Providing a means of returning value to shareholders, where preference shares are redeemable.
Rights attaching to preference shares
The Myanmar Companies Law 2017 (MCL) provides that the rights attaching to preference shares may be set out in the company’s constitution or may otherwise approved by way of a special resolution of the shareholders. It is generally presumed that the statement of the rights attaching to preference shares is intended to be exhaustive. It is therefore important that the rights attaching to preference shares are drafted as precisely and accurately as possible.
Section 73 of the MCL confirms the power of Myanmar companies to issue preference shares. Section 73 only refers to preferential rights in the following categories:
repayment of capital;
participation in surplus assets and profits;
cumulative and non-cumulative dividends;
voting;
priority of payment of capital and dividends in relation to other shares or other classes of preference shares; and
redemption of shares.
Preference shares sometimes carry rights relating to conversion of those shares into another class of shares (such as ordinary shares). Although conversion rights are not expressly mentioned in section 73, section 5 of the MCL confirms that Myanmar companies have the power to issue shares that are convertible into other shares.
It is not entirely clear whether the list of categories of preference share rights in section 73 is intended to be exclusive – such that no other types of preferential rights can be granted – but the section could be read and applied that way. However, the categories listed in section 73, together with conversion rights under section 5, cover the types of rights typically attached to preference shares in any case. It is therefore not likely that a Myanmar company will want to issue preference shares carrying a type of preferential right that is not clearly authorized under the MCL.
The following sections briefly describe the five most common categories of rights attached to preference shares.
Dividend rights
Preferential dividend rights give the holders of preference shares the right to be paid dividends in priority to other shareholders. However, companies are only permitted to pay dividends out of distributable profits. It is therefore not possible to give preference share holders an absolute right to receive a dividend in each financial year. The nature of dividends on preference shares will depend on the description of dividend rights in the preference share provisions. The following are some common types of preferential dividend rights.
Fixed dividends
Preferential dividends are often specified to be payable as a fixed percentage of the original issue price of the preference shares, for example, “6% preference shares”. In such cases, the dividend is fixed unless otherwise stated in the preference share rights, and is usually referred to as a “fixed dividend”.
Participating dividends
Preference shares can be specified as having a right to a particular percentage of profits. This is usually referred to as a “participating dividend”. Where participating dividends are used, it’s important to clearly define what “profits” will mean, and how the percentage of the profits available for payment of dividends to preference shareholders are to be divided between them.
It is also important to bear in mind that under the MCL a “subsidiary” is defined to include a company in which another company is entitled to receive more than one-half of every dividend paid on its shares, other than shares that carry no right to participate in distributions beyond a specified amount. It is therefore possible that the issue of preference shares with a participating dividend right could result in the company becoming a subsidiary of the preference share holder.
Cumulative dividends
A cumulative dividend is a dividend the amount of which will accumulate as a debt owed to the holder of the preference shares if the dividend is not paid on the date on which it is due. Cumulative dividends are commonly used by early stage companies that wish to re-invest their profits to achieve further growth rather than paying out dividends.
Preference share dividend rights are usually deemed to be cumulative unless stated otherwise in the preference share provisions. However, for clarity it is preferable that the provisions deal with this issue expressly. It is also possible to provide for the dividend payment obligations on cumulative dividends to compound in each year, such that the following year’s dividend is calculated based on the original capital amount plus the amount of the accrued unpaid dividends.
Capital rights
Preference shares do not automatically carry any special rights in respect of payments of capital or other distributions on a winding up. However, it is common practice to specify in preference share provisions that the preference shares will carry a right on a winding up to repayment of capital – and often also payment of any accumulated arrears of preferred dividends – in priority to other shareholders. It is also possible to specify that preference shares will carry a right to participate in any surplus assets available on a winding up.
As preference shares form part of a company’s share capital, they can be cancelled by way of a reduction of capital under the MCL. However, the holders of preference shares that are cancelled are only entitled to be repaid capital up to the same amount as they would be entitled to on a winding up.
Voting rights
Holders of preference shares are deemed to have equal voting rights with all of the other shareholders in the company at general meetings, unless voting rights are specifically excluded or restricted by the provisions of the preference shares.
However, it is common to make preference shares non-voting, or to provide only very limited voting rights for preference share holders, such as the right to vote only in certain circumstances, or following the occurrence of certain events, that may particularly affect the rights of the preference share holders.
Conversion rights
Preference shares are sometimes issued on the basis that they are convertible into another form of securities in the company – which will almost always be ordinary shares. The provisions of the preference shares must specify at what time and in what circumstances conversion can or must take place, for example, at any time with notice from the shareholder, or on a particular date, or following the occurrence of a particular event.
As with all conversion rights relating to shares, it is also essential to clearly specify the rate that will be used to calculate the number of ordinary shares into which the preference shares will be converted. This is particularly the case where the conversion will be calculated based on a formula, for example, one that reflects the performance of the company during the period between the issue of the preference shares and the exercise of the conversion rights.
The rights attaching to convertible preference shares are usually drafted to include protections for the preference share holders against the dilutive effects of further share issues by, for example, requiring preference holder consent for further issues or adjusting the conversion rate or formula where further share issues occur.
Redemption
Preference shares are often issued on the basis that they are able to be redeemed, that is, that the company is either permitted or required to buy the shares back. Redemption of redeemable preference shares is usually expressed to occur at the option of either the company itself or of the shareholder, or following the occurrence of a specified event. We have discussed redeemable shares in more detail in a previous article here.
How are preference shares classified?
From a company law perspective, preference shares form part of a company’s share capital. This means that preference shares, like other shares, rank behind creditors on a winding up and they can only be cancelled by way of a reduction of capital under the MCL. However, given the common characteristics of preference shares in relation to fixed and cumulative dividend rights and redemption rights, it is common for preference shares to in fact be classified as a type of debt from an accounting perspective.