“'le ARREARAGES ON CUMULATIVE PREFERRED STOCKS LISTED ON THE NEW YORK STOCK EXCHANGE: AN ANALYSIS OF EXPERIENCES, 1935-62 Thesis for the Degree of Ph. D. MICHIGAN STATE UNIVERSITY Ronald M. .Horwifz 1964. THESIS This is to eertifg that the thesis entitled Arrearages on Cumulative Preferred Stocks Listed on the New York Stock Exchange: An Analysis of Experiences, 1935-62. presented by Rona 1d M. Horwitz has been accepted towards fulfillment of the requirements for Ph.D. degree in Financial Administration [m flake Major professér ./ Date May 5, 1964 0-169 LIBRARY Michigan State University ABSTRACT ARREARAGES ON CUMULATIVE PREFERRED STOCKS LISTED ON THE NEW YORK STOCK EXCHANGE: AN ANALYSIS OF EXPERIENCES, l935~62 by Ronald M. Horwitz When a preferred stock is cumulative, the unpaid por- tion of the stated annual dividend accumulates in favor of the cumulative preferred shareholder, in most cases even if it is not earned. These accumulated unpaid dividends are called arrearages and must be paid or otherwise legally eliminated before any dividends can be paid to subordinate preferreds or common stocks. The easiest way to eliminate the arrearages is with a cash payment or an outright retirement of the preferred issue. Frequently, however, the firm does not have the working capital to afford such payments or it chooses not to make cash payment. In these instances, management must resort to non-cash settlements, the most common of which have been recapitalizations and mergers. The objectives of this study are twofold--to examine the historical role which preferred stock arrearages have had and the value placed on the arrearages when the ac~ crued dividends are settled. To achieve these objectives most effectively the study is organized in the following -—.———— M i.— tanner: Chapters 1 a rounds the prefe‘ legal developmenI exadnes the var tors can employ satisfying the c E Chapter 11 nificances of t on the New Yor‘r' inter“Nils from t° December 31 ' b“ 0f arrearetl rearages on ea to extract tre The chapter Q ( cretionary pox dends and its ChaPter havior of Pre 1950 to 1962‘ scrutiniZQd ‘ and the VOrk In Chay the arreara: or mergers stanCQ the Ronald M. Horwitz manner: Chapters I and II lay the legal framework which sur- rounds the preferred stock contract. In Chapter I the legal development of the contract is traced. Chapter II examines the various alternatives which boards of direc- tors can employ to remove the accrued dividends, thus satisfying the claims of the preferred shareholders. Chapter III discusses the economic and social sig- nificances of the arrearages. The preferred issues listed on the New York Stock Exchange were examined at five year intervals from December 31, 1935 to 1950 and then annually to December 31, 1962. Tabulations were made of the num- ber of arreared issues and the dollar amount of the ar- rearages on each of these dates. The data were analyzed to extract trends and explanations of their behavior. The chapter concludes with a discussion of the dis- cretionary power of boards of directors to declare divi- dends and its relationship to cumulative preferreds. Chapter IV focuses its attention on the economic be- havior of preferred stocks which became arreared from 1950 to 1962. The dividend policy on these preferreds is scrutinized with regard to the level of annual earnings and the working capital position of the individual firms. In Chapter V each of the preferred issues on which the arrearages were settled by corporate recapitalizations or mergers from 1951 to 1962 are examined. In each in- stance the value of the securities in the settlement which the arreared pp to the price "I arreared share determine if t had any value reared preferr The major 1. The gr Preferred stoc in the 193mg Variations in Cyclical feces 2° Arrea: Ronald M. Horwitz the arreared preferred shareholders received is compared to the price which should have been paid to retire the arreared shares. The purpose of these comparisons is to determine if the cumulative feature of preferred stocks had any value in corporate reorganizations in which ar- reared preferred stock was eliminated. The major findings of the study include; 1. The greatest historical cause of arrearages on preferred stocks was the losses incurred by most firms in the 1930-33 depression. Since that time short-run variations in the amount of arrearages were caused by cyclical recessions and recoveries. 2. Arrearages are most likely to be cleared when sub- stantial earnings reappear. 3. The chances of a nonucash settlement increase, on the average, the longer the dividends are in arrears. h. Unlike common dividends, the burden of proof should properly fall upon the board of directors to show that an earned cumulative preferred dividend should not be paid. 5. The problem of the long and large accumulation of arrearages both as to the number of issues and the dollar amount seems to be a thing of the past. 6. In general, the cumulative feature failed to have any value in arrearage settlements effected by recapitaliza- tions or mergers from 1951 to 1962. in Pa lt‘llll'llllll I‘Il' ‘Il'll'llll'll’lI Department ARREARAGES ON CUMULATIVE PREFERRED STOCKS LISTED ON THE NEW YORK STOCK EXCHANGE: AN ANALYSIS OF EXPERIENCES, 1935-62 BY Ronald M. Horwitz A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1964 .— _ . .— _— — — —_ . .— . _ .—— — — A large during the at Fellowship ill a grant from Wingly, I Aperican Ban} Foundation wt. completion of I wish t "”de with m sity. ACKNOWLEDGMENTS A large portion of this dissertation was completed during the academic year in which I held a Harold Stonier Fellowship in Banking and the summer in which I received a grant from the Michigan Accountancy Foundation. Ac- cordingly, I wish to express my gratitude to both the American Bankers Association and the Michigan Accountancy Foundation whose financial aid greatly assisted in the completion of this thesis. I wish to thank the several faculty members who worked with me during my stay at Michigan State Univer- sity. Professor Robert W. Johnson provided the guidance and inspiration in the early part of my doctoral work. Associate Dean Kullervo Louhi was the chairman of my dis~ sertation committee. His invaluable suggestions and en- couragement during the preparation of this thesis were sincerely appreciated. Professor Charles Lawrence and Professor Rollin Simonds offered numerous helpful com- ments and generously served as members of my dissertation committee. Special thanks are also due to Professor James Don Edwards, Chairman of the Department of Accounting and Financial Administration, for his advice and helpful« ii —_ __._—.——._ —_——— ——.—_—_——.—‘ #—__-— ness through: Finally whose gentle F couraged me 1 of my graduat ness throughout the past several years. Finally, I am deeply indebted to my wife, Carol, whose gentle prodding, patience and understanding en- couraged me to undertake and complete this final stage of my graduate education. iii TABLE OF CONTENTS ACKNOWLEDGMENTS . . . . . . . . . . . . . . . . . . LI ST OF TABLES . O O O O O O O O O O O O O O O O 0 LIST OF APPENDICES O O O O O O O 0 0 O O O O O 0 O I NTRODUCTI ON 0 O O O C O O O O C O O O O O O O O 0 Chapter I. THE PREFERRED STOCK CONTRACT . . . . . . . Preferred Dividends and the Law . . . . . The Cumulative Feature in Preferred Shares . . . . . . . . . . . . . . . . Cumulative Rights in Reorganization or Dissolution . . . . . . . . . . . . II. ALTERATIONS OF THE CUMULATIVE PREFERRED STmK C ONTRA CT 0 O O O O O O O O O O 0 0 Rights of Arreared Preferred Stockholders Methods of Settling Preferred Stock Arrearages . . . . . . . . . . . Cash Payment . . . . Other Methods . . . 0 O 0 O 0 Direct Removal . . . . Charter Amendment . . . . Merger, Consolidation or Sale of All Assets . . . . . . . Summary . . . . . . . . . . . . III. THE SIGNIFICANCE OF PREFERRED STOCK ARREARAGES O O O 0 O O O O O O 0 O 0 O 0 History of the Arrearages . . . . . . . . History of the Arrearage Settlements . . Financial Significance of Preferred Stock Arrearages . . . . . . . . . . . Comparative MacromAnalysis of Preferred Stock Arrearages . . . . . Effect of Other Preferred Stock Features on Arrearages . . . . . . . iv Page ii vii ix 23 26 29 29 31 32 33 35 37 52 55 57 58 7O 77 77 82 — —-— — — o M _ .— .A - — _ — — «— .— —— .— .—— _ _ Chapter Soc, Smr1 I IV. ARREA Arr 0th Con RECI TABLE OF CONTENTS--Continued Chapter Arrearages and Investor Reaction . . Social Significance of Preferred Stock Arrearages . . . . . . . . . . sumry . O C C O O C O O O O O O O 0 IV. ARREARAGES ON CONTEMPORARY PREFERRED Arrearages and Preferred Earnings . . Other Considerations . . . . . . . . . Conclusion . . . . . . . . . . . . . . V. THE VALUE OF THE CUMULATIVE FEATURE IN RECENT ARREARAGE SETTLEMENTS . . . . . Introduction . . . . . . . . . . . . . Methodology . . . . . . . . . . . . . Case Study--Armour and Company . . . . Description of Stock . . . . . . . . History . . . . . . . . . . . . . . Test for Value of Cumulative Fe atu ure Exchange . . . . . . . . . . . . . Dissent . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . Case Study-~Missouri- Kansas- Texas Railroad (Katy) . . . . . . . . . . Description of Stock . . . . . . . . History . . . . . . . . . . . . . . Test for Value of Cumulative Feature Conclusion . . . . . . . . . . . . . Case Study-~American & Foreign Power Co., Inc. . . . . . . . . . . . . . Description of Stocks . . . . . . . History . . . . . . . . . . . . . . Test for Value of Cumulative Feature Conclusion . . . . . . . . . . . . . Summary . . . . . . . . . . . . . . . VI. CONCLUSION . . . . . . . . . . . . . . . The Economy . . . . . . . . . A Firm's Board of Directors . The Stockholder . . . . . . . V STOCKS O O 0 0 0 O O 0 O O O O O 0 000000 Page 84 87 93 96 98 101 103 103 105 111 111 112 118 118 119 120 O O O 0 O 0 O O O O O 0 0 O 0 O O O 121 121 121 124 125 000°. 00.00 126 126 126 133 13# 135 138 138 140 141 Chapter APPENDIX A . APPENDIX B . APPENDIX C . BIBLIOGRAPHY TABLE OF CONTENTS--Continued vi Page 145 150 156 158 ..——-_'——~. .———-—— ——-———- _- _ .— ___ _- .— - — *._— .— — .— .—— .— _ —— —- Table 10. o PI'Efern ° Annual I ' Mathod Schedu for Year D Stoc' Corpor. Year Indu 1935 Stoc‘ the I Arre Table 1. 10. LIST OF TABLES Page Schedule of Arrearages on Preferred Stocks, for the Years 1935, 1940, 1945, 1950-62 . . . 60 Year Dividends First Passed on Preferred Stocks in This Study . . . . . . . . . . . . 62 Corporate Net Income After Taxes, for the Years 1931-62 0 o o o o o o o o o o o o o o o 63 Preferred Stock Issues in Arrears by Industrial Classification, for the Years 1935’ 19’40, 19,45 ’ 1950-62 0 o o o o o o o o o 67 Annual Proportion of Dollars of Preferred Stock Arrearages in each Industry, for the Years 1935, 1940, 1945, 1950-62 . . . . . 68 Methods Used to Settle Preferred Stock Arrearages in each Industry, from 1935 to 19 62 O O O 0 O O O O O O O 0 O O 0 O 0 O O 71* Average Time Taken to Settle Preferred Stock Arrearages for each Method Used, 1935-62 0 o o o o o o o o o o o o o o o o o o 76 Number of Stocks Listed on the New York Stock Exchange, for the Years 1935, 1940, 19145, 1950-62 0 o o o o o o o o o o o o o o o 78 Annual Amount of New Preferred Financing Registered with the Securities and Exchange Commission Compared to the Annual Amount of Preferred Stock Arrearages, for the Years 1935, 1940, 1945, 1950-62 . . . . . . . . . . . . . . . . 79 Annual Dividends Paid on Preferred Stocks Compared to the Annual Amount of Preferred Stock Arrearages, for the Years 1935, 1940, 1945, 1950-62 . . . . . . . . . . . . . 81 vii LIST OF TABLES-~Continued Table Page 11. Comparative Yields on Industrial Bonds and Preferred Stocks, for the Years 1940-62 . . . 107 12. Earnings, Dividends and Price Record of the Armour and Company $6 Prior Preferred Stock, for the Years 1934-54 . . . . . . . . 113 13. Earnings, Dividends and Price Record of the 'Missouri-Kansas-Texas Railroad 7%A Preferred Stock, for the Years 1930-58 . . . 122 14. Summary of Tests to Determine the Value of the Cumulative Feature in Preferred Stock Arrearage Settlements Effected by Recapitalizations or Mergers from 1951 to 1962 . . . . . . . . . . . . . . . . 136 viii _ _ _ M m .— ‘ _ —— u-n—r Appendix A. List in 19 B. List Ca St 19 C- Opin on LIST OF APPENDICES Appendix Page A. List of Companies with Preferred Stocks in Arrears as of December 31, 1935, 19u0’ 1945, 1950-62 0 o o o o o o o o o o 1H5 B. List of Earnings, Arrearages, and Working Capital of Companies Whose Preferred Stocks had Original Arrearages from 1950 to 1962 . . . . . . . . . . . . . . 150 C. Opinion of the Illinois Supreme Court on Accrued Dividends . . . . . . . . . . 156 ix INTRODUCTION Cumulative preferred stocks have played an important role in corporation finance since the middle of the nine- teenth century. Together with bonds, common stocks and non-cumulative preferreds, they have been one of the most popular methods of raising corporate capital. Preferred stocks, both cumulative and nonwcumulative, presently constitute over 25% of the total issues listed on the New York Stock Exchange and pay over $300,000,000 of dividends annually.l From the standpoint of dividends, with which this study is primarily concerned, the term "preferred stock” is generally understood to mean stock which is entitled to receive a predetermined amount of corporate distribu- tions of earnings per year before any dividends can be paid on junior securities. When a preferred stock is cumulative, the unpaid portion of the stated annual divi- dend accumulates in favor of the cumulative preferred shareholder, in most cases even if it is not earned. These accumulated unpaid dividends are called arrearages ¥ 1Nengork Stock Exchange Fact Book (New York: New York Stock Exchange, 1963), p. 47. 1 2 and must be paid or otherwise legally eliminated before any dividends can be paid to subordinated preferreds or common stocks. Holders of cumulative preferred stock may-—or may not--eventua11y receive all back dividends due them. Each of the following possibilities also exists: 1. Some, but not all, of the arrearage may be paid off. 2. The cumulative preferred share owners may be given the opportunity to exchange their holdings for some other security issued by the same corn poration. 3. No part of the arrearage may ever be paid off. Arrearages on cumulative preferreds can become sub~ stantial both in dollar amount and the number of issues involved. The ultimate effects of the accumulations can have both economic and social consequences. Large accumulations tend to depress market values of both.the preferred and common issues because dividends have been passed on each. Most preferred stocks have sturdy dividend records; where large arrearages occurred, the majority of stocks in that group date their accumulations back to the Great Depression of the 19303. Generally prosperous business of the 19403 enabled management to pay off back dividends 111 many cases. In other situations, arrears have been p — ,—_—_’-“‘_" reduced. Progre Although earning years been subs dividends, mana The social of a moral or e refusal by a be preferred divic working capita' be paid withou Power held by dividends is . ferreds Since pay a Premium °f an earned 3 reduced. Progress has, however, been far from uniform. Although earnings per share of preferreds have in some years been substantial, sufficient to eliminate back dividends, management has often proceeded cautiously. The social consequences of preferred arrearages are of a moral or ethical nature. The major issue is the refusal by a board of directors to declare a cumulative preferred dividend when it has been earned and when the working capital position is such that the dividend can be paid without financial detriment. This discretionary power held by boards of directors to declare or pass dividends is especially crucial with cumulative pre- ferreds since the investor, in most cases, was willing to pay a premium for the cumulative feature. The passing of an earned dividend in particular dilutes the value of the cumulative feature and should subject the board of directors to close scrutiny. When a corporation with arreared preferreds reaches the position when it is prepared to resume common dividends, it must seek a feasible method to eliminate the arrearages. The easiest way is to pay all of the accumulated dividends in cash or as part of an outright retirement of the pre- ferred issue. Frequently, however, the firm does not have the working capital to afford such payments or it simply ‘Chooses not to make cash payment. In these instances, nlanagement must resort to nonucash settlements, the most roman of vhic‘: The invesi torieal value, I ferred stocks : for example, i lasing statemel tumnlative fea' arrearage settl (preferred sto| removed from J funds can be 1' (parentheses m cumulative fe a 3E9 settlement that an ians t arrefired issue RESearch sadly naglecte ve considere emprehensin ir raison d of SQttlement L, common of which have been recapitalizations and mergers. The investor should have some appreciation for the his- torical value, if any, of the cumulative feature in pre- ferred stocks should he be considering such an investment. For example, it is difficult to understand how the fol- lowing statement could be made if full recognition of the cumulative feature was standard operating procedure in arrearage settlements: "The great majority of the issues (preferred stocks with dividend arrears in 1962) seem far removed from a worth-while pay-off point. We believe that funds can be invested elsewhere to better advantage" (parentheses mine).l Clearly, if it can be shown that the cumulative feature has had little or no value in arrear- age settlements, this would tend to reduce the premium. that an investor would be willing to pay for cumulation, in arreared issues particularly. Research on cumulative preferred arrearages has been sadly neglected on a long-term macro sense. Prior studies have considered arrearages at only one point in time.2 A comprehensive consideration of total arrearages over time, their raison d'etre, their characteristics, and their means of settlement has been noticeably missing in financial * l"Preferred Stocks with Dividend Arrears," The Outlook, May 28, 1962, p. 786. 2See for example, the annual tabulations appearing an- fulfilly in The Exchange from 1952 to 1961. literature . this gap. In I be answered a lighted the hl stocks uncove| ChaptersI Work of the SI stocks and th management of body of the c rishes to div cumulative an SPQCial empha the Cumulativ and their finl Chapter which bOardS dividends, th sharehold,3 rs . are; (1) the the eliminati managerial,t he 5 literature. This study was undertaken as an attempt to fill this gap. In it, it is hoped that the above questions will be answered and the more salient points which have high- lighted the historical record of cumulative preferred stocks uncovered. Chapters I and II lay the legal and theoretical frame- work of the study. The legal characteristics of preferred stocks and their corresponding influence on the financial management of the firm are reviewed in Chapter I. The body of the chapter will consist of a discussion of the rights to dividends, when both earned and not earned, of cumulative and non-cumulative preferred stockholders. Special emphasis will be placed on the several facets of the cumulative feature in reorganization or dissolution and their financial implications. Chapter II will focus upon the various alternatives which boards of directors can employ to remove the accrued dividends, thus satisfying the claims of the preferred shareholders. The most important points to be discussed are: (1) the legal nature of the arrearages under each of the elimination methods; and (2) the related power which management has under each either to completely or partially eliminate the claims of the preferred and the related stock- holder remedies. The discretionary power of boards of directors as it Pertains to the declaration of preferred dividends is exm Vgrk° . mg C aplta mined at len veloped from , arrearages as The preferred some generali nomic causes I rearages, If 0f arrearages Pattern of di, be used as a 5 Purchaseg. I: industrial ca‘. A Similar arrearages in amch more it It is here the elusions regaz which haVE not 1950, thus 811' and Hal-1d war ferreds can be rent times . 'I 5e SCI.utiflized 6 amined at length in Chapter III. The discussion is de- veloped from a comprehensive historical review of preferred arrearages as to dollar amounts and periods outstanding. The preferred issues are analyzed to discover if there are some generalizations that can be made covering the eco- nomic causes of the occurrence and elimination of the ar— rearages. If, by examining the historical fluctuations of arrearages for a wide group of preferreds over time, a pattern of dividend action can be uncovered, it can then be used as a guide for future cumulative preferred stock purchases. The stocks will also be analyzed by general industrial categories. A.simi1ar analysis is applied to contemporary preferred arrearages in Chapter IV. This chapter, however, contains a much more intensive examination than that in Chapter 111. It is here that an attempt will be made to draw some con- clusions regarding the behavior of the arreared preferreds which have not been affected by economic events prior to 1950, thus eliminating the effects of the 1930—33 depression and WOrld War II. In this manner contemporary arreared pre- ferreds can be more objectively evaluated in light of cur- rent times. The dividend policy on these preferreds will be scrutinized with regard to the level of earnings and the Working capital position of the firm. In Chapter V the cumulative feature is subjected to taste to determine if cumulation has had any value in re- cent arrearag on those pref during the pe is to determi the arrearage be presented countered who After ev role that the 0f dividends I Particular, i can Purchase a reasonable will be honor 7 cent arrearage settlements. The tests will be performed on those preferreds which had their arrearages eliminated during the period 1951-62. The objective of the testing is to determine the degree of compensation received for the arrearages. Three representative case studies will be presented to illustrate the types of problems en- countered when attempts are made to settle arrearages. After evaluating the findings of Chapters III-V the role that the cumulative feature has had in the payment of dividends on preferred stocks will be summarized. In particular, it will be determined whether today's investor can purchase a share of cumulative preferred and still have a reasonable degree of assurance that the cumulative feature will be honored by the firm. CHAPTER I THE PREFERRED STOCK CONTRACT Contemporary business corporations seeking to raise original capital or additional external funds through the issuance of corporate securities may choose from three general forms: (1) bonds, or corporate debt; (2) common stock, or corporate ownership; or (3) preferred stock, a hybrid between the two. Preferred stock has been the most recent form of the three securities which corporations have used to raise capital. Its history began in the United States in 1836 when the Baltimore and Ohio Railroad Company and the Chesapeake and Ohio Canal Company received statutory au- thority to issue preferred shares.1 However, it was not until the middle of the 19th century that preferred stock came into general use, with the railroads issuing the majority of the shares. The laws governing preferential rights have consequently had a relatively short period of development. Capital stock becomes preferred when it has claims or 1Donald Kehl, Corporate Dividends (New York: The Ronald Press 00., 1941), p. 187. 8 9 rights which are higher ranking than the outstanding com- mon issue. The preferential status may take the form of a prior claim on earnings for dividend purposes, a prior claim on assets in the event of liquidation, or both. The extent of the preference is governed by the certifi- cate of incorporation, by-laws, stock certificate, and applicable statutory provisions. All leading states of incorporation have statutes which, in broad general language, authorize corporations to issue preferred shares designating usually in the certificate of incorporation the dividend and liquidation preferences and priorities which such shares shall have over other classes of stock. Preferred Dividends and the Law The investment incentive behind the purchase of the vast majority of preferred stock issues is the promise of greater regularity of dividends than would be possible with common stock. Preferred shares are generally entitled to receive distributions of corporate earnings, either Cumulatively or non-cumulatively, before any dividends can be paid on the outstanding common shares or any other subordinate stocks. When a dividend of a fixed amount 1 per year is to be paid, an express provision for this 1.In return for the dividend preference, the preferred shareholder is ordinarily limited in the amount of his dividends so that if the corporation is unusually success- ful he may not claim any share of the earnings beyond the fixed rate. Should the preferred stock be given the right 10 amount should appear in the certificate of incorporation or some other duly authorized corporate instrument. The amount of the annual dividend can be shown as either a given amount of dollars per year or per quarter or as a percentage of the par or stated value of the stock. Even these provisions, however, are only conditional guaran- tees. For in order to pay preferred dividends two pre- requisites must be met: (1) earnings or capital otherwise legally available for dividends must be present,1 and (2) the board of directors must officially declare the divi- dends payable. The problem of defining the rights of the preferred shareholders to their dividends if one or both of these two conditions are not met has been one of the most con- troversial issues in preferred stock financing. If this situation is not specifically covered in the proper cor- porate documents, as was often the case with the early pre- ferred issues, the question arises as to whether: (a) the passed dividends will accumulate over the years in favor of the preferred shareholders and must be paid in to share in additional earnings, the stock is said to be "participating" preferred. lLegal capital available for earnings distributions as dividends is defined by the corporation statutes of each state. See Harry Buttimer, "Dividends and the Law," Accounting Review, XXXVI (July, 1961), 435 for an excellent summary. 11 total before any dividends can be declared on the com- mon, or (b) the shareholder's claim expires at the close of the fiscal year of the corporation. If the claim accumulates beyond the close of the fiscal year as in (a), the shares are said to be cumulative. If the claim expires as in (b), they are non-cumulative. In the absence of a specific provision as to accumu- lation, the stock is nevertheless, as a general rule, treated as cumulative.1 A plain provision stating only that dividends shall be preferred in a certain amount or per cent each year at a minimum means that if there are sufficient earnings in any given year, a claim for payment of the unpaid dividends for that year becomes fixed, even though actual payment may be postponed to some other date. Any other interpretation would make the dividend preference specifically non-cumulative. However, if the dividend for a given year is not earned a question arises as to whether the dividend preference is cumulative in the broad sense of having pre- 1See for example Fidelity Trust Co., v. Lehigh Valle R. R. Co., 64 A. 829 (1906) in which it was stated (p. 8 ): ere 18 no provision in the statute bearing directly up- on the question of cumulation, and in the absence of any specification to the contrary the general rule would seem to be that the preferred stock is entitled to arrears"; and Hazel Atlas Glass Co., v. Van Dyk & Reeves, 8F. (2d) 716 ) where the opinion readFCp.‘720): "For in any case unless a contrary intention appears, dividends on preferred stock are cumulative and arrears in one year are payable in a subsequent year when there are sufficient profits before dividends can be paid on the common stock." 12 viously passed unpaid dividends being payable out of later earnings. Any language which might be construed to in- dicate that the preference was to be from the earnings of a particular year would be sufficient to bar this type of cumulation. To hold otherwise would burden the corporation with unearned fixed charges, similar to debt contracts. There has been a tendency in recent issues to counter this problem by expressly providing that dividends shall be cumulative only to the extent earned.l’2 While it is important to clarify the rights of pre- ferred shareholders it should be remembered at this point that rights to passed (accrued) dividends are only a measure of the preferred stock's priority over the common stock in the firm's retained earnings and nothing more. Regardless of the amount which preferred dividends are in arrears, a preferred shareholder cannot sue for payment of an accrued dividend just as he cannot sue for any unde- 3 clared dividend. The term "accrued" clearly here does 1For example, Lehigh Valley Coal Corp. $3 lst pre- ferred and Chicago and Eastern Illinois Railroad $2A. 2It is possible to conceive of a preferred stock stipulation so strong that it would require directors to declare a preferred dividend whenever earnings were suf- ficient. Payment of the dividend may however present an acute financial problem and thus would deprive the direc- tors of flexibility in their management of the firm. 3The leading case here is New York, Lake Erie Rail- road v. Nickals, 119 U.S. 296 (1886). 13 not mean the same as in the law of debt. The existence of profits creates the potential existence of dividends, while the declaration of the dividend creates the legal liability. The legal differential between cumulative and non- cumulative preferred stock contracts, where the contract it- self was vague as to the rights of its holders, presented a tangle in the courts until the Wabash Railway case of 1930.1 Until the Wabash decision each case concerning (non)cumu1ative dividends was settled on its own particular merits, and the courts adroitly managed to sidestep the basic problem of setting forth a general rule to cover all situations. Before the Wabash case boards of directors deemed that they had the discretion not merely to postpone payments of earnings attributable to preferred stock but also to deter- mdne whether or not such stock should be entitled to share in the earnings, even where the earnings were adequate to satisfy the dividend requirements of the stock. This be- lief stemmed from a fundamental common law right permit- ting the directors to determine the time when the dividends should be paid and to refrain from declaring dividends when, in their judgment, corporate purposes could best be served by retaining earnings in the business. The right of a stockholder to receive a participation in income could 1Wabash Railway Co. v. Barclay, 280 U.S. 197 (1930). 14 be made to depend upon the time when it was payable, and thus management could acquire a very real power to steer earnings. The best known power to route earnings arises when non-cumulative shares are a part of the corporation's capital structure. The most disputed use of this power occurs when there are earnings in any year which could be applied to the payment of preferred dividends (especially on non-cumulative shares) and the directors choose to withhold declaration of the dividends. Should the shares be cumulative or if no stipulation is made as to the ef- fect of passed dividends upon the rights of the share- holders, the preferred shareholder has a claim to the earnings up to the extent of his preference. The con- troversy had centered around preferred shares specifically entitled "non-cumulative." The legal questions surrounding the cumulative or non-cumulative nature of preferred shares most often arise in years subsequent to the original passing of the pre- ferred dividends, when the corporation seeks to pay divi- dends on common stock or second preferred. Such declara- tions by boards of directors, prior to the Wabash case, were met with the claims of the non-cumulative holders that they were entitled to payment of previously earned but un- paid dividends before any distributions could be made to the common or second preferred holders. 15 A group of leading cases prior to the Wabash de- 1 held that such earnings, even though withheld, cision must ultimately be applied to the holders of the non- cumulative preferred, thus giving the non-cumulative stockholders a specific claim on profits not paid to them as dividends. Therefore, a mere failure of the directors F“- in any year to declare earned dividends on non-cumulative preferred did not mean that the holder of that stock . thereby had his rights forfeited to dividends for that I year. A contrary view insisted that the claim of the 't* non-cumulative shareholders to dividends for any year simply ceased to exist if the directors chose to declare none--1eaving the rights of the preferred shareholders at the mercy of the board of directors. These two views were reconciled in the Wabash Rail- way case. Wabash had outstanding an issue of preferred "A" stock entitled to receive dividends in each fiscal year up to 5% before any dividends could be paid upon any other stock, but the dividends on the 5% preferred were non-cumulative. There were also outstanding issues of convertible "B" preferred and common stock. No dividend 1See for example: Basett v. U.S. Cast Iron Pipe and Foundry Co., 74 N.J. Eq., 668 (1908); Da v. U.S. Cast Iron Pipe and Foundry Co., 96 N.J. Eq.:_;36 (1924); Moran v. U.S. Cast Iron Pipe and Foundry Co., 95 N.J. Eq., 389 5:924:320011ins v. Portland Electric Power Co., 7 F. (2d) 16 was paid on the Class A preferred from October, 1913, un- til January 29, 1917. Then one per cent was paid quarterly until and including April 30, 1918. From then until May 25, 1925, no dividends were paid on any class of stock. During this period, the corporation had earned the Class A stock's dividend, but rather than declare any dividends, management chose to use some $16,000,000 (which closely ap- proximated the undistributed profits during the arrearage period) for working capital purposes. On April 1, 1927, Wabash paid a dividend on its second preferred and proposed to pay regular dividends upon the Class B and common stocks without first making good and paying out of surplus the earned but unpaid dividends up- on the Class A preferred. A first preferred holder sought to enjoin both the payment to the other classes out of current earnings and any future dividends until the corporation had first paid the earned but undistributed dividends of prior years on the first preferred. The majority of the Circuit Court of Appeals held that no dividend, even out of current earnings, could be paid on the subordinate stocks until the prior preferred had been paid in full the earned but unpaid dividends.l Recognizing that no dividend, other than in liquidation may be paid except out of earnings lBarclay v. Wabash Railway Co., 30 F. (2d) 262 (1929). 17 . . . cumulative dividends must be paid regardless of the year in which they are earned, while non- cumulative dividends paid any year are dependent upon the earnings of that year. If not earned in the particular year, the stockholders are not en- titled to dividends for that year and the deficiency cannot be made up out of surplus earnings of a sub- sequent year.1 The Court referred to the Norwich Water Co. v. Southern Railway Co. case2 which held that failure to declare non- cumulative preferred dividends within a year resulted in a loss to preferred stockholders of the right to demand that ui‘K-LH 1. .9) “a.- dividend but not a loss to the directors of their right .,____ n‘ 4 to pay it.3 The Court then summarized by stating that a failure by the board of directors to declare dividends on the non-cumulative preferred stock in years when money was earned resulted in giving the plaintiff stockholders a dividend credit entitling them to receive such dividends, and the board may not pay out dividends upon junior stocks until after these earned dividends of the preferred A are first paid and satisfied.‘I The majority decision of the Appeals Court was writ- ten by Judge Manton. Learned Hand vigorously dissented, taking the view that if the dividend was not declared on 11bid., p. 262. 2Virginia Law Register (N.J.) 203 (1925). 3Barclay v. Webash Railway Co., 30 F. (2d) 266 (1929). “Ibid., p. 267. 18 non-cumulative preferred shares, it was forever lost, even though it may have been earned.l Wabash appealed the Circuit Court decision and the last word on the subject was written by Mr. Justice Holmes, writing for the Supreme Court, who found for the Railway: When . . . the dividends in each fiscal year were declared to be non-cumulative and no net income could be so applied within the fiscal year . . . the right for that year was gone. i '- There was one important consideration underlying the Supreme Court's decision in the Wabash case—~that was the use of prior year's earnings for business improvement pur- poses to avoid having to pay non-cumulative preferred dividends. Justice Holmes stated that it was the common understanding of lawyers and businessmen that if directors justifiably apply the earnings of non-cumulative preferred stock for any one year to improvements in the business rather than paying a dividend the right to claim the divi- dend is gone and cannot be asserted later. It therefore has been the general interpretation of the Wabash decision that in order to stir a court to some sort of remedial action non-cumulative preferred share- holders must at least prove that earnings were retained in lIbido’ ppo 267-680 2Wabash Railway Co. v. Barclay, 280 U.S. 204 (1930). l9 conflict with the “wise administration of a going con- cern."1 However, since most boards of directors can readily discover some contingent liability or expan- sionary plan to justify the retention of earnings, this conclusion would be, as a practical matter, ineffective. The Wabash Rule would thus tend to check only the un- [I imaginative common stockholder's board. 3 An outstanding example of recent interpretations of this issue appears in the New Jersey Courts.2 Early interpretations of the New Jersey statutes concerning a, non-cumulative dividends, even after the Wabash case, held to bar nonacumulative dividend accruals for only those years without corporate earnings. The New Jersey Courts themselves, however, have apparently shifted towards the Wabash rule which wipes out non-cumulative claims for earned but undeclared dividends unless the action of the directors was arbitrary or unreasonable. 3 the Second Circuit In the leading New Jersey case Court held the Wabash case to mean that the board of directors could defeat non~cumulative claims by retaining earnings for any appropriate corporate purpose. More sig- lIbid., pp. 197 and 204. . .2Most court cases involving corporate questions have originated in New Jersey and/or Delaware, which are the two most important states of incorporation. 3Guttman v. Illinois Central Railroad, 189 F. (2d) 927 (1§5I72" 2O nificantly, the court went on to hold that once non- cumulative preferred dividends had been reasonably re- tained, directors had no power to distribute them to pre- ferred shareholders in later years. As a result, unde- clared, non-cumulative preferred dividends are truly for- ever lost even though the directors, at a later date, might deem it reasonable to compensate non—cumulative . 7' ins-near —n stockholders for earlier withholdings.l It has been charged that the Supreme Court confused the issue in the Wabash case by failing to distinguish between: (a) the discretionary power of the directors to «- determine the time of distribution and division of earnings; and (b) the contractual claim of preference (even if non-cumulative) to precede the common stock un- diminished by the failure of the directors to declare dividends each year.2 1This finding of the Second Circuit Court is rarely followed. American Car and Foundry made payments of their non-cumulative preferred after 1930 and in 1950 in the form.of previously passed dividends. In Diamond v. Darvis, 38 N.Y.S. (2d) 103 (1942), the directors were penmitted to pay a previously earned dividend to non-cumulative stock. It has been observed that nothing in the Wabash de- cision expressly prohibits a board of directors that had decided to withhold dividends for reasons of conservative financial policy, sound at that time, from re-examining and revising its policy in light of later events. 2Clifford M. Hicks, "The Rights of Non-Cumulative Preferred Stock-~A Doubtful Decision by the United States ggpreme Court," Temple Law Quarterly, V (June, 1931), 2. 21 The only real solution to the problem seems to be to have clear and explicit preferred and common stock con- tracts which would cover all possible situations. Only when this condition would prevail could the market price of the shares accurately reflect their relative rights. And stockholders would no longer need to resort to costly and time consuming court battles to learn just which rights they acquired when they purchased their stock. ‘Based on the decision of the Supreme Court in the Wabash case the relative rights of preferred shares re- garding dividend distributions can now be summarized. The general rule is that no dividend may be declared upon out- standing common shares until the rights of preferred holders to past and current dividends have been settled. The relative rights of different classes of preferreds are as follows: 1. Cumulative: Dividends accrue to the credit of the cumulative preferred shares at the stated dividend rate each fiscal period, regardless of whether they are earned or declared.l 2. Non-cumulative: Dividends accrue to the credit of lMany preferred shares are cumulative only to a stated maximum (usually lower than the annual dividend rate) per year or in total. Examples of this are two issues of the Curtis Publishing Co. One is a $4 prior preferred on which $3 is cumulative and an additional $1 is cumulative to the extent earned, the second is their $0.60-$1.6O prior preferred issue. .m I ‘.~ QTTJm—nlizazrm 22 the non-cumulative preferred shares only when the board of directors chooses to declare them. Should directors pass non-cumulative preferred dividends during any fis- cal period, the claim of the shareholders to those divi- dends is gone. 3. Cumulative-WhenwEarned: Dividends accrue to the credit of the cumulative-when-earned preferred shares on- ly to the extent that they are earned per fiscal period, -O—O.‘ regardless of whether they are declared. The maxi- mum accumulation per period is the stated dividend L~ rate a 1 1The importance of the basic differences between the three types of preferred is illustrated by examining how alternative accounting treatments can affect the relative dividend claims. Non-cumulative or cumulative-when- earned can suffer when profits are shifted from one year to the next so that the preferred can be cut off in year I and forced to share with the common in year 11. For example, assume a corporation is capitalized with 1,000 shares of $5 preferred and 1,000 shares of com- mon. During a given fiscal year it earns $3,000 but also incurs research and development costs amounting to $3,000. The board of directors is faced with two accounting op- tions for these costs; it can capitalize them for 10 years or write them off against current income. If the net in- come for the next fiscal year is $8,000, the claims of the preferred under each alternative accounting method, if no dividends are declared, are as follows: Type of Preferred Capitalize Expense Year I Year 11 Year I Year 11 Non-cumulative - 0 - - O - - 0 - - 0 - Cumulative-when—earned $2.70 $5.00 - O - $5.00 Cumulative 5.00 5.00 $5.00 5.00 23 The Cumulative Feature in Preferred Shares1 The cumulative feature usually appears or disappears respectively in new preferred contracts as business con- ditions become favorable or slacken. During the last stages of the industrial revolution the dividend was more frequently non-cumulative as the promoters of these en- terprises had serious doubts of their promised success. From 1897 to the present preferred issues have tended to be cumulative with lower dividend rates due to a greater confidence in the economics of large-scale production as a buffer against the abrupt fluctuations in earnings which fixed charges against the net income of the common (e.g.,bond interest) or quasi~fixed charges (e.gn cumu- lative preferred dividends) can cause.2 It is common, particularly in corporations not re- cently organized, to vest sole voting power in common shareholders with a provision shifting the exclusive vote to the preferred shareholders upon the passing of a cer- tain number of preferred dividends. While this provision was originally thought to satisfy the preferred holders, 1The balance of this study will be concerned with cumulative preferred and the rights and priorities which attach to this security. 2Arthur Stone Dewing, A Study of Corporate Securities (New York: The Ronald Press, 1934), pp. 169-170. 24 it is no longer popular or effective for two reasons; 1. The shift of voting power brings the preferred in- to the picture too late to save the corporation from re- organization, and these provisions tempt the directors elected by the common stockholders to declare doubtful dividends from a financial management point of view in or- der to maintain their share of the capital and control. 2. In actual practice these provisions are of dubi- ous value. The common stock management is usually able to perpetuate itself in control by the proxy solicitation mechanism at its disposal. The preferred shareholders do the voting but they, in essence, decide on the same proxies that would be presented to the common stockholders, had they the voting power. The effect of passed preferred dividends, which in practice is nothing more than the retention of annual earnings, tends to hit non-cumulative preferred stock the .hardest. Passing of a common stock dividend merely de- prives that stock of its present investment return while its aliquot property interest in the corporation appre- ciates correspondingly. Though this investment gain is subject to continuing business risk, common shareholders can theoretically realize their capital appreciation by the sale of some shares at presumably enhanced market prices. The non-cumulative stock, however, usually has the opposite market effect, and its price drops when its stmmumfl_m___u_fiI 25 dividends are passed. On the other hand, it is often thought that the cumu- lative preferred shareholders fare even worse than the non- cumulative when dividends are passed. The reasoning is as follows: Presumably investors in cumulative preferred shares were willing to pay some type of "premium" when purchasing their shares in return for the cumulative feature of their security. If cumulative dividends are passed, this reten- tion of earnings permits corporate use of back dividends {.43 ’3' ’.:t;fi':"m without payment of an additional return to the preferred shareholders.l This has the effect of lowering the return on the cumulative vis a vis the return anticipated, bar- gained and paid for by the shareholder when the invest- ment was made. The effect of accrued dividends upon the financial management of the firm can be very serious. When there are arrearages the corporation usually cannot raise addi- tional capital by the issuance of ordinary preferred or common shares. Even attempts to pay the arrearages may result in forcing the common shareholders to go without dividends for many years even after corporate earnings increase due to the drain on working capital and available 1There are some preferred contracts which provide for the accrual of interest on passed cumulative divi- dends. 26 legal surplus for dividend declarations. The passing of the dividends will affect the market for the common and may make it difficult for the company to borrow money, or if it can secure debt capital, it most probably will be at a relatively high interest rate. Should the firm resort to debt financing, it must turn to short term.unsecured loans or float mortgage bonds or prior preferred. The first alternative is only tem- porary; the second involves the risk of insolvency through additional fixed charges against net income. The third method, prior preferred, is the most practical, and if the corporation has reserved the power by majority vote to issue prior stock, this method is apt to be chosen. How- ever, if the new issue is subject to the accrued dividends on the old, then it would be no more saleable than the old. Cumulative Rights in Reorganization or Dissolution The last, and perhaps the most important, area of study in cumulative preferred contracts is the rights of cumula- tive preferred shareholders with dividend arrearages at the time of corporation reorganization or dissolution. Since reorganization or dissolution is most often the result of having accrued preferred dividends on the books for a lengthy period of time which prompted the common to attempt some sort of "fresh start," the rights of the cumulative . . u I 27 preferred holder are vital. If in addition to a provision for payment of capital on liquidation, there is also a clause for priority pay- ment of dividends, the majority of cases permit preferred shareholders to recover in the absence of undistributed earnings, in addition to their capital, the equivalent of what would have been the amount of dividends had there been earnings.l If the preferred stock contract grants only a prefer- ence to dividends, the preferred stock is not entitled to a preference in the distribution of capital upon liquida- tion.2 It is entitled to share ratably with the common stock in surplus accumulation prior to dissolution which, had the directors chosen to do so, might have been pre- viously completely distributed to common shareholders.3 If, however, there exists a provision for preference as to capital upon dissolution, the provision will define the full extent of the preference and thus preclude the pre- 1The normal purpose of the rule against payment of dividends from capital, that of protecting creditors in the amount of "legal" capital, would no longer exist since upon dissolution creditors' claims would have to be met in full before any attention can be directed to the distribu- tion between preferred and common stockholders. 2Llo d v. Pennsylvania Electric Vehicle Co., 75 N.J. Eq. 26 909). 3Continental Insurance Co. v. U.S., 259 U.S. 156 (I922). 28 ferred from sharing in surplus available after payment of the liquidation value on the preferred shares and the par or stated value of the common. The cumulative preferred shareholder, entitled to dividends irrespective of earnings, is interested in keeping a failing concern in existence until his dividends wholly exhaust the firm's common capital. On the other hand, a common stockholder is interested in forcing a dissolution or reorganization as early as possible be- cause then the capital assets will be divided, giving him an opportunity to share therein. Consequently, when the dividends of the cumulative preferred shares begin to ac- crue, the affairs of the corporation would be placed at the mercy of the conflict between the preferred and com- mon shareholders. The most serious question confronted here is the use of common capital to pay accrued but unearned preferred dividends. The nucleus of the discussion centers around the legal nature of the claim of the cumulative preferred stockholders to undeclared and unearned dividends with and without the presence of undistributed income as of the date of the reorganization or dissolution. The rights and priorities which the cumulative preferred holders have under various alternatives will be examined in the next chapter. CHAPTER II ALTERATIONS OF THE CUMULATIVE PREFERRED STOCK CONTRACT When cumulative dividends are not paid or declared in accordance with the preferred stock contract, these divi- dends form a type of contingent liability to the firm. Because of the adverse impact of these arrearages upon the financial management of the firm,boards of directors most often seek to eliminate or adjust these claims to give the corporation a quasi ”fresh start." Such a move is necessary because it may be the only one left which management can employ to place the company's capital struc- ture on a basis that can be consistently supported by its new earnings pattern. Rights of Arreared Preferred Stockholders The position of the creditor when his legal rights to receive payment of his claims are not satisfied is vastly different from that of the cumulative preferred share- holder. The creditor can bring suit to force the cor— poration into reorganization or liquidation. But the pre- ferred stockholder has no similar recourse when the cor- poration either fails to earn or pay preferred dividends. 29 _ “U i All. W. I} . 30 At the same time, however, the common shareholder sees the corporation continuing to operate with the burden of preferred arrearages hanging over its head, thus pre~ venting the prospect of any common dividend declaration. .Arrearage elimination plans are generally put forth at a time when the retained earnings begin to show a credit balance after periods of unprofitable operations. It is often desirable to offer a plan creating a "stock- holder reorganization.” It will usually subordinate or entirely abolish the claim of the preferred holders to their accrued dividends. These plans have the dual func~ tion of brightening the future of the corporation for possible additional financing and offering the common shareholders some prospect for future dividends. By the time the corporation recognizes the need to settle its arrearage accumulation, the interests of the preferred and the common shareholders may have become di- ametrically opposed. The preferred holder seeks payment in full of the accrued dividends together with no changes in his rights or priorities. On the other hand, the com— mon holder is interested in convincing the preferred holder to accept an adjustment of his arrearages so that the common will be able to participate in future earnings distributions more rapidly. However, if the corporation is still short of insolvency, the only way for the cor» porate structure to be reorganized is through an adjustment 31 between the conflicting claims of the preferred and com- mon shareholders. Methods of Settling Preferred Stock Arrearages An easy way to resolve the conflict is for the cor- poration to purchase the arreared preferred shares on the open market. By the purchase the corporation automatically diminishes the possibility that the accrued dividends will ever be paid on the still outstanding shares by reducing the fund of monetary assets from which the dividend pay- ments would be made. Conversely and paradoxically, a withholding of dividends helps to provide an asset fund for the purchase of the arreared shares while at the same time reducing the market price of the shares. Common shareholders can, in effect, accomplish the same result themmelves by purchasing the arreared shares. While the preferred shareholders have the oppor- tunity to stand upon their contingent right to a claim, in full, of the accrued dividends, as a practical matter the majority may be expected to take a somewhat less 1 must adamant position. Because the consent of the common be had for all adjustments, preferred shareholders must rely upon their cooperation. Thus the common, through 1Because the common stockholders usually control the board of directors via their voting control, they have virtually all say regarding dividend declarations and the method of reorganization. 32 and with the assistance of management, has the effective power to force the preferred to surrender many of their priorities and rights. Intuitively, such a situation may be difficult to accept since the preferred shareholders would be giving up their legal claims and priorities. However, the com- mon, usually in voting control, will have considerable latitude under their discretionary powers in declining to pay even earned dividends. Further, if there are no earnings but an actual impairment of capital, the common may well be reluctant to approve a "quasi-reorganization” or reduction of capital. Preferred stockholders are, to this extent, dependent upon cooperation from the common stock interests. Thus, the preferred holders may be "casually coerced" into accepting plans under which claims to past accumulations will be given up in the hope of re~ ceiving some future return in the form of dividends, no matter how small. Cash Payment The simplest method of arrearage elimination is cash payment in full of the accrued dividends. Certainly un- der this method there should be no charges of inequity from the preferred holders for they are receiving in dol- lars precisely what they bargained for when their investw ment was made. It is interesting to note, however, that 33 no case could be uncovered where a preferred shareholder has sued for payment of implicit interest or opportunity costs over and above the stated dividend payment.1 Other Methods Any other method of settling dividend arrearages in- volves changing the relative or absolute rights of the existing preferred shareholders with almost always a cor- respondingly lower future dividend rate. The most popu- lar techniques employed in adjustments are the charter amendment and the merger, consolidation or sale of all assets. As an important part of these methods issues of prior preferred are created which modify the interests of the older preferred. Before any of these methods is effectuated manage- ment must be sure that there is a strong enough corporate need to call for such a drastic action as arrearage elimina- tion. Certainly if the corporation is beginning to pros- per the financial strait jacket which arrearages place on it in the money and capital markets is virtually Brigg £2235 evidence that some sort of capital adjustment is necessary. No matter which method is selected there is always 1Some preferred contracts, however, do provide for the accrual of interest on preferred dividends in arrears (e.g., as in Roberts v. Roberts-Wick Co., 77 N.E. 13 (1906). 34 present the problem of the dissenting shareholder who in- sists that he has a vested contractual right which cannot be cancelled or changed without his approval, even though the majority or two-thirds of his fellow stockholders agreed to the adjustment. His only redress can be had in court. Many legal authorities feel that in addition to the stockholders, the state has a decided interest in the wel- fare of corporations to which it has granted charters. Thus, there is a strong belief that the state need not wait for a dissident stockholder to take action but should institute suit as an interested party. Professor Arno Becht has questioned the role of the state in cases of this nature and he raises some interesting issues: To prove a public interest, one has to find some way in which the accrued dividends interfere with the corporation's discharge of its functions. Ob- viously, it can go on rendering service and col- lecting the price without being affected by the ac- cruals. It is only when the corporation needs more money for its purposes that a public interest becomes even faintly discernible. . . . It has been argued that accrued dividends make management over-eager to pay dividends to the common stock and tempt it to engage in too risky enterprises, and answered that the fact that accruals can be re— moved will make the management more willing to en— gage in risky enterprises from the first. If the corporation wishes to borrow money it seems that accrued dividends should not stand in the way be- cause they are subject to creditors' claims anyway. (There is the possibility of) issuing stock for cash, prior to all the old classes, which is subject to the perhaps valid criticism that it further com- plicates the capital structure of the corporation and opens the road to future accruals on the new 35 class. But these doubtful claims of the majority and the corporation are offered in face of the certain fact that the common stock is getting present dividends at the expense of the preferred. Finally, even if it were true that preferred ac- cruals hamper financing, there is no vestige of reasons why a sacrifice necessary to get money should not come out of the senior class. The pre- ferred stockholders presumably pay more for a smaller return, bargaining for security. Such amendments keep the money and give the security to the class that neither paid nor bargained for it.1 Direct Removal When a corporation is burdened with preferred arrear- ages and at the same time does not have either the legal capital or funds from which to make a settlement, it may seek to effect a direct removal of the accrued dividends. The courts quickly made their feelings known regarding this method of arrearage settlement in the Roberts-Wick Co. case of 1906.2 The original capital structure of the Roberts-Wick Co. consisted of common shares and 6% cumulative pre- ferred shares which bore interest at 6% in the event of nonpayment of the preferred dividends. Because of a sub- sequent capital impairment amounting to $91,000, a re- organization took place which reduced total capital by one-third. The necessary legal plurality approved the LArno C. Becht, "Alteration of Accrued Dividends," Michigan Law_§eview, IL (January, 1951), 379-80. 2Roberts v. Roberts-Wick Co., 77 N.E. 12 (1906). 36 plan which left a surplus of $9,000. The plaintiff stock- holder, who originally held 250 preferred shares, voted against the reduction of the capital stock° However, she nonetheless surrendered her old shares, reducing her holding to 167 new shares. After the reorganization the company had profits of $15,000. The board of directors then ordered payment of a one per cent dividend on the common and payment of all accrued cumulative preferred dividends and the associated accrued interest. However, payment was to be based upon the number of preferred shares held Eggs; the reorganiza- tion, thus having the effect of wiping out, without con- sideration, the dividends and interest on the shares eliminated by the reorganization. Mrs. Roberts sued for payment of the dividends and interest on her original holding of 250 shares. The court first established the point that the pre- ferred holders with dividends in arrears were not en- titled to be paid from the surplus arising directly from the reduction of the capital stock, vis a vis subsequent earnings. But, more importantly, the court ruled that when a corporation has preferred stock with cumulative and interest bearing dividends and has reduced its capital stock and afterwards earned "surplus profits," the holders of the preferred stock had a prior right to a sufficient amount of the surplus profits to pay the arrears of divi- 37 dends on the shares held by them prior to the reduction of the stock and the interest on such dividends. In so doing the court became the first to attach the ”vested rights" stigma to accrued dividends, saying: Preferred stockholders . . . would still be "creditors" (quotation marks mine) for the ar- rears of dividends. . . . They may not have been creditors of the corporation in a technical sense; but as between themselves and other stock- holders they were as creditors, with demands to be fully paid certain arrears of dividends before any of the surplus profits should be appropri- ated to a dividend upon the common stock. As a result of this wording, the Roberts-Wick case has become one of the most celebrated references for the vested rights theory of accrued dividends. Further, it seems correct to say, based upon case study, that the Roberts-Wick case has led to the conclusion that the direct removal of accrued dividends, whether or not ac- companied by an exchange of shares, has been for the most part a failure. Charter Amendment Next to the straight cash payment of the arrearages the simplest method to effect an adjustment is through amendment of the articles of incorporation or the by~laws. The amending procedure is meant to function as a device for preventing what a corporate reorganization is supposed to cure-~business difficulties and failures-~without llbid., p. 15. 38 waiting for insolvency and the drastic and expensive pro- cedure of reorganization. As a matter of legal analysis it seems that an ac- crued dividend is not different from a dividend rate. A simple amendment to the corporate charter or by-laws changing or removing the accrued dividends it is not different in kind from one reducing a dividend rate, say, on the preferred. If this be true, the problems presented by accrued dividends are not different legally from those of an amendment of the dividend rate. While there seem to be some shreds of logic in this analogy, these reflec- tions have not prevailed with the courts. Early decisions show an extreme judicial reluctance to permit any tampering with arrearages. Subsequent cases reveal a continuous search by corporations for the means to avoid the pitfalls present in the earlier cases. This search has become so successful that, as will be seen in the discussion below, it may be said that accrued dividends are no longer as safe as they were although the old concept of their legal status still prevails.1 1In contrast to earlier cases, modern statutes per- mitting classification and reclassification of shares au- thorize very complex amendments. In more recent cases, the amendments may abolish the old preferred stock alto- gether replacing it with another class or classes. Some- times the old preferred is replaced in part by new pre- ferred and in part by common. The possible variations are infinite. 39 Most amendments affecting preferred shares are made under the state's reserved power to alter, amend, or re- place corporation laws. Any proposed amendment must first be critically examined from three points of view to be sure that it will meet all legal requirements. The first is one of construction to be sure that the power to make the amendment has been reserved or conferred by the language of the corporation charter or by-laws or the statutes of the states of incorporation. The second ex- amines the constitutionality of the amendment under the due process of law and contract right clauses.l A critical problem here is the enactment of corporation statutes sub- sequent to the granting of the charter and its effect on the interests of the dissenting stockholders. The third is a question of equity-~are the dissenters being treated unfairly. Charter amendments may be either direct or indirect. The direct charter amendment changes the corporate charter by a majority vote (or whatever plurality is necessary) lBecht (op. cit., p. 374) also remarks that relatively few of the cases involving arrearages have raised questions of constitutionality: "Considering the number of cases in- volving accrued dividends it is surprising how seldom con- stitutional questions concerning them have been raised. When a subsequent statute authorizes interference with them, the stockholders can claim that it impairs the obliga- tions of his contract and also that it takes his property in the corporation without due process of law. The argu- ment seems to have been made in relatively few of the cases in which it could have been." 40 to provide for an exchange of the old preferred for some other class. However, this type of amendment, with but few exceptions, has been held to be not valid since it is compulsory with respect to all stockholders. 1 In the benchmark Dartmouth case it was held that the corporate charter is a contract and thus cannot be changed without the unanimous consent of the stockholders, unless some power to effect the change is in the charter itself. So, if the authority to eliminate accrued divi- dends by a direct charter amendment is specifically con- ferred upon the majority or other required number, the amendment would be held to be valid. Wessel v. Guantanamo Sugar Co.,2 heard in the New Jersey Court of Chancery, was the precedent setting case on direct charter amendments. The complainants owned some 8% cumulative preferred stock with a $100 par value which had arrears of $112 per share. A plan of com- pulsory reorganization was offered which retired all of the preferred and cancelled the arrearages by giving the preferred holders a $40 principal, 5%, lZ-year debenture and fourteen shares of a new $5 par value common for each share of preferred held. The plan was approved by 75% 1Trustees of Dartmouth College v. WOodward, u Wheaton (U.S.) 518 (13l97. zwessel v. Guantanamo Sugar Co., 35 A. (2d) 215 (1944). #1 of the comon shareholders and 71+.ll+% of the preferred. The complainant opposed the plan on the grounds that it was inequitable as to him and illegal. The court held that since the plan was mandatory, the recapitalization is illegal and invalid as against the complainants. It drew the distinction with cases of merger or consolidation of corporations where the terms are not mandatory and preferred stockholders have the right to decline the offered terms and instead have their stock appraised and receive cash in payment therefor.l Two years after the court rejected this plan the company offered the preferred holders the voluntary choice between full payment of the arrearages and call price or an exchange for a new preferred stock. About one-third elected to receive the payment, amounting to $227 per share. The indirect charter amendment most often calls for the creation of a new preferred stock prior in preference to the outstanding preferred shares with respect to divi- 2 "Sister" amendments are then enacted dends and assets. which give the holders of the old preferred an opportunity to exchange their shares, dependent on a release of their 1Ibid., p. 217. 2See, for example, the method used in the Armour and Company 1954 recapitalization, infra, p. 111. 42 claim to the accrued dividends, partially or in full.1 This is technically different from the direct charter amendment since here any exchange and/or release of the arrearages is done voluntarily by the stockholders. The indirect charter amendment originates if the corporation does not have, or care to use, the power to remove accrued dividends directly. By assenting to the exchange of the old for prior preferred, the old preferred shareholders thus move ahead of the dissenters to the plan, making the old stock a less desirable investment. If the old shares are listed on an exchange, they will be removed in favor of the new preferred and thus lose their liquidity. While the amendment does not affect or change the absolute priorities of the old preferred, it does change the capital structure so that the relative priori- ties are affected. The effect of sustaining these amend- ments is to condone their use to induce the surrender of the accrued dividends. Also, the dissenters face the danger of losing out if liquidation is in view because the prior preferred would have first preference to assets 1Often the old preferred is convertible into prior preferred plus some common shares. If this arrangement prevails, the holders of the old preferred are made to bear part of the risks originally allocated to the com- mon while the latter is compelled to share its chance of unusual profits with a class of stock which did not bargain for that privilege. 43 after the claims of the creditors. There are two leading cases which illustrate the general position the courts have taken regarding amend- ments involving arrearage eliminations. Keller v. Wilson & Co. was settled on November 10, 1936.1 The original capitalization of Wilson included a 7% cumulative preferred, a 2d convertible, $5 cumulative preferred and the common. On February 1, 1935, the 7% preferred had arrearages totalling $26.25 per share while the 2d preferred arrearages were $21.25. On December 14, 1934, the board of directors voted to submit to the stock- holders a recapitalization plan converting the 7% cumu- lative into 6% cumulative (ratio of l.4292:l) and the 2d preferred into common with both conversions including cancellation of all accrued dividends. The plan and the charter amendment were approved by the stockholders with greater than a 99% plurality. Keller was the holder of some 2d preferred and sought to void the conversion of it and the cancellation of the arrearages and further to en- join a 12 l/2¢ dividend on the common declared on Febru- ary 26, 1935, before the accrued dividends were paid. The case centered around the right of a corporation to cancel accrued and unpaid dividends without the consent of each stockholder by amendment. lKeller v. Wilson & Co., 190 A. 116 (1936). 44 The court ruled that the right of a holder of cumu- lative preferred when the law did not permit cancellation of accrued and unpaid dividends without the consent of a holder is a "substantial right." This right constitutes a "vested right of property.” The statute authorizing amendments of a corporation's charter for the purpose of reclassifying stock did not authorize cancellation by charter amendment of cumulative dividends already accrued, since these were "vested rights of property.” The court went on to conclude that: Property rights may not be destroyed; and when the nature and character of the right of a holder of cumulative preferred stock to unpaid dividends which have accrued through the passage of time is examined in a case where that right was accorded protection when the corporation was formed and the stock was issued, a just public policy . , . demands that the right be regarded as a vested right of property. The cancellation of cumulative dividends is not an amendment of a charter. It is the destruction of a right in the nature of a debt. When the necessary corporate action is taken the status of the shares may be changed and the right thereafter to c1aim.the dividends as originally stipulated may be cancelled, but the amendment statute ought not to have a retro- active effect.1 A similar situation arose in the Consolidated Film Industries case of 1937.2 On October 1, 1936, the company had $2 cumulative participating preferred outstanding 11bid., p. 125. 2Consolidated Film Industries, Inc. v. Johnson, 197 A. 439 (I937). 45 with accrued dividends of $4 per share. On August 31, 1936, the board of directors proposed an amendment to the certificate of incorporation to change all preferred and the rights thereof to all accrued and unpaid dividends for 1 1/4 shares of a new $1 cumulative preferred and 1/4 share of common for each share owned. The necessary stockholders approved the plan. The complainant maintained two grounds for his suit: (1) that accrued dividends could not be cancelled by char- ter amendment (relying on the Wilson & Co. case), and (2) that the corporation did not have the power under the cer- tificate of incorporation to amend its charter in the man- ner proposed. Both Consolidated and Wilson & Co. were incorporated under the Delaware General Corporation Law. However, the two charters were different because when Consolidated was organized the law read that the corporation can change, by amendment, in its certificate of incorporation the re- lationship or other special rights of the shares. This provision did not exist when Wilson & Co. was organized. Another difference between the two cases is that Con- solidated's cumulative dividends had actually been earned while in the Wilson case the corporation had a surplus ’ but it was insufficient to meet the accrued dividends on both the first and second preferred shares. It should be noted, however, that the court did not consider it material 46 on the question of vested rights whether the dividends were earned or not. The court held in the Consolidated case that the owner of cumulative preferred shares was entitled to re- ly on his contractual rights until the accomplishment of the reclassification of the shares and the change of - their status by the necessary legal corporate action. It was held again, as in the Wilson case, that the cancella- tion of cumulative dividends already accrued through the passage of time was not an amendment of a charter.1 It seems clear from these two cases that in Delaware there is a decided reluctance on the part of the courts to approve plans for cancellation of earned dividends. .Also, the courts, with rare exception, do not inquire whether there are economic facts which make an amendment neces- sary even though it may adversely affect the property interests of the stockholders. The inquiry is rather di- rected towards a question of corporate power to act. Contrasting with Delaware are the New Jersey courts where the focal point is the existence of earned surplus at the date of the arrearage settlement. .As long as the surplus is composed of earnings, no matter when they came into being, the New Jersey courts will hold any adjustment plan unfair and inequitable which makes available to the 1Ibid., p. 493. ‘21??? . slur nIIV4 hid 47 common stock any part of a dissenting preferred share- holder's proportionate share of the earnings. The courts have held that the corporation must provide for the ac- crued dividends of the dissenting shareholders to the ex- tent of the available earned surplus, in cash or its equivalent. Since the relief granted is usually an in- validation of the plan with respect to the dissenter, no problem.arises as to payment of dividends from future 1 earnings on the new stocks even if they are prior pre- ferred.1 The general power to amend the articles of incorpora- tion or the by-laws has thus been held not to authorize the removal of the claims of cumulative preferred holders with respect to accrued dividends in the absence of unani- mous consent since it interferes with the "vested rights" of the preferred shareholders. It is rather noticeable that if one desires to deter- mine the basic reason why courts have refused to penmit charter amendments eliminating or adjusting arrearages little aid is found in the ”vested rights" claim, for the courts have generally tended to use the term "vested right" as that in the nature of a debt, which in fact accrued dividends are not. 1John F. Meek, Jr., "Accrued Dividends on Cumulative Preferred Stock: The Legal Doctrine," Harvard Law Review, ‘LV’(1942), llO-ll. 48 The vested rights argument of accrued dividends has been vigorously attacked by E. R. Latty when he stated, "besides begging the question it doesn't stand analysis despite the apparent acceptance by the courts. Accrued dividends are not debt and can't be enforced against the will of the directors. Vestedness is a legal conclusion rather than a reason.”1 The proposed charter amendments which involve volun- tary exchanges of the old preferred together with full or partial release of the accrued dividends have three effects: (1) It is in the interest of the common stock- holders to reduce the present and future claims of the old preferred as drastically as possible because the change would not affect them.and serves to increase the pressure on the dissenting preferred holders. (2) The amendment can create a time limit for the exchange, and after the expiration date the dissenters must keep the old shares subject to all of their disabilities. (3) The dissenters are hurt even more because the old preferred will gen- erally fall substantially in market value. 'One question which results from the decisions in- volving charter amendments concerns these so-called 1E. R. Latty, "Fairness--The Focal Point in Preferred Stock Arrearage Elimination," Virginia Law Review, XXIX (August, 1942), 3. 49 "voluntary" plans. That question involves the relief that should be given to the dissenters. Enjoining the entire amendment and thus keeping the status quo would most effectively prevent any interference with the rights of the dissenter. However, if the amendment is executed it binds those who consented to it as well as those dissenters who are unable to assert their objec- tions through legal means. Moreover, in many cases the amendment is illegal only so far as it affects accrued dividends.l Old stock no longer would be listed on ex- changes and the new would take its place. It appears that the courts have given relief against compulsory plans just as they have against the direct removal of the accrued dividends; but in only one state, New Jersey, do the courts enjoin the entire plan. In others, dividends on the common stock have been enjoined until the accrued dividends have been paid, but the remainder of the plans has otherwise been left operative.2 Immediately after the prior preferred is issued in an arrearage adjustment the dividend rights of the new stock must be settled, most particularly with respect to the accrued and current dividends on the old preferred. 1See the discussion of the Wilson and Consolidated cases, supra, pp. 43-46. 2The leading case here is Harbine v. Dayton Malle- able Iron Co., 61 Ohio App. 1 (I939). 50 The general position of the courts has been to permit pay- ment of the dividends on the new preferred even before any payment is made on the accrued dividends of the old. At the same time courts have generally given dissenters only an injunction against dividends on the common stock until the accrued dividends have been paid. The courts are thus placing great pressure on the dissenters to exchange their shares. No case could be found where the courts enjoined payment of dividends on the new until the old preferred had been paid both the accrued and current dividends. This may seem strange since this last alternative would give the fullest possible measure of protection to the old preferred holders. However, the courts have seemed to be most eager to assist corporations in removing the restraint of the accrued dividends, provided that the plan put forth is equitable. An example of the position of the courts in this matter appears in the American Public Utilities case of 1923.2 The plaintiff held 6% cumulative preferred stock on which a 4 1/2% dividend scrip had been issued while lBrickle v. Cuban American Sugar Co. 19 A. (2d) 820 HWY—‘1. ' 2Morris v. American Public Utilities Co., 14 Del. Ch. 156—(I923). 51 24% of dividends had accrued on each share. An amendment was adopted which created a prior pre- ferred, participating preferred and preferred stock, with the relative priorities in that order. The old preferred was the last but it could be surrendered with a cash pay- ment or dividend scrip totalling $7.50 for 8/10 of a share of participating preferred. The amendment apparently, but not explicitly, also destroyed the accrued dividends. The company, after the amendment was approved and ex- changes made, declared a dividend on the two prior stocks before payment of the accrued dividends on the old pre- ferred. The court held that the company had no power in the amendment to destroy accrued dividends but it also refused to enjoin the payment of dividends on the two prior stocks before payment of the accrued dividends was made, saying: The corporation has neither declared nor set apart from earnings any sum for a dividend on the common stock, nor is it threatening to do so. The payment of dividends to the two preferred classes created by the amendment which come in ahead of the class which the complainants hold is not in violation of the rights secured to them by their contract with the corporation.1 After reviewing the cases involving charter amendments, the following generalization can be made about the method which the courts would be most likely to sustain: "If the 11bid., p. 154. 52 power exists to issue stock prior to the old preferred, an amendment should be drafted offering such new stock in ex- change for the old. If the power also exists to reduce future rights of the old stock, make its dividends non- cumulative, take away its voting power and otherwise con- vince its holders that keeping it would be a bad bargain, these features should also be included in the amendment. It should then provide that the exchange of the new stock for the old be conditional upon the release of the ac- crued dividends. Finally, there should be a statement that if the dissenters wish to keep their old stock with its accrued dividends, they may do so."1 Merger, Consolidation or Sale of All Assets The use of a merger, consolidation, or sale of all the corporate assets is the most recently developed tech- nique employed to eliminate or adjust dividend arrearages. Because mergers and consolidations necessarily involve consideration of the capital structure of the new corpor- ation, the provisions for modification of the rights of stockholders of the constituent corporations are much broader than those of the amendment technique. The rela- tive stockholder rights depend primarily on the prevailing LArno C. Becht, "The Power to Remove Accrued Divi- dends by Charter Amendment," Columbia Law Review, XL ' (April, 1940), 639. 53- state statutes. In effect, these methods are similar to compulsory amendments which eliminate accrued dividends. In ahmost all states, statutes require approval of the merger or consolidation by some percentage of the shareholders. No statute was found requiring 100 per cent approval. Unlike early amendment statutes, many merger and consolidation statutes provide for appraisal and payment to dissenting stockholders. As a component part of the merger plan, a provision is made for compulsory exchange of the preferred stock and the accumulated accrued dividends for a new security. It is here that the courts, recognizing that legislation has long sanctioned such reorganizations to strengthen the financial position of a corporation and being aware of the appraisal remedy afforded a dissenting stockholder, are more likely to relegate the individual interests of the preferred stockholder to a position secondary to that of the corporation. There is one important limitation to the successful operation of merger plans. If the plan of the merger is unfair or inequitable (i.e., it is merely a fraudulent scheme to enrich the common or other group of stockholders at the expense of the preferred) or amounts to cancella- tion of arrearages without adequate consideration, equity, usually via appraisal, will aid a dissenting preferred stockholder to upset such a plan. Nonetheless it does 54 seem strange that while the states and courts have moved to protect accrued dividends from cancellation by amend- ment, they have permitted the equally easy method of merger. The leading case concerning this method is Havender v. Federal United Corporation.1 The company was incor- porated on January 25, 1932, with a $6 cumulative pre- ferred and Class A and B common. Federal subsequently merged with a wholly-owned subsidiary, Corporation Bond and Share Company. Under the merger plan, the preferred would be converted into one share of a new $3 preferred and six shares of common for each share of the old pre- ferred and all of the cumulative dividends in arrears, totalling $29 per share. The stockholders voted in the proper legal plurality for the merger but some preferred holders did not convert. Havender, a preferred holder who did not convert, brought suit to prevent the corpora- tion from forcing the conversion. There was no charge of unfairness or illegality regarding the merger plan. The decision was handed down by the Delaware Supreme Court, which was the same court which has repeatedly re- fused to sanction compulsory elimination of accruals by direct charter amendment, as in the Keller and Johnson cases. The court stated that: 1Havender v. Federal United Corporation, 11 A. (2d) 331 (19955. 55 The average intelligent mind must be held to know that dividends may accumulate on preferred stock and that in the event of a merger of the corpora- tion issuing the stock with another corporation the various rights of the shareholders, including the right to dividends on preference stock accrued but unpaid, may be the subject of reconcilement and ad- justment. . . . While their right to dissent is ad- mitted, public policy does not permit a dissenting stockholder, as against an affirmative vote of two- thirds, to veto a merger agreement if its terms are fair and equitable in the circumstances of the case. Within the time and in the manner provided by the statute, the dissenting stockholder if he so de- sires, may demand and receive the money value of his shares as that value has been determined by an impartial appraisal. In such a situation, the share- holder is not confronted, as was the complainant in the Keller case, with a proposed alteration of rights attached to preference stock and with no alternative right to demand and receive the value of his stock in money.1 Thus the court refused to uphold Havender's claim that the merger was effective to terminate claims of dissenting preferred shareholders to accrued unpaid dividends, claimed to be vested rights under the doc- trines of the Keller and Johnson cases. Summary The various ways by which the dividend rights of cumulative preferred holders can be modified or cancelled based upon court decisions and state statutes can now be summarized: 1. Direct removal of accrued dividends is legal only when the statutes expressly permit it. 1Ibid., pp. 338-39. 56 2. Indirect removal by issuing prior preferred and making other alterations damaging to the dissenters is sustained in most states. 3. Plans offering securities for the accrued divi- dends and the old stock are sustained if voluntary and enjoined if compulsory. 4. Mergers, consolidations, and the sale of all assets legally accomplish compulsory removal in most states 0 CHAPTER III THE SIGNIFICANCE OF PREFERRED STOCK ARREARAGES It has been a distinct contribution of American cor- porate jurisprudence to vest the power to declare divi- dends in the corporate directors. This is in sharp con- trast, for example, to the English custom where for many years the distribution of corporate earnings was under the control of the shareholders. The practice of having directors function for the corporation in de- claring dividends, impliedly sanctioned by statutory pro- visions rendering them liable for illegal distributions, began in America in the 1870s and became the basis of the law on the subject. The rule that declaration of dividends normally is within the discretion of directors may be limited in the. case of preferred stock. The dividend rights of common shareholders are most often dependent upon the general statutes and court decisions. The rights of preferred holders, however, are in general dependent upon the specific provisions in the articles of incorporation, by- laws, and stock certificates. Amounts of the preferred dividend are stipulated in these corporate documents to- 57 58 gether with what should be, but often is not, a definitive listing of the exact nature of the dividend preference as to participation and accumulation in addition to a state- ment of the extent of the preference over the common as to assets. Despite all of these precise characteristics, directors still have under their discretionary control the most important feature regarding preferred dividends-- the right to determine the timing of the dividend declara- tions. The remainder of this study will consider those in- stances where boards of directors have exercised this discretionary power regarding the timing of cumulative preferred dividend declarations and have chosen to pass the dividends so that at the calendar year end a company's cumulative preferred shares had dividends in arrears. History of the Arrearages The cumulative preferreds to be analyzed were taken from those listed on the New York Stock Exchange. The listed preferred issues were examined at five-year inter- vals from December 31, 1935, to December 31, 1950. From that point to December 31, 1962, annual examinations were made. The study began with the 1935 date because it is the end of the first five-year period after the Wabash decision which first differentiated between cumulative and non-cumulative preferreds. 59 Tabulations included only those preferreds listed on 1 Once in the Exchange when they first became arreared. arrears a stock remained in the tabulations even though it may have been suspended from trading on the Exchange be— fore settlement due to market prices lower than require- ments, lack of trading volume, or voluntary delisting. Thus many preferreds first become arreared on the New York Stock Exchange and then were delisted and traded elsewhere, most usually over the counter. The listings which were compiled here are by no means complete since there were many issues which became arreared and were cleared during the interim period between the tabulation dates. For purposes of this study only those issues 2 either cumu- specifically bearing cumulative dividends lative in full, to a stated maximum, or when-earned have been included. The tabulations reveal a total of 180 companies with 248 issues of cumulative preferreds in arrears. Seven of the 248 issues went into arrears, were cleared, and then went into arrears again, all within the study period. In Table l is a listing of the number 1A complete listing of all of the issues included in the study together with their dollar arrearages is in Appendix A. 2Cumulative dividends on both preferreds and Class A common were included. .4 Naocomm< ”monsom m~:.mm on m m m me «was mms.wm ma m o m as Home Hmm.mm m m m m on omma mem.mm a m m a ma mmma mos.~m on m m m an mama mam.mma ma m m a an swan www.mma ma 3 a m as mama mmm.asm ma m m m on mama ama.mmm ma m m m Hm swan www.mmm as s m m Hm mama mam.m>: on as m H mm mama smo.msm we on m H om Hmma acm.mmm a mm mm 0 mm omma mao.smo.a m :4 mm a Hma mama msm.m>o.a mm mm mm mm mes cams mm».swm » son as - - - - - - mmma Annuaaou .mu» on .mg» on HO mOOOV whack: QH dm>ofimm dmdv< GOfihom HO adm HOQEOOOQ mowdndouh< veauom no dam moancamom meadow Meow no pcooa< unwohu< ma moommm no hooasz mm-omma .msma .osma .mmma some» can you uxoOpm wouumuonm co umwsusouu< no vasconomun.a canoe 61 of issues in arrears for each point of tabulation to- gether with their corresponding dollar amount of ac- cumulated dividends. Table 2 has been compiled as a first step in ana- lyzing the causes of preferred arrearages and their set- tlements. In the table is a listing of the number of arreared issues by the year in which the cumulative pre- ferred dividend was first passed. Not surprisingly, the greatest concentration of issues is found from 1931 to 1933 and in 1938. In the 1931-33 period, during the depths of the 1930-33 de- pression, 124 issues, or exactly 50% of the issues in this study became arreared. In 1938, during which there ‘was a mild recession, fifteen issues or 6% had their dividends passed for the first time. These figures would lead one to attribute the lack of after-tax corporate earnings together with the need to conserve working capital, especially during times of a sluggish economy, as the foremost causes of the passing of preferred divi- dends. This conclusion is supported by Table 3 which lists corporate net income after taxes for the years covered by the study. There is a definite similarity in the year-by-year pattern of original preferred dividend passing and periods of low corporate net income. A second reason put forth to explain original ar- rearages was the desire to reduce the burden of the old 62 Table 2.--Year Dividends First Passed on Preferred Stocks in this Study J Year Number Year Number Year Number of Issues of Issues of Issues 1890 1 1931 so 1949 1 1905 1 1932 46 1950 1 1916 1 1933 28 1951 1 1918 1 1931 5 1952 1 1919 1 1935 7 1953 5 1920 2 1936 3 1954 3 1921 4 1937 4 1955 2 1923 2 1938 15 1956 2 1924 4 1939 1 1957 4 1926 6 1940 5 1958 2 1927 6 1941 l 1959 l 1928 2 1946 2 1960 3 1929 6 1947 l 1961 8 1930 6 1948 1 1962 2 Source: Appendix A. 63 Table 3.--Corporate Net Income After Taxes For the Years 1931-62 Year Amount Year Amount (In Billions) (In Billions) 1931 $(O.9) 1947 $20.4 1932 (3.8) 1948 22.5 1933 (1.1) 1949 18.4 1934 2.5 1950 25.4 1935 4.8 1951 21.6 1936 6.5 1952 19.5 1937 6.5 1953 19.9 1938 3.3 1954 19.8 1939 6.0 1955 26.1 1940 6.9 1956 23.5 1941 9.5 1957 22.3 1942 11.1 1958 18.8 1943 12.2 1959 24.5 1944 11.7 1960 23.0 1945 10.5 1961 23.3 1946 16. 3 1962 . .8 Sources: 1931-55: U.S. Department of Commerce, Historical Statistics of the United States, 1960, pp. 580-81; 1956: U.S. Department of Commerce, Statistical Abstract, 1960, p. 492; 1957-61: Ibid., IE3: P0 1‘95- 8Data not available. 64 1 There was excess profits taxation excess profits taxes. during three periods in our nation's history: 1917-21, 1940-45 and from July 1, 1950 to December 31, 1953. The excess profits tax, which was a surtax in addition to the regular corporate income tax, was applied to the ex- cess profits of a corporation earned during the duration of the excess profits tax legislation. In general, excess profits were defined as those profits in excess of one of two amounts: (1) a "normal" amount of earnings, usually the average earnings of a base period which was comprised of the years immediately prior to the enactment of the excess profits act, or (2) a stated percentage of the invested capital at the beginning of the taxable year.2 It is the use of the "invested capital" method which may have caused the passing of some preferred dividends. The World War I tax generally permitted a return of 20% on invested capital before the excess profits tax applied. The 1941 law permitted an 8% return (graduated from 5% to 8% from.l942 to 1945), while the Korean War legisla- tion allowed returns from.8% to 12%. l"Tabulation of Preferred Stocks in Arrears," Maga- zine of Wall Street Manual, 1941, p. 44. 2For a detailed description of the law see, Standard Federal Tax Repgrter, Volume VI (Hillside, N.J.: Commerce Clearing House, Inc., 1964), paragraph 6100. 65 Under the excess profits tax law, the advantage which accrued to a corporation that had passed its preferred dividends was the avoidance of the dilution of the invested capital base which would have taken place had the preferred dividends been declared. By so doing, the amount of ex- cess profits tax could be reduced or possibly eliminated. The importance of this reason for original arrearages how- ever, seemm to be relatively minor, since only a total of twenty issues went into arrears during the periods of ex- cess profits taxation. However, the excess profits tax may have been very instrumental in decisions not to pay any of the accumulated dividends on the preferred, thus causing the total dollar amount of arrearages to rise, while not affecting the number of arreared issues. Some interesting conclusions can be made by observing the relative dollar make up of the arrearages by indus- trial classification. The arreared preferreds will be divided into four categories: railroads, utilities, in- dustrials and other (usually financial corporations). The 248 arrearages included here were distributed among the industries as follows: Railroads: 28 issues or 11.3% Utilities: 25 issues or 10.r% Industrials: 189 issues or 76.2% Other: 6 issues or 2.4% 66 In Table 4 is the industrial breakdown of the number of issues in each set of arrearages, while Table 5 shows the relative dollar amount of each industry to the total dollar amount of arrearages for each period. The steady climb of the proportion of arreared pre- ferred shares of railroads from 1935 to 1950 illustrates the financial problems which confronted that industry during those years. Although the dollar amounts are a high percentage of the total, the ratios are somewhat mis- leading since the total railroad arrearages were primarily due to two issues: the Missouri Pacific 5% preferred which was recapitalized in 1955 dropping the proportionate dollar amount 16.1% and the Missouri-Kansas-Texas 7%A pre- ferred which was exchanged in 1958, cutting the relative arrears by 58.8%. Nonetheless, the railroads have, except for three years (1951, 1959 and 1960) always had a higher percentage of arrearages in dollars than in the number of issues. Even this is not too surprising since both the railroads and utilities could be expected to have, on the average, more preferred financing per company than the other two classifications because of their asset structure. A situation similar to that of the railroads is found in the history of the utility preferreds, with relatively few companies with several issues accounting for most of the dollar arrearages. Still, every period in which there ‘were arreared utility preferreds the proportionate dollar >0 H0000 anvnpo sHaH0000000 ssHpHHHpa mcdouafimm .owmpnmoummm .< denomm< “oohoom 0.00H 0H 0.0 H 0.00 0H -0- -0- 0.00 0 000H 0.00H 0H 0.0 H 0.00 0H -0- -0- 0.00 0 HO0H 0.00H HH -0- -0- 0.00 0 -0- -0- 4.00 s 000H 0.00H 0H -0- -0- 0.00 0 -0- -0- 0.0: : 000H 0.00H 0H 0.0 H 0.00 0 -0- -0- 0.00 0 000H 0.00H 0H 0.0 H 0.00 0H -0- -0- 0.H0 s 000H 0.00H 0H 0.0 H 0.00 HH 0.0 H 0.00 : 000H 0.00H 0H 0.0 H 0.00 0H 0.0 H 0.0H 0 000H 0.00H 0H 0.0 H 4.00 0H 0.0 H 0.H0 : :00H 0.00H H0 0.: H 0.H0 0H 0.: H 0.00 0 000H 0.00H H0 0.: H H.00 0 0.0H 0 0.0: 0 000H 0.00H 00 0.0 H H.00 0 0.00 0 0.00 0H HO0H 0.00H 00 -0- -0- 0.00 0H 0.00 0 0.0: 0H 000H 0.00H 00 -0- -0- 0.00 00 0.00 0H 0.00 0H 0:0H 0.00H H0H 0.0 H 0.00 :0 0.0H 00 0.0H 0H 0:0H 00.00H 00H 00.0 0 00.00 HOH 00.0H 00 00.0H 0H 000H «.0 .0 000000 0.0 .0 000302 0.0 .0 sagas: 0.0 .0 000000 0.0 .0 000000 000» 00-000H .040H .0s0H .000H 0000» on» 000 nofipmoauammdao HmHupmduuH hp mummhh< d0 moommH xoopm cannonanmcu.: mHnt 68 Table 5.--Annua1 Proportion of Dollars of Preferred Stock Arrearages in each Industry For the Years 1935, 1940, 1945, 1950-62 Year Railroads Utilities Industrials Others 1935 24.6% 21.7$ 52.4% 1.3% 1940 27.0 42.4 29.8 0.8 1945 29.3 51.7 19.0 -0- 1950 31.1 60.6 8.3 -0- 1951 28.9 63.0 8.0 0.1 1952 58.6 24.7 16.6 0.1 1953 66.9 10.4 22.6 0.1 1954 68.2 11.0 20.6 0.2 1955 52.1 16.8 30.8 0.3 1956 67.5 21.7 10.5 0.3 1957 86.5 -0- 13.0 0.5 1958 27.7 -0- 69.6 2.7 1959 27.9 -0- 72.1 -0- 1960 31.3 -0- 68.7 -0- 1961 30.9 -0- 68.7 0.4 1962 56.1 -0- 41.0 2.9 Source: Appendix A. 69 amount of arrears exceeded the number of issues. The opposite circumstance is found in the industrial classification. Until 1958, the proportionate number of issues exceeded the dollar amounts. From 1958 to 1961 the percentage of dollar amounts was greater than the num- ber of issues. However, this too is somewhat misleading since one issue, the Virginia-Carolina Chemical 6% par- ticipating preferred, which was exchanged in 1962, ac- counted for over 75% of the industrial dollar arrearages in the 1958-61 period. The industrial issues in arrears remained in a relatively stable proportion from 1935 to 1940 and from 1953 to 1962. From 1940 to 1951, however, there was a decided decline in the proportion of indus- trials, falling from 69.4% in 1940 to a low of 32.1% in 1951, rising again annually until 1953. The major reason for the increasing proportion of industrial arrearages is the recent elimination of preferred shares which has taken place in many railroad and utility reorganizations. The "other" classification of preferred contains only six issues and reached its maximum relative dollar amount of arrearages of 2.9% in 1962 when the relative signifi- cance of the $678,168 of Atlas Corporation's 5% preferred arrearages was magnified due to the overall drop in the total amount of arrearages. One last observation of interest is that at the end of 1962, railroad preferreds were 9.5% of all preferreds 70 listed on the New York Stock Exchange but were 27.8% of the number of preferreds in arrears; the industrials were 59.8% of the listed preferreds and 66.7% of those in ar- rears; others were 3.1% of the listed preferreds and 5.5% of the arreared; the balance of the listed preferreds were utilities.l History of the Arrearage Settlements The pressure on boards of directors to somehow remove the accrued dividends on the cumulative preferreds becomes greatest when the earnings of the corporation improve to a point where the common shareholders believe that they should begin to share in the prosperity. As a result, it is not unexpected to find that as corporate profits in- crease, arrearages are settled. However, the fact that earnings have recovered to levels which of themselves would have permitted sizable arrearage payments is no indication that the payments will occur. One reason is the need to build working capital to a level commensurate with the current and prospective 'volume of business. In addition there may be senior cor- porate_0bligations which have matured or are nearing maturity and require cash outlays before it would be pru- dent to make any substantial distributions to preferred 1Data from The New York Stock Exchan e Fact Book (New York: New York Stock Exchange, 19 ), p. I4. 71 stockholders, thus leaving a comparatively narrow margin for the preferred. The size of the preferred issue is another important consideration in determining the eventual treatment of the accrued dividends. Recapitalizations, for example, are quite common to large arrearages where cash payment would be financially prohibitive. Recapitalizations are usu- ally undertaken in good times when earning power is high and when the price of the common stock is also high. Offers to pay preferred arrears in common stock are usu- ally made nearer the top than the bottom of bull markets. And in order for the preferred holder to realize his ac- crued dividends in cash, he must be able to sell the stock he received in exchange for the arrearages at the equiva- lent of the dividend accrual, which would mean selling out at the top of the market.1 Another consideration in the settlement of accrued dividends is the prevailing money rates. At a time when money is "cheap" the high dividend rates on many of the preferred issues become a real financial burden. This suggests that when dividend arrearages are cleared up an attempt will be made to convert the outstanding preferreds into issues bearing lower interest or dividend rates, if this has not already been done in the process 1Herbert Lawrence, "37 Preferreds with Dividend Arrears," Barrons (December 18, 1939), 20. 72 of the arrearage settlement. A last consideration is the tightening of the undis- tributed profits tax in 1936. The Revenue Act of 1932 first provided for a surtax to be levied on a corporation's undistributed income that has been accumulated beyond the reasonable needs of the business. The surtax rates were raised sharply in 1936 which lead many to assume that many companies which had arreared preferreds would shortly resume the payment of preferred dividends. By resuming the dividends the amount of undistributed earnings would be reduced thereby reducing or avoiding the surtax. Nonetheless, there is no evidence that avoidance of this surtax was the motivating factor in most arrearage payments. Improved earnings and adequate finances seem to be the governing factors in guaging dividend prospects. Although the dollar amount of arrearages showed no significant drop until 1952 when two utilities with five preferred issues with arrearages totaling $503,877,000 'were exchanged1 the number of preferred issues in arrears ‘that were settled each period was substantial: From 1936 to 1940: 86 of 179 or 48.0% 1941 to 1945: 69 of 121 57.0% LAmerican and Foreign Power's $7, $6, and $7A 2d, preferreds and Standard Gas and Electric's $7 and $6 prior preferreds . 73 1946 to 1950: 29 of 53 or 54.7% 1951 to 1962: 46 of 64 71.9% Of the 248 instances of preferreds going into arrears, only eighteen were still in arrears as of December 31, 1962. Only two of these have been in arrears for over ten years with the average period for the other sixteen issues being 2.7 years and for all eighteen issues, 4.8 years. As discussed in Chapters I and II, there are five major methods of settling accumulated dividend claims on cumulative preferred stocks: 1. Recapitalization--including for the purposes of this study a corporate reorganization, recapitalization, or a simple exchange of the old preferred and accumulated dividends for a new preferred issue. 2. Cash payment of the accrued dividends. 3. Corporate merger. 4. Retirement of the old preferred at its call price plus payment of the accumulated dividends. 5. Liquidation. All five of these methods were used in the settle— ment of the 230 issues of arrearages which were cleared. In Table 6 is a listing of the methods employed by each industrial classification. The most significant factor in this table is the comparatively high percentage of full cash settlements which appeared in the industrial category vis a vis the other three. On the other hand, also of :0 .omdpqoouoms .< ~00c09m< "000500 0.00H 000 00.00H 0 00.00H 00H 00.00H 00 00.00H 00 sHsooa 0.: 0H -0- -0- 0.0 : 0.00 0 :.: H sOHpueHsqu 0L0 . 0H -0- -0- 0.0H 0H 1-0- -0- -0- -0- paoamsHpom 0.0 00 0.0: m m.> m0 0.00 m o.m0 m 00000: 0.00 00 0.00 H 0.00 00 0.0H 0 H.00 0 0003000 0000 00.:: 00H 00.0: 0 00.H: :0 00.00 :H 00.00 0H soHpsuHHapH0aoom 0.0 .0 .oz 0.0 .0 .oz 0.0 .0 .oz 0.0 .0 .0: 0.0 .0 .02 doses: 00009 000:00 masHupmouqH moHvHHHpD udsonaasm 000H 00. 000H 300.0 mupmsonH H0000 H00 momma-00.0.3 xoopm dmuuwhobm mappmm o». .0me 0695.02-16 0.309 75 significance is the relatively high proportion of recapi- talizations found among the utility and railroad pre- ferreds. These findings would tend to lead the potential in- vestor in arreared preferreds to turn first to industrial preferreds. The preferred stockholders in this category seem to have come out the best since most of the arrear- age settlements here were in the form of cash or retire- ments, where the investor cannot lose any of the accumu- lated dividends except for the opportunity cost involved in having to wait for his funds.1 With a recapitaliza- tion, the preferred investor benefits or suffers depending upon the market action of the new securities he holds. In general however, the arreared preferred investor whose securities are exchanged in a recapitalization cannot ex- pect to match the degree of success to be had in a cash settlement.2 It stands to reason that if a corporation cannot meet its old preferred obligations in cash the chances of its meeting the greater obligations that vir- tually always accompany a recapitalization are slim. More insight into the settlement of arrearages is had by considering the average length of time that a given lAn exception to be found in this study is the Pitts- burgh Coal 6% preferred which provided for interest on the arrearages. 2Examples of these types of settlements will be studied in Chapter V. [tr- 76 issue is in arrears before a settlement is made. This is done in Table 7. Table 7.--Average Time Taken to Settle Preferred Stock Arrearages for Each Method Used, 1935-62 W Settlement Time Issues (In Years) Method Involved Mean Mode Range Recapitalization 103 9.7 3 2-37 Cash 77 5.5 4 1-30 Merger 21 12.1 14 1-29 Retirement 19 6.4 2 1-19 Liquidation 10 13.1 . .a 1-23 Source: Appendix A. 8No uniquely identifiable mode. Not surprisingly, the seventy-seven arreared preferreds that were settled by cash payments were in arrears, on the average, the shortest period of time. Both cash payments and.retirements (which, in essence, are the same as cash payments except that the preferred issue is called and re- tired at the same time that the accumulated dividends are paid) have taken place in relatively short time. .And only under these two methods is the preferred holder 'guaranteed of complete satisfaction of his claims. Based upon the information in this table, the preferred investor should be alert when a corporation gets into such 'rs from: capit discu stock cruet W 77 dire financial straits that it passes cumulative preferred dividends for more than 6 1/2 years. For, when this oc- curs the stockholders will, more often than not, be con- fronted with an arrearage settlement plan of either a re- capitalization, merger, or an outright liquidation. As discussed earlier, under any of these three methods, the stockholder has a greater difficulty of realizing his ac- crued dividends in cash. Financial Significance of Preferred Stock Arrearages Comparative Macro-Analysis of Preferred Stock.Arrearages The relative importance of preferred shares on the New York Stock Exchange, as measured by the number of listed issues, is shown in Table 8. Does the slight de- crease in both the absolute number of preferred issues and the number of preferreds relative to the total issues listed imply that preferred financing is becoming passe? Table 9 shows that the dollar total of new preferred financing registered with the Securities and Exchange Commission during the study period levelled off in the last three years to about one-quarter billion, approxi- mately one-half the ammunt registered annually in the early fifties. What caused this drop? Two outstanding reasons appear: 78 Table 8.--Number of Stocks Listed on the New York Stock Exchange, for the Years 1935, 1940, 1945, 1950-62 Number of Number of Percentage of Year End Total Issues Preferred Issues Preferred Issues 1935 . .‘ . .3 - - 1940 . . . .8 - - 1945 1.269 395 31.1$ 1950 1,472 433 29.4 1951 1,495 441 29.4 1952 1.522 455 29.9 1953 1,530 461 30.1 1954 1,532 456 29.8 1955 1,508 432 28.6 1956 1,502 425 28.3 1957 1,522 424 27.9 1958 1,507 421 27.9 1959 1,507 415 27.5 1960 1,528 402 26.3 1961 1,541 396 25.7 1962 1,559 391 25.1 Source: New York Stock Exchange Fact Book (New York: New York Stock Exchange, 1963), p. 47. EData not available. .4. L311 1:“ bl... 79 Table 9.--Annua1 Amount of New Preferred Financing Registered with the Securities and Exchange Commission Compared to the Annual Amount of Preferred Stock Arrearages For the Years 1935, 1940, 1945, 1950-62 Annual Amount of Arrearages Percentage of Year Ending New Preferred Outstanding at Arrearages to June 30, Financing Year End New Preferred (in millions of dollars) Financing 1935 $ 288 $ 985 3,517.86% 1940 110 1,080 981.82 1945 407 1,097 269.53 1950 468 968 206.84 1951 427 ' 976 228.57 1952 851 474 55.70 1953 424 359 84.67 1954 531 353 66.48 1955 462 241 52.16 1956 539 196 36.36 1957 472 159 33.69 1958 427 27 6.32 1959 443 30 6.77 1960 253 30 11.86 1961 248 37 14.92 1962 253 23 9.09 Sources: U.S. Securities and Exchange Commission, Annual Report: 1962, p. 171; Table 1., supra, p. 60. 8For ten months only. 80 l. The dollar amount of new preferred financing has dropped presumably due to the impact of the 52% marginal corporate tax rate. Because preferred dividends are not deductible for tax purposes while interest payments on debt are many firms turned to funded debt for new financing to ob- ' “II tain this tax advantage. 2. For the same reasons old preferreds are also dis- appearing via sinking fund arrangements, outright retirements or exchanges for other securities. ‘7 4;. in ism The significance of the dollar amount of the preferred arrearages can be seen in Tables 9 and 10. Prior to 1956 the amount of preferred arrearages was greater than half of the total funds raised via new preferreds.l Likewise, until 1958 the arrearages alone amounted to at least 47% of the total preferred dividends paid on the New York Stock Exchange. While the $23 billion of arrearages as of December 31, 1962, is small relative to the amount in as recent as 1951, the 1962 arrearages still represent 9.09% of the new preferred stock financing for that year and almost 1The percentage of arrears to new preferred issues on the New York Exchange would be even higher since SEC registration is required of all companies whose securi- ties are publicly held, not just those listed on the Ex- change. 81 Table 10.--Annua1 Dividends Paid on Preferred Stocks Compared to the Annual Amount of Preferred Stock Arrearages For the Years 1935, 1940, 1945, 1950-62 Estimated Aggregate Year PreferredDividendsa Arrearages (in thousands of dollars) Percentage of Arrearages to Dividends Paid 1935 . .g 3 984,726 -- 1940 . . 1,079,978 -- 1945 $337,203 1-097-019 325-33$ 1950 379-315 968-301 255.28 1951 380,367 975,664 256.51 1952 377-564 473-515 125.38 1953 383-323 359-255 93-72 1954 367-805 353,191 96.03 1955 335-532 241-638 71-99 1955 332,998 195,752 58.78 1957 334-554 158-596 47.41 1958 331,414 27,405 8.27 1959 335-544 29,503 8.77 1960 330-983 29:921 9.04 1961 340-925 36.735 10.78 1962 336,283 23,472 6.98 Sources: New York Stock Exchange Fact Book (New York: New'York Stock.Exchange, 1963), p. 47; Table 1., supra, p. 60. .Dividends paid on preferreds listed on New York Stock Exchange only. hbata not available. 82 7% of the total preferred dividends paid. Real progress has been made in reducing the dollar amount of the arrear- ages. How much this progress has aided or harmed the preferred shareholder will be looked at in Chapter V. It is evident that despite the presence of large amounts of arrearages that were present in the early fif- ties investors were continuing to put their money into new preferred issues. Presumably then investors do not direct their attentions to what can happen to the pre- ferred if business turns bad or if the directors choose to withhold their dividends, even though earned. It seems that investors, if they consider anything at all, would more probably direct their attentions to what is likely to happen or what has happened most frequently in the past. Effect of Other Preferred Stock Features on Arrearages However, notwithstanding these considerations, there are two ways by which preferred investors can protect them- selves against future events, both of which offer a po- tential sharing in residual profits after the stipulated preferred dividends have been paid. The first, the par- ticipating feature, offers the preferred an opportunity to share in some predetermined ratio with the common in any earnings distributions made after the common has re- ceived the same amount per share as the preferred. 83 The tenms of participation may take on different varia- tions of this form. Participating preferred are rela- tively rare with only six issues appearing in this study. The second feature, convertibility, is a more popu- lar added inducement of preferred issues which may op- erate in favor of the preferred shareholders both when preferred dividends are being paid and not. There are forty-six convertible issues in this study. The conver- sion privilege permits the preferred shareholder to con- vert his stock into a stipulated number of common shares whenever he believes that it is to his advantage to do so within the time specified. Of course the corporation can force conversion by exercising its call privilege if the conversion value of the preferred has risen substan- tially above its call price. The chief difference be- tween the participating and conversion privileges is that under the latter the preferred stockholder is forced to give up his preferred position in order to enjoy the in- creased income. When a preferred issue becomes arreared, both the participating and most usually, the conversion features cease to have value. Clearly the participating privilege is worthless, since while the preferred is in arrears no dividends can be paid to the common, hence no participa- tion. With the conversion privilege however, it is diffi- cult to make a flat statement. Usually the cause of a 84 preferred going into arrears is the lack of earnings, and this in itself would usually drive down the price of the common enough so that conversion would be unwise. How— ever, it is not too difficult to visualize a company per- mitting its preferred to go into arrears when there are enough earnings to pay the preferred dividends, but where working capital is in a tight position and where there is 4 a small proportion of preferred stock in the total capi- talization. Here there is a distinct probability that the conversion value of the preferred may warrant exercising because the market may well view the situation as tem- porary and ignore it. Arrearages and Investor Reaction It would be interesting to know the proportion of preferred investors who realize that, with respect to their investment in cumulative preferred stocks having no guarantee of dividends, the majority of cases have held that directors have the discretionary power to refuse pay- ment.1 At first blush, cumulative preferred shareholders may feel that they have little cause for alarm and com- plaint if the directors should pass a current dividend, even though earned, because this dividend will have to be 1See for example: Hastin s v. International Paper Co., 175 N.Y.S. 815 (l9l§5; Fernald v. Frank.Ridlon Co., Ito N.E. 421 (1923). """"'"" 85 paid before distributions can be made to the common share- holders or at liquidation if the stock certificate provides for a preference as to dividends as well as capital. Ac- tually there is the possibility of serious damage to the preferred. Non-payment actually subjects the accumulated earnings not yet distributed to the cumulative preferred holders to the general risks of the business. Subsequent bad times for the particular corporation or a general de- pression may erode the undistributed profits entirely, pre- venting any future dividend payments. If not actually lost by business reverses, the accumulation of large preferred arrearages will, as discussed in Chapter II, frequently result in pressure from management and common shareholders for a recapitalization to wipe out the arrearages so that the barrier to future common dividends will be removed. With the great number of the preferred which have ended in recapitalizations, mergers and liquidations, one may wonder why any investor would be interested in ac- quiring preferreds with accrued dividends. Yet arreared preferreds often present a distinct opportunity for profit. The average investor has a habit of overlooking this po- tential. When he thinks of monetary safety his first thought is of a high grade bond; when he thinks of par- ticipation in the improving earning power of some business he naturally turns first to common stocks. Thus preferreds 86 have become a kind of no-man's land of investments-- neglected by investors and speculators alike. As a re- sult of this one can many times find a high grade pre- ferred that affords a return higher than that which can be obtained from a bond of equivalent quality. For speculation on natural business recovery or ac- tive inflation arreared preferreds offer opportunity for profit. The news that preferred dividends will be resumed 1 or just that the corporation is attempting to find some means of settling the arrearages is usually enough stimuw S T.— 71392“ _ lus to cause an increase in the market price of the pre- ferred.1 Further, the investor in an arreared preferred stands to better his rate of return when the arrears are paid, provided that the market price at the time of acquisition had not already been discounted on the basis of the out— standing arrearages. For example, assume a share of $5 preferred was acquired at a price of $80 several years ago when there were $10 of arrearages attached. Provided the price of $80 does not reflect the probability of a rapid clearing of the arrearages, the investor's cost would be reduced to $70 when the arrearages were paid»- thus viewing them as a return of capital, as in the case of a bond purchased in default. After the $10 recovery 1Cases of this will be observed in the next chapter. 87 the preferred shareholder‘s annual rate of return would rise to 7.1% ($5/$70) from the 6.25% ($5/$80) received be- fore the recovery. The Treasury Department however, does not recognize the $10 as a return of capital but taxes amounts received in discharge of accumulated unpaid divi- dends as income in the year received.l Social Significance of Preferred Stock Arrearages The second aspect of preferred arrearages is their ef— fect upon society, mainly as a question of equity or fair- ness. It is here that the discretionary power of the directors regarding dividend declarations should come un~ der close scrutiny. As Johnson points out: If the financial manager has the interest of the common stockholders at heart, he will recognize that failure to pay preferred dividends also means failure to pay common dividends. Consequently, contentment on the part of the common stockholders depends upon prior satisfaction of the preferred shareholders. Moreover, many corporate directors believe that the terms of their agreement with the preferred stock- holders carry a moral commitment to treat the obligation to pay preferred dividends with almost the same respect as they view the interest require~ ments on a bond issue.2 Even where the preferred dividend is nonwcumulative it has been held that directors have the usual discretion 10.8. Treasury Department, Internal Revenue Service, Special Ruling, January 29, 1951, 515 Commerce Clearing House. 2Robert W. Johnson, Financial Management (2d ed.; Boston: Allyn and Bacon, Inc., 1962), pp. h85-#86. 88 in refusing to declare dividends from earnings.l In addi- tion, in those jurisdictions following the Wabash de— cision,2 if directors are given the same type of discretion as they have with respect to common stock, serious injus- tice to non-cumulative preferred shareholders may result. Under the broad application of the Wabash Rule, the non- cumulative preferred dividend, though earned, is lost forever if not paid. Often, however, non-cumulative pre- ferred stock will be issued upon a reorganization when it definitely is not the purpose to impose anything re- sembling a compulsory charge upon the corporation. During the period of rehabilitation, sufficient latitudes should be accorded the directorate in declining to declare divi- dends. However, after the recovery period a considerably closer scrutiny of the directors” actions in withholding dividends on non-cumulative preferred when earned is necessary. Usually a non-cumulative preferred stock is not a de- sirable investment holding because of this discretionary power. Its existence is a standing inducement to the 1See McLean v. Pittsburgh Plate Glass Co., 28 A. 211 (1893); and Morse v. Boston & Me. R. R. Co., 160 N.E. 894 (1928). 2Wabash Railway Co. v. Barcla , 280 U.S. 204 (1930), discussed here at supra, pp. 15—19. 89 improper passing of dividends. It is a standing invita- tion to the directors, unless their ethical standards are high, to administer the corporate finances to the advan- tage of the common shareholders. It is now easier to see and appreciate why preferred contracts are written as cumulativeuwhen-earned. By having preferred of this type the stockholder is partially able to overcome the directors' discretionary right to -,J a 'nIl‘::b.1-*z-7 \ omit dividends when they have been earned. The crucial question is that even without this legal requirement, do corporate directors feel a strong enough moral obligation to pay 322 kind of preferred dividend at least, as a mini- mum, to the extent that the dividend is earned in any one year? The problem of the cumulative preferred shareholder is even more acute. Given a company having two issues of preferred outstanding bearing the same contractual rights, except that one is fully cumulative while the other is non-cumulative, it would be expected that the fully cumu~ lative issue would command a higher market price because the risk of non-payment of dividends is less since the c1aim.to the dividends is more certain. Because of paying this "premium" the cumulative preferred holder anticipates a return commensurate with the security he obtained. However, here again, even though the claim to the dividends may be more certain, it is only more certain in 90 a relative sense. As we have seen, the discretionary power of the directors continues in effect with cumulaw tive preferreds as well. We have already discussed the two practical limita- tions on dividend payments of lack of available earnings and lack of cash. However, when earnings are present r. and there is available cash to pay the cumulative divi- 5 dends, if the directors still choose to pass the divi- dends, they are, in effect, depriving the preferred shareholders of their bargainedwfor return. The direc— tors are using funds which should have been distributed to the preferred holders without paying the shareholders an additional return for the use of their capital. There can be no doubt that in the typical inw vestor's mind incidents of favor, preference and pri- ority are ordinarily associated with preferred stock. However, the directors have the power to ignore these preferences and deny them all. When is the exercise of this power fair to the preferred shareholders? As will be seen when some case histories are examined in Chapter V there are many cases where directors chose to use funds for working capital purposes which, had the preferred stock been bonds, would have been distributed as interest. Should this discretionary power of the directors, of withholding earned dividends, be subjected to some sort of test in order to determine the equity of the 91 situation? It seems that some standard must be estab- lished to apply to directors‘ actions when they with« hold earned dividends on preferred. The traditional rubber stamping by the courts of every action of the directors which does not harm the corporation on the them ory that it is an exercise of “business judgment” appears to be basically unsound with respect to the preferred stockholder. Certainly when arrearages of 207% of the total new preferred financing can be present in a given year as was the case in l950~wa year of substantial business improvemento-it seems that some new theory which transcends that of "business judgment” must be devised. If business judgment means judgment which benefits the stockholder or the corporation, nearly every with- holding of income and every reduction of investor‘s rights in favor of the corporation becomes good business judgment. The only limitation would be the need to make future preferred stock issues attractive to investors. But the more money that a company retains, the less need it has to attract preferred stock investors, in par~ ticular due to the inherent tax disadvantage. In almost all cases observed where the cumulative dividend could have been continued but instead was withheld ”for the sake of the stockholder's future advantage," the quoted price of the preferred suffered a severe decline, in» dicating that the investment market did not agree with the 92 directors as to what was really sound ”business judgment" regarding the preferred investor.l The respective claims to dividends of preferred and common shareholders are hardly on a parity. The entire history of common stock is the theory of venture capital and primary risk, with the distribution of profits de- pendent upon business expediency as the directors see it; whereas the purpose underlying preferred stock, as far as dividends are concerned, is the desire for greater . . a" .a'1W: argfimvh"? regularity of time and certainty in amount of the dividends than would be true with the common stock. The stipulation upon issuance of preferred stock to pay dividends out of earnings very much resembles a fixed charge; it is like common in that no payment can be made until creditors are satisfied--that is, the distributions of dividends must be out of earnings; but it is like a bond in fixing precisely the amount to be paid. Like com- . mon, the right of preferred shareholders to dividends should be subject to the discretion of the directors to retain the earnings in the business when there is a real 255g, Unlike common, the presumption should be in favor of the preferred shareholder when he shows that the cor- poration has earnings sufficient to pay a dividend. The lBenjamin Graham, D. L. Dodd, and Sidney Cottle, Security Analysis (4th ed.; New York: McGraw-Hill Book Co., Inc., 19627, p. 380. 93 burden of proof should properly fall upon the corporation and its directors to show that a dividend should not be paid. Summary The great power which boards of directors have over the steering of corporate earnings with respect to their preferred shareholders is demonstrated in Table 1 showing 2 the total arrearages of those cumulative preferreds listed on the New York Stock Exchange and in Table 9 comparing the dollar amount of arrearages to the total funds raised i— from new preferred financing. In addition to this finan- cial aspect of arrearages there is the question of sound- ness from an ethical and equitable point of view of direc- tors withholding earned cumulative dividends. The central issue in this problem is how many prea ferred investors realize that the security is subject to the above discussed discretionary action together with the relative ease of amending the preferred contract, as discussed in Chapter II? Becht suggests that this probe lem.can be overcome by having the preferred stock cer~ tificate bear on its face a statement that it is subject to alterations in a great variety of ways, most of which are to its detriment, and that if business is bad losses will be forced upon the stockholders regardless of the liquidity and other paper preferences. It seems not un- likely that the corporation will find that the temporary 9h expedients it adopts will make it more difficult to at- tract that part of the market which prefers security to speculation, the very thought behind preferred stock.1 LArno 0. Becht, "Alteration of Accrued Dividends," Michigan Law Review, IL (February, 1951), 594. ’ .‘r Thi— ‘- My. CHAPTER IV ARREARAGES ON CONTEMPORARY PREFERRED STOCKS We shall now turn from the overall significance and trends of preferred arrearages and concentrate on the more .3337! aim ? ‘5') n, ., recent experiences of cumulative preferred stocks from L‘ L 1950 to 1962. The purpose of this investigation is to see if there are any indications in this period of the future trend of preferred arrearages. 4 From 1950 to 1962 thirtwaive issues of cumulative preferred stocks went into arrears.l Among these were thirty corporations; two issues went into arrears twice.2 There were four railroads, no utilities, twentywnine inw dustrials and two ”other“ preferred issues in the group. 0f the thirty-five preferreds, sixteen were still in arrears on December 31, 1962; fifteen were cleared with cash payments, one issue was retired, two corporations were recapitalized and one merged. The very high proportion of cash arrearage settle~ 1Table 2, supra, p. 62. 2A complete listing of the thirty-five issues, their arrearages, earnings and working capital position is in Appendix B. 95 96 ments together with the relatively few recapitalizations is indicative of the fact that by the fifties most firms had "put their houses in order” and found their present capital structures satisfactory. Therefore, the lapses in dividends on contemporary cumulative preferreds should not be viewed as the result of awkward capitalizations but rather, in general, as nothing more than temporary withholdings of the dividends until the firm had both the earnings and the working capital to pay the preferred .- v R."'."-.‘ -‘( . 411-".i‘LE-‘U—‘r dividend requirements. Arrearages and Preferred Earnings The original arrearage in thirtywtwo of the thirtyw five issues occurred during fiscal years when there were net losses. 0f the three cases where there were earnings, in one, the Lehigh Valley Coal Corporation, $3 first prew ferred, cumulative to the extent earned, the dividend was not earned in full. In the other two instances, the 4 1/2% Cudahy preferred in 1953 and the Van Norman $2.28 convertible preferred, the earnings of the preferreds were more than the preferred dividend requirement. Thus continuing evidence is uncovered to support the lack of earnings as the prime reason for the passing of cumulative dividends. In fact, among the sixteen issues still in arrears at the end of 1962, only one has earned enough since the stock went into arrears to cover the arm rearageSweEndicottaJohnson Corporationis 4% preferred 97 earned $8.58 per share in 1962, over four times the $2.00 arrearage. This company, however, has paid half of the preferred dividend requirements during both years of its arrearages. Three issues, General Baking's $8 preferred and Pittsburgh Steel's 5% and 5 1/2% all earned part of their total arrearages in 1962. But in all three cases, no dividends were paid. When there were corporate earnings during this .‘ .31.. - *‘27‘:ii (inseam-4.1 period it was noticeable that boards of directors did make some effort to pay at least part of the preferred dividend requirement. Ten companies made payments on the accumulated dividends of their preferreds when current earnings were present. A good example of this practice is the experience of the Gar Wood 4 1/2% convertible pre~ ferred. Here the corporation paid out at least part of the preferred dividend requirement whenever earnings were present. Just the opposite situation is found in the Spear & Co. $5.50 preferred where full dividend payments ‘were made for three years although there were no pre- ferred earnings. Fourteen issues, including twelve still in arrears, had no earnings while they were in arrears and likewise paid no dividends. Viewed from the other side, that of settlement, the relationship between earnings and arrearages appears to continue. Eleven of the fifteen arrearages cleared with cash payments were settled only when preferred earnings 98 were present. One of the other four, the Van Norman $2.28 preferred, first merged, then had the arrearages paid and finally was exchanged for the stock of the new company, Universal American Corporation. Only Min- neapolis Moline Company and Spear & Company paid their arrearages when there was no preferred earnings. How- ever, one may speculate that the small dollar size of these two arrearages, $98,000 and $26,000 respectively, both less than one per cent of their company's working capital, may have influenced the decision for payment. 0n the other hand, of the four issues with non- cash settlements, in only two cases, the recapitaliza- tion of the Lehigh Valley Coal Corporation and the re- tirement of the Amalgamated Leather 6% convertible pre- ferred, were there any preferred earnings during the ar- rearage period. The other two issues had no preferred earnings up to the date of settlement. Other Considerations While we have seen that the expected pattern between earnings and dividends exists for contemporary preferreds in arrears, it was difficult to extract any type of pat- tern between the dividends and the working capital. In many cases, the amount of the arrearages was less than one -«i-L. f. a}'_S§ . ‘. 'h “‘1.11. 3‘ ., 99 per cent of working capital. In five corporations1 the working capital was less than the arrearages and at times was negative (i.e., current liabilities were greater than current assets). This situation was present in three companies at the end of the first year of arrearages, which may well have been a contributing factor in the de- cision to pass the dividend. The absence of utility shares among the current pre- ferreds which were in arrears and the relatively few rail- road stocks, both in number of issues and dollar amount, stands out. It is difficult to attribute any one cause to this other than that by the fifties most of the firms in these two industries had been relieved of the burden- some roles which cumulative preferred stocks formerly played in their capitalizations via prior mergers or re- capitalizations. However, probably the most outstanding feature of the thirty-five issues being reviewed is the general tendency of boards of directors to treat cumulative pre- ferreds as cumulative only when enough is earned to cover all of the prior arrearages. It appears that no matter how the preferred contract is written boards of directors will still, in general, declare cumulative 1J. 1. Case Co., United States Hoffman Machinery Corporation, Chicago and Eastern Illinois Railroad, New York, New Haven and Hartford Railroad, and the Hotel Corporation of America. 100 preferred dividends only when there are current earnings to support them.1 This of course, aside from the element of timing, has no effect on those preferreds settled by cash payments or retirements. But, to those preferreds settled by recapi- talizations, the effect may be severe. As we have seen, r~ times for recapitalizations have not depended upon the presence of earnings as have cash payments. Because boards of directors are reluctant to declare cumulative preferred dividends without the presence of earnings, and because 1 capitalizations usually take place after periods of ex- tended losses, the preferred shareholder is unlikely to receive any dividends even if his shares are cumulative. This, of course, has the effect of converting cumulative preferreds into non-cumulative shares. Thus, the value of 1There are, however, some notable exceptions. During the period 1950-62, there were eight cumulative preferreds listed on the New York Stock Exchange on which dividends were paid every year even though the dividends were not always earned. The stocks and the years in which the divi— dends were not earned are: 1. Colorado Fuel and Iron, 5 1/2% B (1960 and 1962). . Coéumbia Pictures Corp., $4.25 (1958, 1959 and 19 1. Continental Copper, 5%, (1961 and 1962). Kroehler Manufacturing, A l/2% A (1961). Publicker Industries, $4.75 (1958, 1955, 1957- 59, and 1961-62). U.S. Industries, Inc., 4 l/2%.A (1959 and 1960). United States Smelting, 7% (1953, and 1957-60). Ward Baking Co., 5 1/2% (1961 and 1962). m~qox Lntwo N 101 the cumulative feature is lost. This problem will be studied at depth in the case studies of the next chapter. Conclusion The problem of the long and large accumulations of arrearages on cumulative preferreds both as to number of shares and dollar amount seems to be a thing of the past. Most indicative of this trend is the fact that contemu porary preferred arrearages have existed for shorter peri- ods of time than in the past. This is supported by: l. The short time it has taken to settle contem~ porary arrearages compared to the average time for all of the issues included in Appendix A of this study. Current cash settlements took only 3.7 years on the average versus 5.5 over- all; the two issues recapitalized were in ar- rears for three and five years versus the over- all average of 9.7 years.1 While there is a natural bias for the averages of the contemporary preferreds to be lower since the sample was taken from a set of fewer years than the overall set, the bias is not as severe when the second indicaw tor is considered: 2. Contemporary preferreds with accumulated dividends 1From Table 7, supra, p. 76. 102 as of December 31, 1962 have been in arrears for a relatively short time. Their average is only 2.7 years and none has been in arrears for more than seven years. It was during the 1930a33 depression that the problem of preferred arrearages became acute. Because of depressed _fl_ earnings boards of directors passed preferred dividends and forced cumulative issues into arrears. Since that time, however, the economy of our country has not been so tested. It is unlikely that arrearages as large as those en- countered in the thirties and forties will ever reappear. There are two major considerations which lead to this con- clusion: 1. The reduction in the absolute number of old cumu- lative preferred shares in corporate capitalizations be- cause of retirements and/or recapitalizations within the last twenty-five years. 2. The decline in popularity of new preferred financing. CHAPTER V THE VALUE OF THE CUMULATIVE FEATURE IN RECENT ARREARAGE SETTLEMENTS Introduction In his classic work on corporate securities Arthur Stone Dewing makes the following statement: "Considerable :an?mrh I‘m-s I 1 stress is usually laid by the banker and his salesmen up- on the fact that the dividends on a preferred stock are l 1‘- 1.. cumulative. Practically, this is of little value."1 Al- though Dewing's statement was made during the depression of the thirties, preferred stocks are still very much an active security for both financing and investment. And the cumulative feature has been very popular.2 Because the cumulative feature always has value if regular divi- dends are paid, the time to question its worth is when dividends are not paid and an arrearage settlement is made. The purpose of this chapter is to determine if Dewing's claim is still valid when considered in light of lArthur Stone Dewing, A Study of Corporate Securi» ties (New York: The Ronald Press, 1934), p. 171. 2In a recent study of 72 preferred stocks issued in the period 1946-1950, all were found to be cumulative. D. A. Fergusson, "Recent Developments in Preferred Stock Finapcing," Journal of Business, XXV (September, 1952), ##7- 2. 103 108 recent arrearage settlements. The gain or loss of an individual investor in an ar- rearage settlement is dependent upon (1) his purchase price for the preferred, and (2) the dividends received and the value of the settlement. However, in this study we are not interested in how any one investor prospered but rather in how the entire issue of preferred fared when the arrearage settlement was made. If the cumula- tive feature of a preferred share is worth anything, the value of the arrearage settlement must reflect it. If it does not, it becomes apparent that the cumulative feature is simply a facade-~an addition to "sweeten” the preferred contract but without value. To determine the value of the cumulative feature we shall examine those cumulative preferred issues which had arrearage settlements from 1951 to 1962. In particular, we are interested in determining if the cumulative feature was given adequate consideration when the settle- ments were made. In other words, was the value of the settlement enough to compensate in full for the accumu— lated but unpaid dividends. In arrearage settlements made with cash payments or by retirement of the preferred the problem of adequate compensation for accrued dividends is not present because aside from the delay of payment, the arrearages are paid in full. Therefore, only the nineteen settlements which 105 involved recapitalizations (fifteen) or mergers (four) shall be evaluated. These represent 41.3% of the settle- ments made from 1951 to 1962. One company from each industrial group (except "others") will be examined in depth to see how the mechanics of non-cash settlements operate.l Methodology The value of the cumulative feature in each arrear- age settlement is a matter of opinion and negotiation. In almost all recapitalization and merger cases there is an infinite scope for speculation and dispute on every element of valuation. However, in order objectively to measure the extent of the value of the cumulative feature 100% recognition of the unpaid dividends in our measuring stick will always be assumed. The test to be applied to measure the value of the cumulative feature must also be objective and so will be in terms of money received or obtainable in the market. The first problem is to analyze the market value of the cumulative preferred shares. Because preferred stocks lThese nineteen issues differ from the nineteen issues discussed at p. 95. Chapter IV dealt only with those issues which became arreared from 1950 to 1962. This chapter is concerned with those arrearages which were set- tled from 1951 to 1962, regardless of the year in which—— the arrearages first began. 106 are in most cases arranged to resemble closely a bond issue as far as practicable, their yields follow a pat- tern similar to that of bond interest rates. The return for preferred shares is typically higher than that for bonds (see Table 11) because preferred dividends and any related sinking funds are contingent rather than fixed fig” payments as are bond requirements. Usually the protec- tion of the preferred consists of contingent voting '3'" 7"!) - - o-_.- - rights rather than the creditor‘s right to throw a de- .- -m- faulting corporation into bankruptcy. However, once a preferred share goes into arrears the usual yield relationship collapses. The market price of the stock will fall below its normal yield price re- flecting the market's discounting of the probability of the payment of the preferred arrearages plus resumption of the regular dividends. Should full dividends be re- sumed, the market price should theoretically rise to its normal yield relationship plus a discounted premium for the yet unpaid arrearages.l The discount rate is dependent upon the probability of payment. The market price of the preferred will also rise when a non-cash settlement is announced. The amount of the rise depends upon the value of the securities received in .1A good example of this pattern was found in the .American and Foreign Power $7 first preferred, which will be analyzed later in this chapter. 107 Table ll.--Comparative Yields on Industrial Bonds and Preferred Stocks, for the Years 1940-62 Average Preferred Stock Yields High Dividend - Industrial Series Medium Grade Speculative Grade Composite Average Year of Yields on Industrial Bonds 1940 3.10% 5.74% 9.79% 1941 2.95 5.53 7.86 1942 2.96 5.74 9.28 1943 2.85 5.16 7.72 1944 2.80 4.89 6.43 1945 2.68 4.49 5.19 1946 2.60 4.31 4.62 1947 2.67 4.59 4.96 1948 2.87 4.97 5.58 1949 2.74 4.94 5.81 1950 2.67 4.79 5.45 1951 2.89 4.82 5.42 1952 3.00 4.83 5.53 1954 3.09 4.75 5.40 1955 3.19 4.49 5.14 1956 3.50 4.74 5.39 1957 4.12 5.28 5.91 1958 3.98 5.14 5.77 1959 4.51 4.99 5.58 1960 4.59 5.18 5.77 1961 4.54 4.82 5.41 1962 4.47 4.81 5.34 Source: Moody's Industrial Manual, 1963 (New York: Moody's Investors Service, Inc., 1964). 108 the settlement. The value of these securities is the re- sult of negotiation between the various groups of stock- holders involved and the board of directors. If the negotiations give full recognition to the value and claim inherent in the cumulative feature of the preferred shares, the value of the settlement should be equal to the sum of the normal yield price of the preferred plus the dis- ”"“"! counted present value of the accrued dividends. There is a practical limitation, however. If the preferred shares are callable, as most are, it is highly unlikely that the market price will rise over the call price. Any investor who purchases a callable security at a price higher than the call price is taking the risk that his security will be called. However, in the case of cumulative preferred shares, since virtually all call pro- visions provide for the payment of any accumulated divi- dends together with the call price, the risk is not as great as it first appears. In evaluating non-cash settlements, these market ac- tions and the call price feature will be taken into con» sideration. In measuring the value of the cumulative feature the settlement will be viewed on an "as if" basis. It will be assumed that the retirement of the old pre- ferred shares in the recapitalization was paid for by issuing the new securities arising in the settlement. Therefore, the market price of the securities received in 109 the settlement will be compared with the sum of the call price of the old preferred plus the amount of the accrued dividends which would have been payable had the old pre- ferred been called. This method is the call price test. The theory underlying this method is that the call price plus the accumulated dividends is what the pre- ferred shareholders could have expected had their stock been retired in accordance with the terms of their con- tract. Thus the value of cumulation can be measured by the difference between what the shareholders should have gotten had outright retirement taken place and what they actually got in terms of the market value of the exchange package. The settlement value of both alternatives should theoretically be the same since they both accomplish the same thing--retirement of the old preferred and the set- tlement of the outstanding arrearages. Should a preferred not be callable, then an alterna- tive measure will be used--the difference between: (a) the sum of the "normal yield" price of the preferred and the preferred arrearages (without adding an amount for the compound interest element), and (b) the market value of the securities in the settlement package on the date of the settlement. This method is the market price test. This method is based upon the theory that if the stock were paying its regular dividend its market price should follow the usual yield pattern. Further, if the 110 stock has claim to accumulated dividends, the price should rise over the normal yield price by the amount of the dividend claim. The yield rate that will be used to calculate the "normal yield” price is the average pre- ferred stock yield on speculative grade high-dividend in- dustrials in the year of settlement as compiled in Table 10.1 In making the comparisons it will be assumed that I the proceeds were first a recovery of the call price (or "normal yield” price) of the preferred and then a recovery 7 of the accrued dividends--exact1y the same accounting treatment that is applied to payments on defaulted cor- porate bonds. Applying this methodology each test of the cumulative feature will have one of the following re- sults: l. Full value to cumulation--when the value of the settlement package was equal to or greater than the call price (or "normal yield” price) plus the accrued dividends (without compounding interest) but greater than the call price (or "normal yield" price). 1One may argue that it would be more reasonable to add a premium to the required yield to reflect the addi- tional risk of investing in an arreared preferred. While it is true that arreared preferreds do sell at a discount, reflecting this risk differential, it would be double counting to add this yield premium in these computations. What is trying to be measured here is the value of the cumulative feature and to do this the arreared preferred must be compared with a like investment completely ig- ‘noring the arrearage factor for yield determination. 111 2. Some value to cumulation-~when the value of the settlement package was less than the call price (or "normal yield” price) plus the accrued dividends (with- out compounding interest) but greater than the call price (or "normal yield" price). 3. No value to cumulation-~when the value of the set- tlement package was equal to or less than the call price (or "normal yield” price). It must be remembered, however, that the value of the cumulative feature is being measured solely in com- parison with the call or ”normal yield" price plus the accrued dividends. And that while on the basis of this test it may be concluded that there was no value to the cumulative feature in a given arrearage settlement, it cannot be concluded what the value of the settlement package would have been if the preferred dividends were not cumulative. It may well be that the cumulative feature helped to increase the consideration given to the holders of the arreared preferred even though this increase would not be revealed in the tests used in this study. Case Study--Armour and Company Description of Stock Stated value of $100 per share. Preferred as to assets and dividends. Entitled to cumulative divi- 112 dends of $6 per share. Each share convertible in- to six shares of common stock. Could be redeemed at the option of the company at a price of $115 per share plus accumulated dividends. Each share had one vote in corporate matters. History This case study of the Armour $6 convertible prior preferred is of particular interest because of the liti- 53‘ gation which ensued from the recapitalization to remove E the preferred arrearages. The Armour stock went into arrears twice, once for ten years, from fiscal 1938 to 1947, and then for six years from 1949 to 1954 (see ;, Table 12). The stock was exchanged in a recapitaliza- tion on December 21, 1954. The company's annual reports for 1938, 1940, 1942, 1945, 1949 and 1953 all contained explanations of the causes of the preferred arrearages and the intentions of management to clear them. Much of the comment was caused by the presence of large earnings per share of preferred and the reluctance of management to declare preferred dividends in those years. In eighteen of the twenty- one years examined the stock earned more than its divi- dend requirement, but in ten of these years management chose not to declare any preferred dividends. This policy seems strange, especially when viewed together with the president's statement in the 1938 annual report that it was the policy of the company not to pay any 113 Table 12.--Earnings, Dividends and Price Record of the Armour and Company $6 Prior Preferred Stock For the Years 1934-54 Per Share Year Earnings Dividends Arrearages Market Price Ending at Calendar Year End 10/31/34 $13.11 $ 1.50 $- 0 - 67 3/4 35 10.51 6.00 - 0 - 65 3/8 36 12.08 6.00 - 0 - 82 37 10.81 6.00 - 0 - 57 38 - 0 - 1.50 4.50 45 39 6.13 - o - 10.50 46 1/4 40 9.49 - 0 - 16.50 49 41 23.56 1.50 21.00 62 1/2 42 22.95 4.50 22.50 45 1/2 43 21.47 - - 28.50 74 44 21.11 6.00 28.50 104 45 17.21 6.00 28.50 123 3/4 46 39.01 9.50 25.00 129 47 45.90 31.00 - 0 - 103 48 - 0 - 6.00 - 0 - 71 3/4 49 1.12 3.00 3.00 71 1/2 50 38.08 - - 9.00 86 51 32.06 6.00 9.00 92 3/4 52 14.28 3.00 12.00 83 53 20.68 6.00 12.00 86 1/2 54 3.11 - - 18.00 -- 12/20/54 -- -- 18.50 98 Source: Moody's Industrial Manuals, 1935-55 (New York: Moody's Investors Service). 114 dividends unless they were earned.l The very large increase in earnings in the forties and early fifties found Armour unable to pay any common dividends because of the large accumulation of accrued dividends on the preferred. Unwilling to pay $66,750,000 to retire the preferred ($9,250,000 of arrearages plus I ~.— I ‘__7 $57,500,000ca11 price for the 500,000 outstanding shares) and/or reduce whatever favorable financial leverage was afforded by the preferred, the company of- fered its shareholders the following compulsory recapi- talization plan as an amendment to the articles of incor- poration: Each share of preferred and the corresponding ac- crued dividends were to be redeemed at $120 payable in 5% subordinated income debentures of like principal maturing November 1, 1984, and one warrant for the pur- chase of one share of the company's common stock at the following prices: $12.50 from redemption to 12/31/57 15 . 00 1/1/58 12/31/59 17.50 1/1/60 12/31/61 20.00 1/1/62 12/31/64 The plan was approved by the necessary plurality on December 7, 1954. The entire issue of the $6 preferred (except for 4,715 shares held by dissenters to the plan) plus the $18.50 of accrued dividends per share was retired 1Armour and Company, Annual Report: 1938, President's Letter. 115 on December 21, 1954. The recapitalization had two distinct favorable financial advantages for Armour: (1) conservation of working capital by not redeeming the shares for cash, and (2) retention of a favorable degree of financial leverage by converting the preferred into debentures. The company estimated a resulting annual tax saving of $1,560,000 due to the tax deductibility of the debenture interest. One of the preferred shareholders who voted against the plan, Johnston A. Bowman, instituted suit in Janu- ary, 1955, to void the plan, alleging that the amendment to the articles of incorporation authorizing the redemp- tion of the $6 preferred was an impairment of,his con- tractual rights. The case was heard in January, 1958, in the Superior Court of Cook County, Illinois. The court found for Armour and Bowman appealed. On May 22, 1959, the Illinois Supreme Court ruled on the appeal.1 Bowman's appeal asserted that the 1954 amendment operated to deprive him of rights and privileges as a holder of preferred stock contrary to constitutional in- hibitions. Questions relating to the necessity of the recapitalization, the tax advantages to the corporation, the fairness of the plan, the financial consequences of l )lBowman v. Armour & Co., 160 N.E. (2d) 753 (May 22, 959 . 116 its adoption on the preferred holders and the infringement of "contractual" or "vested rights" were all tossed aside by the court, who chose only to examine the statutory in- terpretation of the Illinois Business Corporation Act as it applied to the amendment. The particular article of the Act upon which the court focused its attention read: In particular, and without limitation upon such eneral power of amendment, a corporation may amend its articles of incorporation from time to time, so as: '. -mflfiir ii. —‘-‘I n” . .g. (g) To change the designation of all or any part of its shares, whether issued or unissued, and to change the preferences, qualifications, limitations, restrictions, and the special or relative rights in respect of all or any part of its shares, whether issued or unissued. .' Appearing in the court's opinion is one of the clearest expositions of the rights of a preferred stock~ holder and the nature of any arrearages which may have ac- crued.2 The court attacked the "vested rights" theory, first found in the Roberts-Wick case,3 and threw out any question of vestedness as it related to the Bowman case. The court stated that the problem at hand was not one of power to amend or the power to divest certain 1Section 52 (g) Business Corporation Act, I11. Rev. 2The text of this section appears in Appendix 0. 3See pp. 35-37, supr . E 117 rights and privileges. Rather it was a question of whether or not the Corporation Act gave Armour the right to amend its charter to the extent that holders of the prior pre- ferred were required to surrender their ownership in stock and accept in lieu thereof, the debentures: The amendment, whether it is viewed as effecting a purchase of the preferred stock with bonds or as a compulsory redemption thereof, obviously contem- plates that the fundamental relationship of stock- holder . . . will be changed and the preferred stockholders will become mere creditors of the com- pany.1 mthmvj -' Rather than being a modification of ownership, the plan 1 1.57. mi 1 was a liquidation of ownership status in exchange for creditorship status. The Articles of Incorporation of Armour expressly provided that the preferred stock could be redeemed at a ppigg of $115 per share plus accrued dividends. The atw tention of the court centered around the word "price." It ruled that "price" meant money and not bonds or other evidences of debt. The court recognized the right, sub- ject to legal restrictions, of a corporation to purchase its own stock, with the consent of the shareholder.2 It held that the effect of the amendment was in fact a purw chase with bonds without the consent of the owners of lBowman v. Armour & Co., 160 N.E. (2d) 757 (1959). 2Ibid., p. 757. 118 the stock. Therefore, Armour could only reacquire its preferred when an individual stockholder was willing to sell and no amendment passed with the approval of a two- thirds vote of the shareholders can force him to sell. The Supreme Court reversed the Superior Court and found for Bowman. The basis of the reversal was that the redemption of the preferred was not in legal accord with the provisions in the preferred stock certificate and the articles of incorporation. On December 2, 1959 the Superior Court entered a de- H. P... cree stating that the preferred shareholders who did not vote for the amendment and did not surrender their cer- tificates were entitled to receive, instead of the de- bentures and common stock warrants, 7.26 shares of common for each share of preferred and the accrued dividends plus total damages of $208,000. These shares of common had a total market value of $98.01 on December 20, 1954, the date of the exchange, and $263.18 on December 2, 1959. Test for Value of Cumulative Feature Exchange Those shareholders who accepted the exchange offer be- came the holders of a warrant for the purchase of one share llbid., p. 758. 119 of common at varying prices plus a cumulative income de- benture bearing 5% interest, maturing in 1984, and call- able for sinking fund purposes at 100° The opening mar- ket quotations of these securities on their first trading date after the exchange were: Debenture (February 18, 1955) - 80 1/2 Common (December 21, 1954) - 13 1/2 The value of the exchange package was $97.60.1 The call price of the Armour preferred should have been $133.50 ($115.00 call price plus the accrued divi- dends of $18.50). Under the call price test the cumula- tive feature failed to have any worth because the new securities had a value of $35.90 less than the call price of the old preferred. Dissent ' Surprisingly, it was the dissenters to the 1954 ex- change who had the most profitable experience. This was due to the rise in the market price of the common between the dates of the original exchange offer and the end of the litigation. Here we can use two dates to evaluate the worth of the cumulative feature. It is not difficult to see how the number of common shares awarded to the dis- lCalculated as follows: $120 principal of debentures X 80 1/2 plus the value of the common warrant of $1.00 (market price of the common of $13.50 less the warrant cost of $12.50). 120 senters was determined. Apparently the court attempted to make payment in common stock of equivalent value to that of the exchange package on the date of exchange. Thus the values of the 7.26 shares of common on Decem- ber 21, 1954 ($98.01) and the exchange package ($97.60) were virtually the same. However, the court decision was handed down on December 2, 1959, and both the judge and the plaintiff had the advantage of hindsight, for on that date the common was selling at 36 1/4, well above the 13 1/2 on the exchange date. Thus the plaintiffs could have asked for payment in common stock knowing full well that the market value of their package had appreciated substan- tially over that on the date of the exchange. Conclusion Quite clearly, the non-dissenters to the Armour exchange offer did not receive fair value for their cumu- lative preferreds on the date of the recapitalization. This conclusion is supported by the call price test. The ultimate gain or loss to be had by the participants in the exchange offer depends on the market action of the common stock and the common dividend policy of the company now that the preferred has been removed from the capital structure. However, as of the date of the exchange, the preferred shareholders were not compensated in any degree for the cumulative feature of their shares. 121 On the other hand, the dissenters would argue that they did receive value for their cumulation and that the non-dissenters were too hasty. However, the argument of the dissenters is not convincing since it is based upon events that occurred subsequent to the date of the ex- change. Case Study--Missouri-Kansas-Texas Railroad (Katy) Description of Stock Series A. Par value of $100 per share. Entitled to cumulative dividends of 7% per share beginning January 1, 1925. Preferred as to assets and divi- dends. Callable at $110 plus dividends. No pre- emptive rights. One vote per share, equal with the common. History - The history of Katy's 7% preferred was very unsteady. After paying some cash dividends in the late twenties, the losses suffered during the thirties prompted the direc- tors to halt dividend payments until 1953 when the rail- road paid its first dividend in twenty-one years (see Table 13). Additional dividends were paid through 1957. The 7% preferred was retired in a compulsory recapitaliza- tion which was effective January 1, 1959. The indenture agreement of an issue of outstanding 5% Adjustment Bonds prohibited any dividend payments un- til all interest arrearages on the bonds were cleared. This was not done until 1952 and it was this clearing which 122 Table l3.--Earnings, Dividends and Price Record of the Missouri-Kansas-Texas Railroad 7%A Preferred Stock For the Years 1930-58 Per Share End of Earnings Dividends Arrearages Market Price Year at Calendar Year End 1930 $10.62 $7.00 $ - 0 - 80 1931 1.01 5.25 1.75 12 1/8 1932 - _ o _ _ 0 _ _8;75 ;1_3 8_ 1941 71.75 1 1 4 1942 8.82 - 0 - 78.75 3 3/8 1943 7.67 - 0 - 85.75 8 3/8 1944 9.16 - 0 - 92.75 18 1/2 1945 8.80 - o - 99.75 45 3/4 1946 2.57 - 0 - 106.75 22 3/4 1947 4.23 - 0 - 113.75 16 1948 9.75 - 0 - 120.75 21 3/4 1949 7.30 - 0 - 127.75 22 3/8 1950 9.52 - o - 134.75 50 3/4 1951 6.26 - 0 — 141.75 51 1952 11.32 - 0 - 148.75 67 1953 9.51 5.00 150.75 61 5/8 1954 6.03 6.00 151.75 77 1/4 1955 4.66 4.25 154.50 81 3/8 1956 2.91 2.00 159.50 62 1/2 1957 - 0 - 0.50 166.00 31 1958 - 0 - -- 166.00 66 1/4 Source: Moody's Transportation Manuals, 1930-59 (New York: Moody's Investors Service). 7 123 prompted the 1953 resumption of preferred dividends. The current status of the Adjustment Bonds also marked the on- set of a series of four recapitalization plans which were put to the stockholders and the Interstate Commerce Com- mission for approval. As the president of the railroad explained: This constructive step (the 1953 preferred divi- dend) was made possible by the payment during the year of the remaining interest arrearages on the Company's Adjustment Bonds. It then became prac- ticable, with the bond interest on a current basis, to offer a plan of recapitalization of the Company. This first recapitalization plan was filed with the Inter-State Commerce Commission in 1952 and was subse- quently withdrawn from consideration. Later, in 1955 an important change in the common stock ownership took place. The estate of E. N. Claughton sold 525,000 shares of com- mon (about 65% of the outstanding shares). Three invest- ment corporations purchased 450,000 of these shares and succeeded in placing four new directors on the board. A second plan was then filed with the ICC late in 1955. It was withdrawn because of the opposition of the four new directors. The third plan met a similar fate after the ICC examiner recommended that the application for a recapitalization be denied. On October 31, 1957 an 100 examiner gave approval to lMissouri-Kansas-Texas Railroad, Annual Rgport: 1952, p. 3. 124 the fourth plan. This recapitalization, to be effective January 1, 1959, called for the exchange of the preferred shares and their respective accumulated dividends for: (1) a $110 non-interest bearing certificate, (2) a 5 l/2%, $100 income debenture maturing in 2033, and (3) one share of a $5 par value common. By supplemental order dated November 26, 1958, Finance Docket No. 19760, the ICC ap- proved the plan as amended. The recapitalization was ap- proved by 77.32% of the outstanding shares. As a result of the exchange, arrearages totaling $110,722,830 or $166.00 per share, were cancelled and the following securities issued: a. Subordinated Income Debentures--$66,700,500 face value b. Certificates at $110 -—$73,370,550 face value c. Common Stock --667,005 shares Test for Value of Cumulative Feature In the 1958 recapitalization, the preferred stock- holders received the income bond whose opening market value was $42.00; one share of common worth $7.875 and the certificate which was traded on the American Stock Exchange at $17.75. The total market value of these secur- ities was $67.625. The call price for the 7% preferred was $276.00 (call price of $110.00 plus arrearages of $166.00). Un- 125 der the call price test the theoretical shortage in the exchange was $208.375. Conclusion This seems to be another case of ”shall we at least take something or stick with our nothing." It is obvious that the preferred shareholders chose at least to raise their position in liquidation one notch, up to that of an unsecured creditor, at least to the extent of their bonds and certificates. Unfortunately the exchange did little else for them. For by agreeing to the exchange offer they completely gave up any claim to their arrearages. There is no doubt that they were not compensated to any degree for their accumulated dividends in the exchange. The Katy preferred, for all intents and purposes, may just as well have been non-cumulative. The resumption of dividends and the attempts at a recapitalization brought about a sharp increase in the market price of the preferred, but not nearly enough to recover the cumulative dividends that were in arrears. In fact, the stock had not even risen to a point commen~ surate with the average yield. This, of course, rem flects the pessimism of the investors as to the future prospects of the company. The accuracy of their judgment can only be evaluated by the future of the company's financial history. 126 Case Study-~American & Foreign Power Company, Inc. Description of Stocks (1) $7 preferred, cumulative. Entitled to $100 plus accrued and unpaid dividends upon liquidation. Redeemable at $110 plus dividends. Ranks pari passu with the $6 preferred. (2) $6 preferred, cumulative. Same provisions as the $7 preferred. (3) $7 second preferred, cumulative. Junior in all respects to both classes of first preferred. Liquidation price of $100 plus accrued dividends. Redeemable at $105 plus accrued dividends. History American & Foreign Power is a subsidiary of Electric Bond and Share Company, both of which are registered holding companies. Foreign Power's financial difficulties began in the early thirties when its earnings began to fall. In 1933 the company failed to earn the dividends on its first preferreds and from that date to 1939 did not declare dividends on any class of the outstanding pre- ferred. Because of the lack of earnings, the non-payment of preferred dividends, and the resulting large accumulations of arrearages, the company was ordered to simplify its capital structure by the Securities and Exchange Commission in 1940. A plan for recapitalization was filed in 1947 under Section 11 (e) of the Public Utility Holding Company Act of 1935. It called for the exchange of the preferreds 127 for new 4 1/4% debentures, cash and shares of a new com- mon stock. However, after the SEC gave its approval to the plan, as amended, a substantial need for cash arose and the company found itself having to float a larger bond issue than originally anticipated. After a dis- cussion with institutional investors it was concluded that the sale of the debentures could not be effected within the framework of the plan. As a result, the SEC withdrew its order but directed the company to reorganize on a single common stock basis and such debt securities that would meet the existing circumstances. Before the 1947 plan was withdrawn a group of $6 preferred shareholders asked for SEC rejection of the plan because $59,000,000 of arrearages on the first pre- ferreds would be cancelled without any compensation to the preferred shareholders. The group asked for issuance of 4% notes or dividend certificates convertible into the new common in exchange for the arrearages. The entire plan was withdrawn before the Commission gave a ruling on this proposal. It is unfortunate that the SEC did not have the opportunity to give an opinion on this mat- ter for then it would have been compelled to take a stand on the value of the cumulative feature in this recapitaliza- tion. Foreign Power filed a subsequent plan of reorganiza- tion dated January 15, 1951. At that date the capital 128 structure of the company was: $8,750,000 of short term bank notes. $49,500,000 of 3.75%--4.20% notes all owned by Bond and Share. $50,000,000 of 5% gold debentures all held by the public. 478,995 shares of $7 preferred, 2.88% held by Bond and Share. 387,026 shares of $6 preferred, 17% held by Bond and Share. 2,547,761 shares of $7 second preferred, 34.7r% held by Bond and Share. 2,281,138 shares of common stock, 38.64% held by Bond and Share. 6,444,595 common stock warrants, 90.2% held by Bond and Share. The plan was approved by the SEC on November 7, 1951, and ordered enforced by the United States District Court for the District of Maine on January 15, 1952.1 The ef- fective date of the plan was February 29, 1952. Substan- tially all of the persons and all of the committees who were in opposition to the 1947 plan participated in the negotiations on the 1951 plan and were in accord with its provisions. However, the enforcement decree was appealed by three stockholder groups, two of which were affirmed and one dismissed.2 The 1951 plan provided for the following new capital 8 1: rue ture 2 1In re American & Foreign Power Co., Inc., 102 F. Supp. SET—TI952). 2Kantop; Zucker et a1.; and Silver v. American & Foreign Power Co., Inc., 197 F. (23) 307 (1952). 129 1. $8,750,000 of the short term bank notes 2. $50,000,000 of 5% Gold debentures 3. $67,564,600 of 4.8% Junior debentures 4. 7,152,711 shares of new no-par common stock. The debentures and common stock were distributed as follows: Outstanding security of Foreign Power Security to be Issued 1. Each share of publicly $90 principal amount of held $7 Preferred 4.8% debentures and Stock 4.0021 shares of new common. 2. $6 Preferred Stock $80 principal amount of 4.8% debentures and 3.2032 shares of new common. 3. $7 Second Preferred Stock .85 share of new com- mon. 4. Common Stock .02 share of new com- mon. 5. To Electric Bond and Share 3,902,956 shares of for all of its holdings new common stock. of notes, preferred, come mon and common warrants. In determining the allocations of the new securities as between the various classes of stocks the Securities and Exchange Commission extensively reviewed the history of the transactions betweem.Foreign Power and its parent Electric Bond and Share, considering in detail various claims of mismanagement and over-reaching on the part of Bond and Share. The Commission concluded that it was appropriate to settle these alleged claims as part of the 130 allocations; that Bond and Share was therefore not en- titled to treatment on a parity with the public security holders on the basis merely of its relative holdings in Foreign Power; but that in the allocation of the new securities there should be an appropriate reduction of Bond and Share's participation and an increase in that of the public security holders. 0n the basis of the evidence the Commission concluded that a net "give-up" of annual earnings of about $4,500,000 on the part of Bond and Share fell within the range of a fair settle- ment of the claims. As a result of the recapitalization, Electric Bond and Share's position as a creditor was eliminated and its proportion of the common stock rose from 38.64% to 54.57%. The division of the new securities between the various classes of the old stock was done primarily on the basis of their seniority and the relative dividend rates. .As a result, the $7 second preferred, even though its per-share arrearages were almost 80% of the total of the arrearages on both of the first preferreds,l failed to receive interest and earnings on its new shares equal to either of the first preferreds. The following chart was constructed comparing the re- LAs of December 31, 1950 arrearages were $141.75 on the second preferred and $89.425 and $76.65 on the two first preferreds. 131 turn to each share of the old classes of stock based up- on the new securities to be distributed.1 Annual net in- come was assumed to be $15,700,000, the same amount used in the SEC hearings. Total Per Share $7 Preferred Spock Interest on Debentures $ 2,010,000 $ 4.32 Earnings on Common 2,373,000 5.10 $ 4,383,000 S 9.42 $6 Preferred Stock Interest on Débentures $ 1,233,000 $ 3.84 Earnings on Common 1,312,000 4.08 Total $_2,545,000 $ 7.92 Second Preferred Stock Earnings on Common $ 450,000 $ 1.16 Common Stock Earnings on Common $ 38,000 $ 0.027 Electric Bond and Share Earnings on Common $ 54246,000 $ -- Total $12,662,000 Interest on Gold Debs and Bank Loans 3,038,000 Total Earnings $15,700,000 One $6 preferred shareholder sued, challenging the SEC's use of the relative dividend rates as the basis of allocation.2 The suit requested a greater participation in earnings than was provided for in the plan via an 1 lTable taken from: In re American & Foreign Power Co., Inc., 102 F. Supp. 335 (1952). 2Kantor v. American & Foreign Power Co., Inc., 197 F. (2d) 307 (1952). 132 allocation based upon liquidation values. In the above chart the ratio of the projected earnings of the two issues of first preferred after the exchange is $9.42 $7.92 or 100 : 84.08. This ratio is very close to the ratio of the respective dividend rates of $7 and $6 or 100 : 85.71. The court rationalized the slight dis- crepancy between 85.71 and 84.08 by pointing out the higher quality of the earnings of the $6 preferred because of the greater proportion of debentures in the settlement. 0n the other hand the liquidation price on the date of the exchange for the $7 preferred ($100 plus dividend ar- rearages) was $196.425. The liquidation price of the $6 preferred ($100 plus dividend arrearages) was $182.65. The ratio between the two was 196.425 : 182.65 or 100 : 92.99, decidedly more in favor of the $6 preferred than the ratio of the dividend rates. The Court, however, rejected the use of liquidation values. It held that the possibility of liquidation or redemption was considered by the SEC to be too remote to warrant consideration and that the Commission properly viewed the company as a going concern. This conclusion was consistent with the other findings--in particular, the large scale capital equipment construction program of the company from 1946 to 1950 which caused the 1947 Plan to be set aside. The liquidation value of the $7 second preferred 133 was higher than that of either issue of the first pre- ferred because of its large dividend accumulation. But its share of the earnings after the recapitalization on a per share basis is just slightly more than 1/7 of that of the $6 preferred. The Court supported this relationship by pointing out that there is no guarantee to any class of junior investors of a participation in a reorganized enterprise. The principle of absolute priority implies a sacrifice, if such be necessary, by those at the bottom of the investment ladder.l Test for Value of Cumulative Feature The respective market values that were first avail- able for the securities which the holders of the pre- ferred shares received in the recapitalization were: Common Stock - $10.875 4.8% Debentures - 71.375 The total market value of the packages received by each class of preferred was (including accrued interest on the debentures): $7 first preferred stock - $ 113.86 $6 first preferred stock - 97.35 $7 second preferred stock - 9.24 The deficiencies for all three issues under the call price test were computed as follows: lEgntor et al. v. American & Foreign Power Co., Inc., 102 F. Supp. 338‘(1952). 134 Value of Call Exchange Deficiency Stock Price + Arrearages - Package = In Exchange $7 lst Pfd. $110.00 $96.425 $113.86 $92.565 $6 lst .Pfd. 110.00 82.65 97.35 95.30 $7 2d Pfd. 105.00 148.75 9.24 244.50 Conclusion In only one instance did a share of American & Foreign Power preferred recover a portion of its accumulated divi- dends, and that was the $7 first preferred. Therefore, in general, the 1952 recapitalization failed to give any recognition to the claim of the preferred holders to the accumulated and unpaid dividends. Indeed, the deficien- cies in each case bore a similar resemblance to the ratio of the arrearages. Clearly, if the recapitalization gave full effect to the arrearages, an acute over- capitalization would occur, either in the form of debt or equity. In addition, the common shareholders and probably the second preferred holders would have received none of the new stock, and thus would have had their equities wiped out. Certainly, if cumulation is to have full value, should not all subordinate claims be eliminated if such a step is called for? If a preferred is truly preferred as to assets and dividends it seems that an af- firmative answer is called for. This, however, was not 135 the case with Foreign Power and, as a result, the cumu- lative feature was virtually ignored in the recapitaliza- tion. Summary The same methodology as was used in the analysis of the three previous cases was applied to the other fourteen exchanges of arreared preferred stocks. The findings of all of these analyses are summarized in Table 14. In only four of the nineteen issues was full accumu- lation of dividends realized in the exchange of the old preferreds. The remainder of the stocks, except for the Alleghany $5.50 and the Virginia-Carolina Chemical Cor- poration 6% where the arrearages were substantially re- alized, were, in essence, treated entirely as non- cumulative in the recapitalizations. While one may feel that only fifteen cases in twelve years is not substan- tial enough to refute Dewing's statement that introduced this chapter, the fact remains that in these cases the preferred contracts were fundamentally violated when the shareholders were not compensated for their cumulative rights. However, it does not appear sound to condemn the cumulative feature as worthless for contractual reasons only. ‘What should also be considered, although not quan- tifiable, is the number of instances where the mere pres- mma .ooaaso ma Muopm moan oaomhsm mooooH>Ho 020 .oaooaaso poo hpfiaooomp .oaouafis>s so: spans x mm.asa 00.n0m 00.m0 00.n0H .eeea mm .Heoesoeo seeaoemo-.s> x m0.0m 0m.0m 0m.m 00.0w .>o as .eooamaaez copes: x 00.mm 00.nm o. . 00.nm .>o 0m.me .ppoeespm-eooasoae x 00.nma No.0ma mm.0w 0m.mm . . a» .oampooam one one .05m x m0.wmm 0m.m0a 0m.mw m0.0aa .eo we .oeepooam one one .00m x 0m.mmm 00.sam om.m0a 00.maa .em as .oeepooam one moo .00m x mm.mm ms.sm mm.m 0m.mm .>o no.4 .oaaex oceanom x Hm.00H 00.msm 0m.sma 0m.soa an ..m.m oemeoem-eesomee2 x mo.s0 00.0sm 00.00H 00.0aa «as ..m.m esxoa-eemqseeoz x ma.0s mm.0sa No.0m 00.00 as» ..am00 unease aaom soon a 0m.0s mm.00 0m.m 00. m .eoa m» .aeoo soaae> smegma x mm.mm sm.em 0m.0m sm.mm» n. . .oeao m» ..am-oeesm A.sueeopoH - - - a. . 00.3mm 00.184 00.0: no .320 no .m.m 03820800 x 00.sm 0m.mma 0m.ma 00.nHH .so .eo we .sqeasoo one noose< x sm.m ms.mmm ms.msa 00.n0H .em so .eosom .eos e asoenoa< x mm.sm mo.m0a mo.mm 00.0HH m» .eosom .eom a asoeeose x ow.maa ms.00m ma.00 00.0Ha s» .eosom .eos e esoeeoaa x 00.nm mm.0s mm.0m 00.0w .>0 .me 0m.m» ..ee00 sesawoaae x mm.0saa ma.~mme ma.ssae 00.noae < awn ..mn00 squamoaae HH< osom oooz owsxosm oofiam ooHpsHoaoo ow ooas> unmanappom Haves mowsasoaa< mo doas> oHOHH H oedhm Adahoz o HHdo madam ooaaomoam pom mead op Hmma Bonn shaman: no encapsuaaspamsoom no oopooumm upoosoappom omensoaa< moopm ooauowoam on soopm enousoh o>HpsHoauo one no ooas> on» oofisuopon.0p apnea no hhdaaomnu.:a vague 137 ence of the cumulative feature was enough to persuade the directors to declare preferred dividends where had the preferred been non-cumulative, they would have passed the dividends. Also, if one wishes to evaluate the cumu- lative feature in contemporary arrearages, it is essen- tial to note that thirteen of the fifteen issues found to be without value as cumulatives, went into arrears prior to 1950. Therefore, there does not appear to be sufficient evidence to make a blanket condemnation of the cumulative feature in contemporary preferred financing as Dewing did in 1934. There have been cases where the cumulative feature failed to have value, most particularly in those cases where the arrearages were eliminated by recapi- talizations. It seems however that these cases are still repercussions of the 1930-33 depression. It does appear that contemporary preferred experiences point to a real value for the cumulative feature-~especially when con- sidered in light of the high proportion of recent cash settlements. What the analyses of this chapter do prove is that if preferred arrearages are subjected to elimina- tion via recapitalization, the chances are very high that the preferred will fail to realize any value for their cumulative feature. . ‘.Jfimlfll-a‘ (4"..uu-1 ‘77:- E. CHAPTER VI CONCLUSION The experiences of cumulative preferred stocks listed on the New York Stock Exchange with dividends in arrears have been examined over a twenty—seven year period (1935- 62). Their role in corporate finance has been analyzed with respect to the economy, a firm's board of directors and its stockholders. The Economy The dollar amount of arrearages from 1935 until 1952 was close to the $1 billion level. It was not until 1952 that arrearages showed a substantial decrease, dropping to below $500,000,000. In 1958, arrearages dropped under $100,000,000 for the first time. They have since not exceeded that amount. Arrearages in 1951 were as high as 325% of the preferred dividends paid on preferreds listed on the New York Stock Exchange. By far the most important historical cause of the large dollar amount of arrearages present in the 1930s and 408 was the severe losses incurred by most firms in the 1930-33 depression. During that time 50% of the arrearages first began to accumulate. A similar relationship between 138 139 arrearages and corporate net income has been found to ex- ist since the depression. Another cause of preferred arrearages was the desire to reduce the burden of excess profits taxes computed by the "invested capital" method. However, only twenty issues went into arrears during periods of excess profits taxation. Settlements of arrearages have been analyzed by the five major methods used. It was found that the longer the arrearage was outstanding the greater the chances were that the arrearages would be settled by a non-cash method. The settlements have been attributed to three factors: 1. The fact that the earnings of the firm had re- covered to a level where the common stockholders believed that they should begin to share in the new prosperity. However, sizable earnings proved to be no guarantee that a cash settlement will occur. 2. When interest rates have fallen it could be ad- vantageous for a firm to retire its arreared preferred issue and raise the required funds by floating a bond issue or new preferred stock at the lower interest or dividend rates. 3. An attempt to reduce the amount of retained earnings to avoid any undistributed profits tax. In summary, it appears as though the problem of long and large accumulations of arrearages on preferred stocks 140 both as to the number of issues and the dollar amount seems to be a thing of the past. There are four reasons for this conclusion: 1. Recent arrearages have been settled, on the average, faster than they were prior to 1950. 2. Tabulations on December 31, 1962 show that the preferreds with accrued dividends on that date had been in arrears, on the average, only 2.7 years. 3. The reduction in the number of outstanding pre- ferred issues due to their elimination in corporate reor- ganizations and mergers. 4. The decline in the popularity of new preferred financing. A Firm 3 Board of Directors The power to control the distribution of corporate earnings that is held by a firm's board of directors was subjected to close scrutiny. Despite the inferences of preference and priority usually conveyed by a preferred stock, boards of directors have the power to treat, in essence, cumulative preferred stocks virtually the same as common. For regardless of the level of earnings and working capital a board of directors can refuse to declare dividends on cumulative preferred stocks. This, however, does not stop the undeclared dividends, whether earned or not, from accumulating as a contingent claim of the pre- F545 1* 141 ferred stockholders in accordance with their contract. It is strongly recommended that all cases where boards of directors have passed earned cumulative pre- ferred dividends be subjected to some sort of objective test in order to determine the equity of each individual withholding. Otherwise the firm.will have the use of funds which should have been distributed to the preferred shareholders without paying them an additional return for the use of their capital. The Stockholder From the standpoint of the stockholder the cumulative feature in the majority of arrearage settlements in recent times (1951-62) has proven to have full value. 0f the forty-five settlements that occurred in this period, twenty-one that were effected by full cash payments, three by retiring the preferred and four by recapitalizations or mergers proved to have fully compensated the preferred shareholders for the amount of the arrearages that had ac- cumulated on their stocks. Of the forty-five cases there were fifteen recapitaliza- tions and two liquidations in which there was little or no value to the cumulative feature in the settlement. Clearly in the case of the liquidations it was a situation of a hopeless investment choice. But what protection, if any, should have been given to the investors in the fifteen 142 other situations? Should an individual stockholder who does not agree with a settlement proposal put forth by a corporation consent to sacrifice his claims for the good of the whole as long as the majority is convinced that a settlement is needed? The question becomes especially poignant when .a_. one considers how the majority of the preferred stock- holders approve corporate amendments for settlement of their arrearages. In almost all cases the approval is not so much an exercise of intelligent judgment as the re- sult of an efficient functioning of the proxy machinery. Court decisions examining arrearage settlements are too often based upon the legal power to remove accrued dividends without examining the fairness of the plan in light of its facts. Orschel has raised the question of whether the final authority to judge the fairness of settlement plans should rest with the courts. He advo- cates setting up a special administrative agency to pass on the equity of all questioned arrearage settlement plans.l Becht, on the other hand, sets forth certain proposi- tions based on the assumption that if there is a real 1Albert K. Orschel, "Administrative Protection for Stockholders in California Recapitalizations," Stanford Law Review, IV (1952), 217. 143 need for the plan the corporation can prove it. And in the absence of such proof it is better to keep the status quo than to force the stockholders into an expensive in- quiry whose outcome is likely to be inconclusive. He advocates: l. Requiring dissenters to prove that the plan alters their interests in the property of the p corporation. 2. Requiring the corporation to prove a specific need which justifies the amendment. 3. If proof is given, let the majority further sus- tain the burden of proving that there is no other solution to the difficulties which would not affect the relative priorities of the classes of stock. 4. If the majority fails to sustain the burden of proof of these issues, let the court enjoin the plan entirely or so much as puts pressure on the dissenters.1 The worst possible result of Becht's proposal would be a continuation of the status quo. Is this undesirable? It seems that any redefinition of a security holder's rights should call for a show cause--a cause that is something vital and specific. The courts should insist that senior security holders receive substantially the equivalent in value for what they give up in the plan; and that this value is primarily a question of the c1aim.upon earnings. If this is not possible, then a status quo situation seems to be the only other alternative-~one that should . .LArno C. Becht, "Alteration of Accrued Dividends,” Michigan Law Review, IL (1951), 592. 144 be in effect at least until the cumulative preferred share- holders can be sure of getting their bargained-for return in the arrearage settlement plan--one which fully recog- nizes the value of the cumulative feature. If these measures are not adopted it seems as though all cumulative preferred shares would have to bear a state— ment on the face of their certificates warning the pre- ferred shareholder that although his share is cumulative with respect to dividends, it is possible that should the dividends on his stock go into arrears, he will never re- ceive full value for them in an ultimate settlement of the arrearages--thus completely negating any positive feature which accumulation may have had. APPENDIX A LIST OF COMPANIES WITH PREFERRED STOCKS IN ARREARS AS OF DECEMBER 31, 1935, 1940, 1945, 1950-62 .11 146 RAILROADS Description Year of Type 9 Arrearages in thousands of dollars as of December 31: flame of 10mpany of SLOCK First Settlement Arrearage 1235 1940 1945 1958 1951 1952 1953 1954 195‘ 1956 1957 1958 195: 1&0 1961 1062 55‘le 1931 Recapitalization 5 17,136 $ 35,491 $ 53,848 $ 26,452 $ 26,910 $ 16,307 $ 17,059 $ 17,800 $ 18,484 $ 19,315 $ 20,056 $2.50 Phcv. 1934 Recapitalization 411 ,683 3,135 1,363 1, 49 796 5; cv. 1940 Cash 48 5 B 1940’ Casn 2 222 2 222 2 222 2 491 551.13 1961 -- I ’ ’ ’ 3 850 s 1,"0C 6“} 1924 Recapitalization 15,873 J . and Eastern $2A 1,47 Cash 756 768 ' and Eastern Illinois $2A 1958 -— $ lFl $ 151 $ 151 :50 150 ‘. 0 Great Western 4: 1919 Recapitalization 35,016 36,859 r _ Great Nestern 5 1946 Cash 2,746 1,236 751 _ >in;de Is. and Pacific 7%A (5% cum) 1931 Recapitalization 6,325 13:679 3: :0 02 Is. and Pacific 6%8 (5% cum) 1931 Recapitalization 5,525 11,804 ' idated R.h. of :uba 6 1932 Recapitalization 6,668 14,396 23,488 36,218 35,036 39:65“ .. and Rio Grande 0% 1924 Recapitalization 11,830 16,762 21,692 Lacka‘danna 5 1959 -- 157 83 1,410 1,880 Jx,f, Mobile and Northern 6% 1923 Recapitalization 5,308 internat'l 13.8 or Cent. [410.573 part. 1931 -- 2,125 2,475 3,725 3,225 3,725 4,100 4,225 4,600 4,600 4,475 4,475 1,,975 5,1,7; 5,97, 4,75 “7,57? M;s lurl-Kansas-Texas 7%A 1931 Recapitalization 19,835 23,181 36,356 89,870 94,5:0 98,372 93,041 logy375 102,710 109,04” 1107350 M .nuri-Pacif‘ic 5% 1918 Recapitalization 49 901 7,851 5, 1 103,751 107,3 1 110.93l ll .521 ll Jill ELL-Chicago-St. Louis 61.1 1931 ash 9,734 20,553 30,822 21,635 Y.Y.-New Haven-Hartford 1932 Recapitalization 8 581 12 22 12 22 N.Y.-New Haven-Hartford 5% cv. A 1948 ’ y ’ 5,820 5,870 4:305 21861 ISL-New Haven-Hartford 5% cv. A 1956 -- 2:350 2.350 2,454 2.454 2,458 2.45R 2.459 Pete Marquette 5% prior 1931 Merger 2,380 1,773 4,013 Pare Marquette 5% 1931 Merger 2 641 5 852 8,959 Rutland 21.. a. 7‘70 1090 Merger 31:234 , Western Pacific 9.3. Corp. 6% cv. 1927 Liquidation 6,655 9,655 6.655 6.655 Wheeling and Lake Erie 4% 1916 Recapitalization 4,152 _ . _____. ___ __ __._ _.__ _ _ Totals 241 $291,288 $320,945 00 2 $281,191 $271,638 $240,128 $240,886 $125,194 $132,184 $137,261 $7,580 $8,237 $2,367 $11,343 $13,163 UTILITIES American & Foreign Power $7 1932 Recapitalization $ 13,412 $ 29,506 $ 35,290 $ 42,834 $ 46,187 American 8. Foreign Power $6 1932 Recapitalization 9,288 20,435 24,441 29,665 31,987 Amtrlcan 8. Foreign Power $7 20 1932 Recapitalization 96,388 186,326 274,333 361,143 378,979 American Power and Light $8 1933 Recapitalization 11,308 17,617 American Power and Light. $5 1933 Recapitalization 11,619 18,101 Br10k1yn & Queens Transit $6 1934 Liquidation 1,204 Commonwealth 71 So. Corp. $6 1935 Liquidation 4,498 31,500 43,340 Electric Power 8: Light $7 1932 Me or 11,398 29,213 46,129 Electric Power a. Light $6 1932 Merger 4,853 12.439 19,642 Engineers Pub. Service $5 cv. 1933 Cash 1,778 Engineers Pub. Service $5.50 1933 Cash 2,437 Engineers Pub. Service 1933 Cash 1,013 Federal Water Service $274 1931 Recapitalization 4,923 10,617 General Gas & Electric $8 1933 Recapitalization 338 General Gas & Electric $7 1933 Recapitalization 429 1,208 General Gas 8. Electric $671 cv. 1933 Recapitalization 6,045 15,699 , Internat'l Hydro—Electric $2 part. 1932 Merger 6,354 17,119 23,500 32,l27 33:840 $ 35:55“ $ 37:267 $ 381981 $ “0269“ $ “2;“08 Ex Laclede Gas 5 1933 Liquidation 271 9 6 6 4 4 6 Market Street Railway 6% prior 1924 Liquidation 8,888 13,071 1 ,55 20,0 2 20,739 21, 3 Market Street Railway 1924 Liquidation 4,114 5,909 7,405 Philadelphia Rapid Transit 7% 1932 Recapitalization 3,920 Standard Gas and Electric $7 prior 1933 Recapitalization 2,450 17,920 30,812 37,903 37,903 Standard Gas and Electric $6 prior 1933 Recapitalization 570 4,170 7,170 8,820 8,820 Standard Gas and Electric 4 1933 Recapitalization 5,555 23,733 38,882 54,031 57,061 601075 Twin City Rapid Transit 7% 1932 Recapitalization 840 1,260 _________ _________ ________ ________ ________ Tatals $131823 giggflg M67 60 Q86 6 61 16 ML .99. mg £822.43; 2&2 1‘2 1‘08 OTHER Atlas Corp. 5% 1961 -- $ 170 $ 678 General Realty a. Utility $6 1931 Recapitalization $ 6,141 $ 9,177 Hotel Corp. of America 5% cv. 1951 Cash $ 147 $ 344 $ 540 $ 737 $ 784 $ 656 $ 770 $ 742 Second Nat'l Investors $5 cv. 1930 Recapitalization 1,343 Sterling Securities $3 cv. lst 1931 Merger 2,356 Sterling Securities $1.20 1931 Merger 2, E20 ____. ____. .___._ __ __ _.____ _____ 1.12.222 Lg §_-___1fl Q $.___.=J=“O L411 1.,—LE8 11:25—26. i=7£ Ll: Totals Name of Company {amazed Leather an Crystal Sugar 0 Hide & Leather and Company - Del° “our and :0mpany - 111. ‘ and Company - Ill. ~m Beck Shoe Corp, Bethlehem Steel S. Blumenthal Cc. Botany Consolidated Bucyrus Erie Budd Manufacturing Burns Broso Burns Bros. Bush Terminal Bldgs. Aa M. Byers J. 1, Case C0. J. 1. Case Co. J. 1. Case Co. Certainteed Chi. Pneumatic Tool Consolidated Film Ind. Continental Baking Crown Williamette Paper Crown Williamette Paper Crucible Steel Cuban American Sugar Cudahy Packing Cudahy Packing Curtis Publishing Curtis Publishing Curtis Publishing Cushman's Sons Cushman's Sons Deere & Co. Durham Hosiery Endicott-Johnson Corp. The Fair Dept. Store Fairbanks Co. Fairbanks Co. FEderal Mining & Smelting Foster Wheeler Corp. Franklin-Simon Fuller Co. Fuller Co. Gar Wood Industries Gar Wood Industries General Amer. Industries General Cable INDUSTRIALS Description Ye of Stock First Arrearage $7 1920 6% cv. 1938 6% cv. 1956 7% 1931 7% 1926 7% 1905 7% 1932 6% cv. 1931 7% 1933 7% 1932 7% 1927 $6 1930 $6 1920 $5 pr. cv. 1937 $6 pr. cv. 1931 7% 1938 $6 pr. cv. 1938 7% 1932 6% lst. 1932 7% 2d. 1932 $5 Pr- A 1933 1 1932 4 3/4% 1962 7% 1932 7% 1933 $4A 1926 7% 1932 7% 1928 7% 1932 $8A part. 1931 7% l933 7% 1933 7% 1933 7% 1960 61% 2d, 1960 7% 1929 $3-50 1931 $2 1932 8% 1932 $7 lst. 1931 $6 2d. 1931 7% 1932 7 1929 45% 1953 45% 1962 7% 1933 $3- 4 1%1 $.60 - $1.60 1961 7% 1936 $8 1936 7% 1930 6% 1932 4% 1961 7% l938 8% lst. 1921 8% 2a. 1921 7% 1931 $7 1933 7% 1931+ $6 lst. part. 1932 $6 2d. part. 1932 4% cv. 1950 4 cv. 1955 6% c . 1952 $8 1%1 7% 1931 $4A 1941 ar of Type 0 Settlement Recapitalization Cash Retired Recapitalization Recapitalization Cash Recapitalization Cash Retired Recapitalization Recapitalization Recapitalization Recapitalization Cash Recapitalization Retire Recapitalization Cash Cash Cash Recapitalization Recapitalization Recapitalization Cash Recapitalization Recapitalization Recapitalization Recapitalization Recapitalization ash Cash Cash Cash Recapitalization Mer er Recapitalization Recapitalization Recapitalization Recapitalization Cash Cash Cash Cash Recapitalization sh Recapitalization Retired Recapitalization Recapitalization Recapitalization Recapitalization Retired Recapitalization Recapitalization Recapitalization Recapitalization __1232__ __1239__ __1222__ __1229_ __1221_ __1222_ __l221_ __1223_ _ A222 1226 1227 1258 1253 1960 1961 1962 $ 5,096 $ 2,008 2,918 775 007 433 80 2 ) } 1 17,977 292 4,988 399 $ 15,046 27,913 85 649 8,794 1:735 643 1,644 3,600 2,005 234 1,457 731 1,314 3,160 937 805 7,875 147 177 20,563 Arrearages in thousands of dollars as of December 31 $ 19 $ 93 $ 167 $ 241 $ 315 $ 1,888 7 16,311 $ 4,500 $ 4,875 $ 6,750 $ 6,750 878 1,628 7,875 1,227 2,999 2,999 , 569 325 163 136 450 $ 900 $ 1,350 675 35 137 137 103 109 182 328 185 188 232 371 813 1,463 682 1,227 338 753 1,756 108 251 Name uf Company ‘utdoor Advertising tdocr Advertising eel Casting e Sugar Stee 3n Watch Izrp. of America ational Minerals rnational Paper International Silver Jone. Long Bell Lumber Corp. Louisiana Oil Refining Ludlum Steel Manati Sugar Maytag Co. McKesson and Robbins Mead Corp. Mengel Mengel Minneapolis—Moline Minneapolis-Moline Minneapolis-Moline Mullins Manufacturing National Dept. Stores National Supply Co. National Supply Co. National Supply Co. National Supply Co. New York Shipbuilding Norwalk Tire & Rubber Otis Steel Panhandle Producing Paramount Pictures Paramount Pictures Peabody Coal Co. Penn-Dixie Cement Penn-Texas o° Phillips-Jones Phoenix Hosiery Pierce Oil Pittsburgh Coal Pittsburgh Steel Pittsburgh Steel Pittsburgh Steel Pittsburgh Steel Pittsburgh Steel Pittsburgh Terminal Coal Pittsburgh United Corp. Porto-Rico American Tobacco Pressed Steel Pure Oil Co. Pure Oil Co. Radio Corp. of America Description Year of Type of of Stock First Settlement Arrearage 6% 1931 Cash $uA 1933 Retired $6 1931 Cash 7% 1932 Recapitalization 7% 1931 Cash $7 1933 Recapitalization 7% 1935 Cash $3 1931 Cash 1929 Recapitalization 7% 1931 Merger 6 1931 Cash 65% 1932 Cash 7% pr. 1926 Merger 7% 1931 Recapitalization 7% 1932 Cash 7% 1932 Recapitalization 1931 Liquidation $1.50 A 1936 Cash 1931 Cash 8% 1927 Recapitalization 7% 1932 Recapitalization 6% cv. 1931 Recapitalization $3 lst. 1955 Recapitalization RA 1927 Merger 6%% cv. 1933 Merger $6.50 cv. 1931 1926 Recapitalization $3 1932 Cash $3 cv. 1938 Recapitalization $6 1932 Cash 7% 1931 Recapitalization 5% cv. 1939 Cash $6.50 1931 Merger $5.50 lst. 1957 Cash $1.50 2d. cv. 1957 Cash $7 1938 Cash l9h0 Retired 7% 1931 Recapitalization 6% pr. 1938 Recapitalization 55% cv. 1938 Recapitalization $2 1938 Recapitalization 7% 1935 Retired 7% 1935 Cash 7% pr. 1931 Merger 8% cv. 1923 Recapitalization 6% lst. 1935 Cash 6% 2d. 1935 Cash 5% pr. cv. 1953 Cash 1929 Recapitalization $1.60 cv. 1957 sh 7% 1933 Recapitalization 7% 1931 Recapitalization 8% cv. 1921 Liquidation 6% 1926 Recapitalization 7% 1931 Retired 5 1937 Recapitalization 5§% 1937 Recapitalization 5% 1961 ‘- 55% 1961 -- 6% 1927 Liquidation % cv. 1931 Liquidation $3.50A 1931 Recapitalization 7% 1931 Recapitalization 5% 1st. cv. 1938 Retired 5% 2d. cv. 1938 Retired 6% 1933 Cash 8% cv. 1933 Retired $53 1931 Cash 125? lQuO 128‘ 1250 1251 1252 125} 125% 1255 1256 1257 1256 1259 $ 383 2,027 $ 1,200 2,700 5,700 u,183 8,829 6,776 1H3 128 239 968 1,660 595 7&5 196 5,600 8,600 29,695 10,u17 95 13,50h 26,u21 1,913 1,001 1,016 1,918 323 1,22u 1,385 2,718 6,308 19,597 3l,h75 803 86h 2,328 6&2 u,oes 650 980 195 2:967 3,87% “03 82 ”,9h5 631 2,023 1,258 70 11 3,62u 1,885 1,683 750 193 5,303 9,h23 A1 282 #11 822 16,800 26,079 u3,050 3,300 2,389 1,215 962 1,685 2,597 1,732 ,h6u u,ou6 102 luh h,982 1,801 16,297 $ 6,150 $ 2,000 $ 113 9,662 13,091 3,393 699 56,339 699 u,ogu 83 $ u7,266 u7,771 $u8,989 $50,361 $51,833 52,605 3,068 Arrearages in thousands of dollars as of December 31: 900 352 1,055 827 $ #56 887 $ 779 $ 50 38 16u 753 $ l,“03 nun 1960 lgél 1062 $ 226 $ u51 1,083 2,165 , 2*. New. ,_ t; Name of Company Radio Keith Orpheum Real Silk Hosiery Republic Steel Republic Steel Revere Copper Revere Copper Revere Copper Robbins Mills Robert Reis Robert Reis Schulte Retail Stores Servel Inc. Shell Union Oil Skelly Oil Alexander Smith Inc. Alexander Smith Inc. A. J. Spalding Spang Chalfant Thompson-Starrett United Dye & Chemical U. S. Distributing U. S. Hoffman Machinery U. S. Leather U. 3. Steel United Stores United Wallpaper Universal Pictures Universal Pictures Universal Pipe & Radiator Vadsco Sales Van Norman Industries Va.-Carolina Chemical Va. Iron Coal & Coke Ward Baking Warner Bros. Pictures Webster - Eisenlohr Weston El. and Imp. Wheeling Steel White Sewing Machine Willys Overland Motors Wilson & Co. Worthington Pump Worthington Pump Yellow Truck Yellow Truck Youngstown Sheet Totals Description Year of Type of of Stock First Settlement éEEEEEEfiE 6% cv. 19ho Cash 7% 1931 Cash 6% pr. cv. 1935 Cash cv. 1930 Cash 7 1931 Retired 5» 1937 Retired $hA 1980 Recapitalization 4.5% cv. l95h Mere 7% lst. 1921 Recapitalization $1.25 pr. cv. l9h9 1932 Recapitalization $8.50 1958 Cash 55% cv. 1931 Cash 6% 1931 Cash h.2o$ 1953 Cash 5% 1953 Cash 7% lst. 1932 Merger 1932 Mer er 7% 1932 Recapitalization 1932 Recapitalization $5.50 195h Cash 1927 Recapitalization $3.50 cv. 1931 Her er l9h0 Retired 7% cv. 1931 Merger 5% cv. 1960 -- 7% pr. 193 3 Cash 1932 Cash $6 1929 Cash h% cv. 1953 Recapitalization 8% lst. 1932 Retired 1958 7% 1931 Recapitalization 1930 Recapitalization $2 28 cv. 1957 6% part. 1929 Recapitalization 5% 1931 Recapitalization 193h Recapitalization $3.85 1932 Retired $1 lst. 1932 Recapitalization $3 cv. 1932 Recapitalization 7 1931 Cash $2A 1933 Retired 6% 1932 Recapitalization $k cv. 1930 Retir 6% cv. 1938 Recapitalization $6 1938 Cash 7%A 1932 Cash 1932 Cash h cv. 1938 Cash k§% pr. 1938 Cash 7% 1928 Cash 75¢ B 1926 Cash 55% A 1932 Cash 1u9 Arrearages in thousands of dollars as of December 31: __1232__ __$259__ __12&2__ __l229_ __1221_ __£222_ __1221_ __£22&_ __$222_ __$22§_ __l221_ __122§_ __1222_ __12§9_ ._12§l_ .12§2_ $ 769 $ 660 775 1,612 h,328 2,665 1,2h8 1,235 827 1,62h 2,388 $ 3,126 $ 28“ $ “26 $ 568 $ 710 852 $ 99“ $ 1,137 $ 1,279 $ 1,820 $ 1,563 $ 1.2“? $ “92 $' hhl 2,59“ 154 359 56“ 770 97 290 483 676 655 76 229 382 535 516 27 27 27 26 895 21069 3,187 4,305 1+529 1~5752 I5976 102 766 861 903 1,072 1,276 871 826 2,265 1,2uh 57a lhl 829 1,525 167100 682 uh3 uu3 9,816 15,872 19,068 15,659 15,659 15,659 15,659 15,659 15,659 15,659 15,659 15 659 16, 938 18,216 19, h9u 397 918 l 022 5,672 9,721 1:889 3.356 6h 1th #78 1,09% 360 229 11 9,151 M66 2,200 #72 56k 358 2,ueu 1,50% 356 2,192 #68 589 589 8,u00 1,563 ___£1§§§* _______ _______ _______ _______ _______ _______ _______ ______. _______ _______ _______ _______ ______ $216,256 $521,25h 2208,51u581!01§ £18120“ §78,% 8§81,250 §72,587 §74,366 §2ol5oh§201565 §12,083 $21,271 §2ol55u 2221222 §gz6 31 APPENDIX B LIST OF EARNINGS, ARREARAGES, AND WORKING CAPITAL OF COMPANIES WHOSE PREFERRED STOCKS HAD ORIGINAL ARREARAGES FROM 1950 TO 1962 151 Year Earnings Arrearages Total Working Ending Per Share Per Share Arrearages Capital Amalgamated Leather, 6% cv., $50 par 1956 s - o - $ .75 $ 18,500 $ 2,uoo,ooo 1957 - 0 - 3.75 93,400 2,300,000 1958 - 0 - 6.75 166,800 1,900,000 1959 6.25 9.75 2ho,800 2,200,000 1960 - 0 - 12.75 31h,900 2,100,000 1961 - 0 - 15.75 37l,h00 1,700,000 F‘ ‘_ (Retired in 1962) ‘ Atlas Corporation, 5%, $20 par 1961 $ - 0 - $ .25 $ 169,800 $ 59,000,000 1962 - o - 1.00 678,200 35,000,000 Beck Shoe Corporation, h 3/h%, $100 par 1962 $ - 0 - $ 1.19 $ 38,900 $ 9,300,000 J. I. Case Co. 52%2d. $7 par 7%. $109_par 1960 $ - 0 - $ .11 $ - o - $ 1.75 $ 299,000 $ 10,800,000 1961 - 0 - .57 - 0 - 8.75 1,u9h,800 (26,000,000) 1962 - o - 1.02 - 0 - 15.75 2,690,600 (21,u00,000) Central of Georgia Railwayggo., 5%B, $100 par 1961 $ - 0 - 1962 - o - $ 850,200 $ 6,200,000 1,700,h00 6,500,000 $ 5.00 10.00 Chicago and Eastern Illinois Railroad, $2A (Cumulative if earned) 1958 1959 1960 1961 1962 $ 00000 I I c I I 0395;: Packigg Co., 1953 195h 1955 1956 1962 3 5.h3 - 0 - 27.03 52.68 - o - $ $ hfiii $100 Par $ “.50 $ 9.00 13.50 6.75 150,800 150,800 150,800 150,200 150,200 h50,ooo 900,000 1,350,000 675,000 (Cash paid in 1957) 3-75 337:500 $ (70.000) (1,300,000) (600,000) (2,000,000) (1,900,000) $ 25,700,000 16,000,000 17,200,000 21,600,000 8,100,000 152 Year Earnings Arrearages Total Working Endigg Per Share Per Share Arrearages Capital Curtis Publishi Co. 3 - $h Pfd.* $.60-$1.60 Pfd* 1961 $ - 0 - $ 2.25 $ - o - 3 .30 $ 860,u00 $ 32,200,000 1962 - o - 5.25 - 0 - .90 2,007,u00 13,700,000 Endicott-JOhnson Corp., h%, $100 par 1961 $ - o - $ 1.00 $ 72,h00 $ h7,100,000 1 1962 8.58 2.00 luu,800 50,800,000 Erie-Lackawanns Railroad, 5%, $100 par (Cumulative to 15% maximum) 1959 $ - o - $ 1.25 $ 156,700 $ 8,300,000 1960 - 0 - 6.25 783,300 11,h00,000 1961 - 0 - 11.25 1,h10,000 2,900,000 1962 - 0 - 15.00 1,880,200 h,000,000 Gar wood Industries, “2% cv., $50 par 1950 3 - o - $ 1.13 $ 70,900 $ 8,100,000 1951 u8.02 2.25 1h1,700 11,100,000 (Cash paid in 1952) 1955 - o - .56 35,300 11,200,000 1956 16.5h 2.25 137,100 11,600,000 1957 8.h5 2.25 137,100 12,000,000 1958 8.28 1.69 103,000 12,200,000 (Cash paid in 1959) General American Industries, 6% cv., $50 par 1952 3 - 0 - $ 2.25 $ 109,200 $ 2,500,000 1953 12.55 3.75 182,000 3,100,000 1954 - 0 - 6.75 327,600 2,200,000 1955 - 0 - 9.75 185,300 1,100,000 1956 - o - 12.75 187,900 3,200,000 1957 138.6h 12.75 232,100 1,600,000 (Cash paid in 1958) General Baking Co., $8 1961 $ - o - $ 6.00 $ h93,h00 $ 16,000,000 1962 3.79 18.00 1,013,100 16,300,000 *Cumulative to the second amount only if earned. 153 Year Earnings Arrearages Total Working Ending Per Share Per Share Arrearages Capital ggtel Corporation of America, 5% cv., $25 par 1951 $ - 0 - 3 .94 $ 117,200 $ (85,000) 1952 - 0 - 2.19 313,900 36,000 1953 - 0 - 3.11 510,200 (300,000) 1951 - 0 - 1.69 736,500 800,000 1955 1.1 5.91 781,300 2,000,000 1956 19.16 7.19 655,800 150,000 1957 8.85 8.11 769,800 - 0 - ””“““ 1958 5.31 8.13 711,500 9,700,000 (Cash paid in 1959) Lehigh Valley Coal Corp., $3 lst. (Cumulative to the extent earned) 1955 $ 1.53 s 3.72 $ 826,700 $ 5.700.000 V 1956 1.61 3.98 886,900 6,900,000 ; 1957 2.79 3.19 778,500 6,7 .000 1 n. 1958 - 0 - 3.38 753,100 6,100,000 1959 2.91 6.29 1,103,000 7,300,000 (Recapitalized in 1960) Minneapolis-Moline Companl $5.50 lst. 31,50 2d cv. $ ' 0 - $ 2.75 $ - 0 - $ -75 $ (Cash paid in 1958) 1957 88,100 $ 38,000,000 New York, Rev Haven & Hartford Railroad, 5%A cv., $100 par (Cumu- lative 1r earned) 1956 $ ' 0 ’ 3 5000 $223509000 $ (9002000) 1957 - 0 - 5.00 2,350,000 500,000 1958 - 0 - 5.00 2,153,600 1,100,000 1959 - 0 - 5.00 2,153,600 (7,100,000) 1960 - 0 - 5.00 2,157,700 (21,500,000) 1961 - 0 - 5.00 2.157.700 (5,500,000) 1962 - 0 - 5.00 2,157,700 37,000,000 Peabod Coal C , 5% prior cv., $25 par 1953 3 - 0 - $ .31 $ 351,600 $ 5.500.000 1951 1.99 1.56 1,051,900 8,800,000 1955 5.62 .81 156,100 12,200,000 (Cash paid in 1956) 151 Year Earnings Arrearages Total Working Ending Par Share Per Share Arrearages Capital Penanexas Corporation*, $1.60 cv. 1957 3 - 0 - $ .10 $ 163,700 $ 23,000,000 1958 - 0 - 2.00 739,600 63,000,000 1959 8.65 1.20 113,600 75,000,000 (Cash paid in 1960) Pittsburgh Steel Company _ ' 55%. $100 par 5%L$100 par ’ 1961 $ - 0 - $ 5.50 $ - 0 - $ 5.00 $1,308,100 $ 39,000,000 1962 7.51 11.00 8.88 10.00 2,616,300 11,000,000 Robbins Mills, 1.5% cv., $50 par 1951 3 - 0 - 3 1.69 $ 282,000 $ 9,100,000 3‘ (Merged with Textron American in 1955) .. 13 Servel Inc., $1.50 1951* $ ' 0 " $ 3038 $ 153.9% $ 1128001000 1955 - 0 - 7.88 359,100 9,100,000 1956 - 0 - 12.38 561,300 9,100,000 1957 - 0 - 6.88 769,500 12,100,000 1958 - 0 - - - - 0 - 10,600,000 1959 81.10 - 0 - - 0 - 1,200,000 (Cash paid in 1958) Alexander Smithp19c. 35% 1.211 1953 $ - 0 - $ 1.75 $ 2.10 $ 173,100 3 19,100,000 1951 - 0 - 5.25 6.30 519,200 13,100,000 1955 - 0 - 8.75 10.50 865,300 12,900,000 1956 12.10 12.25 11.70 1,211,100 31,100,000 1957 39.21 12.25 11.70 1,171,200 31,800,000 (Cash paid in 1958) Spear & Co., $5.50 preferred 1951 s - o - $ 2.75 $ 26,800 $ 7,100,000 1955 - 0 - 2.75 26,800 6,900,000 1956 - 0 - 2.75 26,800 5,500,000 1957 - 0 - 2.75 26,000 3,000,000 (Cash paid in 1958) *Forlerly'rairbanks - Whitney Corporation. 155 Year Earnings Arrearages Total Working ‘Endigg Per Share Per Share Arrearages Capital United States Hoffman Machinery Corp., 5% cv., $50 par 1960 $ - o - 3 .63 $ 38,800 $ 135.000 1961 - 0 - 3.13 192,300 89,000 1962 - 0 - 5.63 316,100 (1,500,000) ‘United Wallpaper,gInc., 1% cv., $50 par .r1__ 1953 $ ' 0 ' $ 1.00 $ 35:600 $ 13:700:000 1951 - 0 - 3.00 106,800 10,200,000 1955 - 0 - 5.00 178,000 7,100,000 (Recapitalized in 1956) Universal Pictures Co., Inc., 1%%, $100 par 1958 $ - 0 - $ 3.19 $ 111,100 $ 31,500,000 1959 113.00 - 0 - - 0 - 32,600,000 1 ,9. (Cash paid in 1959) van Norman Industries, $2.28 cv. 1957 $ 2.77 $ .61 $ 166.900 $ 20,500,000 1958 - 0 - .39 99,600 18,600,000 1959 3.92 2.67 681,700 19,000,000 1960 5.15 2.85 112,600 19,000,000 1961 - 0 - 2.85 112,600 19,900,000 (Cash paid in 1962 after merging with'Universa1.American) APPENDIX C OPINION OF THE ILLINOIS SUPREME COURT ON ACCRUED DIVIDENDSa We hold that defendant acquired his shares of the pre- ferred stock of the plaintiff corporation subject to a lkmflfi contractual condition investing a two-thirds majority of the preferred shareholders with the right to adopt a char- ter amendment eliminating unpaid accrued dividends on the preferred stock. . . . We are further satisfied that the 5 “ right of a preferred shareholder to receive unpaid accumu- lated dividends, regardless of how characterized, is no different from the many other rights possessed by pre- ferred shareholders. Notwithstanding its frequent de- scription as a "vested right" or a "vested property right" or "right in the nature of a debt," in the final analysis it is nothing more than a simple contract right. The same contract creating the right to accrued cumulative dividends may, by other terms and conditions, render the right defeasible by appropriate action of the majority of the members of the corporation. Furthermore, although an amendment cancelling accrued dividends appears to have aBowman v. Armour & Co., 160 N.E. (2d) 756-57 (1959). 156 157 a retroactive effect, its actual operation is prospective only. The accrual of dividends by the mere lapse of time does not alter the nature or character of the dividend rights of preferred stock. Where a corporation fails to declare a dividend on its preferred stock, the only change effected is an enlargement of the size or quantity of the right to dividends. The character of the right remains unchanged and continues to be prospective. 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Special Ruling, January 29, 1951. 515 Commerce Clearing House. Court Cases Barclay v. Wabash Railway Co., 30 F. (2d) 262 (1929). Bassett v. U.S. Cast Iron Pipe and Foundry Co., 71 N.J. Eq. 668 (1908). Bowman v. Armour and Company, 160 N.E. (2d) 753 (1959). Buckley v. Cuban American Sugar Co., 19 A. (2d) 820 (1910). Collins v. Portland Electric Power Co., 7 F. (2d) 221 (1925). Consolidated Film Industries, Inc. v. Johnson, 197 A. 189 (1937). Continental Insurance Co. v. U.S., 259 U.S. 156 (1922). Day v. U.S. Cast Iron Pipe and Foundry Co., 96 N.J. HQ. 736 (1921). Diamond v. Darvis, 38 N.Y.S. (2d) 103 (1912). Fernald v. Frank Ridlon Co., 110 N.E. 121 (1923). 162 Fidelity Trust Co. v. Lehigh Valley R. R. Co., 61 A. 829 (1906). Guttman v. Illinois Central Railroad, 189 F. (2d) 927 (I951). Harbine v. Dayton Malleable Iron Co., 61 Ohio App. 1 (1939). Hastings v. International Paper Co., 175 N.Y.S. 815 (1919). Havender v. Federal United Corporation, 11 A. (2d) 331 T19u0) o F'- *7 Hazel Atlas Glass Co. v. Van Dyk & Reeves, 8 F. (2d) 716 (1925). In re American & Foreign Power Co., Inc., 102 F. Supp. 331 (1952). Kantor; Zucker et a1; and Silver v. American & Foreign f_ 5 Power Co., Inc., 197 F. (2d793C7 (19557} '_— Keller v. Wilson & Co., 190 A. 116 (1936). Lloyd v. Pennsylvania Electric Vehicle Co., 75 N.J. Eq. 263 (1909). McLean v. Pittsburgh Plate Glass Co., 28 A. 211 (1893). Moran v. U.S. Cast Iron Pipe and Foundry Co., 95 N.J. Eq. 389 (1921)} Morris v. American Public Utilities Co., 11 Del. Ch. 136 (19237. Morse v. Boston & Maine R. R. Co., 160 N.E. 891 (1928). New York, Lake Erie Railroad v. Nickals, 119 U.S. 296 (18857. Norwich Water Co. v. Southern Railway Co., 11 Virginia Law Register (N.J.) 203 (1925). Roberts v. Roberts-Wick Co., 77 N.E. 13 (1906). Trustees of Dartmouth College v. Woodward, 1 Wheaton (U.S.) 518 (1819). Wabash Railway Co. v. Barclay, 280 U.S. 197 (1930). Wessel v. Guantanamo Sugar Co., 35 A. (2d) 215 (1911). .r' 1 fun .3" z. " A ‘1 Lip U = .5 I” a u .9» E - U (‘4‘ E "'71111171711171!31771711117111ES