Editor’s note: This is general educational information about how two classes of Canadian equity are constructed and ranked. It is not investment advice and it does not concern any particular company. It is based on the statute, accounting standard and securities instrument listed at the end.
Analysis: why the two classes trade against each other
The common explanation for preferreds and commons moving in opposite directions is that preferreds are interest rate sensitive and commons are growth sensitive. That is true and incomplete. The structural reason is that the two securities hold opposite ends of the same fixed claim.
A preferred share is a capped claim with priority. Its upside is the dividend and the redemption price in the articles, and section 36 caps the redemption at that stated price. Improvement in the business raises the probability that the fixed amount is paid, which is worth something, but it cannot raise the amount. A common share is an uncapped claim in last position: it receives what is left after the preference is satisfied, on a dissolution and in the earnings figure alike.
When a company’s prospects deteriorate, the preferred’s value falls with the rising probability that the section 42 test fails, while the common falls with the residual itself, which is the more leveraged quantity. When prospects improve, the preferred recovers to its cap and stops, while the common keeps going. The classes are not two views of the same asset. They are a fixed slice and everything above it.
A careful reader would go to the articles rather than the yield. The questions the statute makes decisive are whether the dividend is cumulative, what the redemption price and any formula are, whether the class carries a separate vote on amendments beyond the statutory minimum in section 176, and where the class ranks against every other preferred class on the register. None of those appear on a quote screen, and all of them are in a filed document.
What the documents say
On a trading screen a preferred share and a common share of the same Canadian issuer look like the same kind of thing. They have a ticker, a bid, an ask and a dividend yield. They are not the same kind of thing, and the difference is invisible for as long as the company is paying. It becomes the only thing that matters when the company stops.
Where the classes come from
The Canada Business Corporations Act sets a default and then allows it to be broken. Section 24 requires shares to be in registered form and without nominal or par value, and provides that where a corporation has only one class of shares, the rights of the holders are equal in all respects and include the right to vote at any meeting of shareholders, the right to receive any dividend declared, and the right to receive the remaining property of the corporation on dissolution.
Subsection 24(4) is where preferred shares come from. The articles may provide for more than one class, and if they do, the rights, privileges, restrictions and conditions attaching to each class must be set out in the articles, and the three basic rights must be attached to at least one class but are not all required to be attached to one class. A corporation can therefore create a class with a dividend entitlement and a liquidation entitlement but no vote, which is what a conventional preferred share is, and the terms of that class live in a document filed with the registrar rather than in any general rule of law.
That has a consequence readers often miss. There is no such thing as a standard Canadian preferred share. Rate reset, perpetual, retractable, cumulative, non cumulative, convertible: every one of those features is a term in a particular corporation’s articles. Two preferreds from the same issuer can rank differently from each other.
The payment order is a solvency test, not a queue
The ranking language on a prospectus cover describes seniority. The statute enforces it through solvency tests that apply at the moment of payment.
Section 42 provides that a corporation shall not declare or pay a dividend if there are reasonable grounds for believing that it is, or would after the payment be, unable to pay its liabilities as they become due, or that the realizable value of its assets would thereby be less than the aggregate of its liabilities and the stated capital of all classes. Both limbs bind, and the second one is the harsher of the two because stated capital sits alongside liabilities in the comparison.
Section 36 applies an analogous test to redemption. A corporation may purchase or redeem redeemable shares at prices not exceeding the redemption price stated in or calculated under the articles, but must not make the payment if there are reasonable grounds for believing that it is, or would be, unable to pay its liabilities as they become due, or that the realizable value of its assets would after the payment be less than the aggregate of its liabilities and the amount that would be required to pay the holders of shares ranking rateably with or before the shares being redeemed. A retractable preferred is therefore retractable only while the company passes that test.
On a dissolution, section 43 and the liquidation provisions of the Act direct the remaining property to be distributed among the shareholders according to their respective rights, which are the rights in the articles. The preference has effect at that point and not before.
What a preferred holder can actually block
The absence of a vote at general meetings does not mean the absence of a vote. Section 176 gives the holders of a class the right to vote separately as a class on a proposal to amend the articles in ways that touch that class, and subsection 176(5) applies that right whether or not the shares otherwise carry a vote.
The list is specific. A separate class vote is required to increase or decrease the maximum number of authorised shares of the class, or to increase the maximum of a class with equal or superior rights. It is required to effect an exchange, reclassification or cancellation of the shares. It is required to add, change or remove the rights attached to the class, including to remove or change prejudicially rights to accrued or cumulative dividends, to add, remove or change prejudicially redemption rights, to reduce or remove a dividend preference or a liquidation preference, and to change conversion privileges, options, voting, transfer or pre emptive rights or sinking fund provisions. It is required to create a new class equal or superior to the class, or to promote an inferior class to equal or superior standing.
Subsection 176(4) limits the right at series level: holders of a series vote separately only if the series is affected differently from other shares of the same class. Where a company proposes something that harms the class without amending the articles, the oppression remedy in section 241 is the residual route, which allows a complainant to apply to a court where the affairs of the corporation have been conducted in a manner that is oppressive or unfairly prejudicial to or that unfairly disregards the interests of a security holder.
The accounting makes the split visible
The divergence shows up in the reported earnings figure before it shows up anywhere else. IAS 33 requires basic earnings per share to be calculated on profit attributable to ordinary equity holders of the parent entity, which is profit adjusted for the after tax amounts of preference dividends, differences arising on the settlement of preference shares and other similar effects of preference shares classified as equity.
The treatment differs by type. For non cumulative preference shares, the deduction is the after tax amount of dividends declared in respect of the period. For cumulative preference shares, it is the amount required for the period whether or not the dividends have been declared, and it excludes arrears from earlier periods paid in the current one. A company that stops paying a cumulative preferred keeps charging it against the earnings attributable to the common shares. The cash stops. The claim does not.
Disclosure of any such decision runs through National Instrument 51-102. Where a material change occurs, the reporting issuer must immediately issue and file a news release authorised by an executive officer disclosing the nature and substance of the change, and file a material change report as soon as practicable and in any event within 10 days.
