Irony for you
The irony of preferred stock is that courts treat it with disdain.' It should be a staple of modem finance, because it offers an unparalleled financial flexibility that helps businesses stay afloat during hard times and thus reduces bankruptcy risk for investors.2 Yet it has virtually disappeared in most mature industries, largely because preferred shareholders have found it terribly difficult to protect the value of their investment. As a result, they demand a risk premium that few companies are willing to pay, except as a
last resort. Today, nearly all public preferred stock is issued by financial institutions, insurance companies, or other institutions subject to strict capital adequacy regulation, as illustrated by the size and composition of preferred stock exchange-tradable funds. Preferred stock is more commonly used for funding startups, owing to the peculiar risk-return ratio sought by venture
capitalists. Even in that context, however, its use may be declining, as some venture capitalists are rethinking their commitment to an investment vehicle that offers few legal protections. The problem is that corporate law now gives short shift to the equity aspect of preferred stock. Financially, preferred stock resembles debt, in that it has limited upside and its return comes in the form of periodic coupon payments. Legally, though, it is much more like common equity: preferred shareholders, unlike creditors, cannot sue in contract to recoup either their
principal investment or unpaid coupons, and the terms of a preferred stock investment, unlike those of a debt contract, can be altered unilaterally by the firm. As a result, the value of fixed income equity can be opportunistically expropriated by common equity, by such means as dilutive mergers, leveraged recapitalizations, or risk-seeking economic strategies.'' Not even venture capitalists are safe, despite their deep experience with preferred stock and their business power over the companies. Occasionally, they let down their guard, and then can only watch helplessly as their investments are decimated.
Preferred stock also resembles debt in that both instruments are
vulnerable to exploitation by the common. By their nature, fixed claims lose value when subject to increased risk, whereas equity tends to benefit from additional risk. Thus, if the common shareholders can impel the firm to take on additional risk, the value of their investments will appreciate, at the expense of the fixed claimants.
Preferred stock, by contrast, must rely on much weaker remedies. To
be sure, preferred stock typically issues with covenants similar to those included in bond indentures, but they are not backed by the power of accelerated repayment of principal and interest. Dividends promised to preferred stock can be retracted, and the preferred generally cannot force repayment of the principal in the event that a covenant has been breached. The preferred can roughly approximate accelerated principal repayment by obtaining a promise from the firm to redeem the stock if any covenants are breached but redemptions cannot be relied upon in a pinch-they are subject to statutory restrictions and are regulated less by contract than by
equitable principles of corporate law. Ultimately, the preferred
shareholders, as shareholders, must seek legal remedies by means of actions in corporate law. In board-friendly jurisdictions such as Delaware, this operates as a powerful practical disadvantage. While the common shareholders occasionally win when taking action against the board, the preferred nearly always lose.
The corporate law once offered at least a modicum of protection
against exploitation. For instance, the famous 1986 Court of Chancery case Jedwab v. MGM Grand Hotels, Inc. held that boards must respect fiduciary duties when dealing with the preferred. Over the past three decades, however, courts have eroded such duties to the preferred so far that they exist in name only. Indeed, recent opinions have suggested that the board may even have a fiduciary duty to siphon value from the preferred when the
opportunity arises. Today, preferred shareholders must protect themselves with contract-like covenants in the certificate of designation---covenantsthat are most often interpreted very narrowly, in favor of the common. It is
no wonder, then, that investors have lost interest in preferred stock; if one must rely on covenants, better that they be included in an unalterable, legally enforceable debt contract. Preferred stock cannot survive if the board, acting on behalf of the common, can readily expropriate much or all of its value.
The Corporate Decisional Calculus
Corporate decision-makers (e.g., the officers and/or the board) can be induced to take heed of investors' interests primarily by three familiar mechanisms: the investors' power to replace the decision-makers, the alignment of interests between investors and the decision-makers, and the firm's capital market reputation. In standard governance arrangements, these inducement mechanisms are over-allocated to the common, mildly under-allocated to debt, and allocated hardly at all to the preferred. Alignment of
interests almost always redounds to the common's benefit, as directors and managers frequently are paid in part with common equity interests and essentially never with preferred. Thus, common stockholders can confidently anticipate that the board will at least attempt to increase the share price of the common. In most corporations, the common equity also elects the board, and, as noted above, they enjoy the protections of fiduciary duties as against the preferred. Creditors have no direct representation on the board, but they hold the greatest leverage in terms of capital market reputation. Firms more frequently need to roll over their debt than raise new equity;if they wish to secure low-cost financing, they need to establish a reputation in the debt markets for good capital stewardship.
Preferred stock, by contrast, has little input into or sway over firm policy.
