By Jinrong Liu｜Alex Liu｜Sophia Hh｜Xiang Wang｜Qin Zhu｜Jessica Ye｜Lin Shang
On July 1 2013, General Office of the State Council issued Guiding Opinions of the General Office of the State Council on promoting the adjustment and reform of economic structure by finical support (“Opinion”). This Opinion explicitly proposes to encourage merger and reorganization of enterprises by ways of, among others, issuing preference shares (also called preferred stock) and M&A financing in targeted sectors.
As one of financial innovation tools, preference shares' regime innovation has been put on the agenda by the Opinion. Thus, with an introduction to the legal regime of preference shares of the relevant countries, this Article would like to generate more discussions in this regard so as to promote the set up of such regime in China.
I. The Concept of Preference Shares
Preference shares is term in comparison with common shares. As a special class of shares, its "preference" usually lies in priority over ordinary shares in terms of the payment of dividend and distribution upon liquidation.
Preference shares can be divided into following categories depending on the rights and obligations attached thereto:
(1) Cumulative v. non-cumulative, depending on whether the unpaid dividends will accumulate for future payment.
(2) Convertible v. non-convertible, depending on whether the preference shares are convertible to ordinary shares.
(3) Participating v. non-participating, -depending on whether the holders of the preference shares have the opportunity to receive extra dividends if the company achieves predetermined financial goals.
II. Current PRC laws and regulations
The current PRC company law has reserved space for preference shares. According to article 132 of the company law, the State Council may separately formulate provisions on the issuance of shares of classes other than those provided for in this Law.
In addition, there are certain other laws or local regulations which occasionally mention preference shares. For example, in the Interim Administrative Measures for Venture Capital Enterprises which was issued by NDRC and became effective on January 1 2006, article 15 states that venture capital enterprises may, upon concluding an investment agreement with the investee enterprise, make investment in unlisted enterprises in the form of equity interests, preference stocks, convertible preference stocks, and other quasi equities. In addition, the Regulations on the Cooperative Stock Enterprises of Guangdong Province, which was revised on July 26 2012, divide shares into common shares and preference shares. In the Guangdong Regulations, article 19 further stipulates that the common shareholders have the right to elect, be elected and vote. The preference shareholders will get the dividends based on the contract and enjoy priority of payment in bankruptcy, but do not have the right of election or being elected and voting right. The preference shareholders can be transformed into common shareholders upon agreement with the company or require the company to redeem their shares.
Nonetheless, the universal legal basis of preference shares is still under construction for the lack of relevant detailed regulations and guidance rules.[Endnote 1] In addition, both the PRC Administration for Industry and Commerce and the China Securities Depository and Clearing Company, which are core departments for the implementation of this regime, are not familiar with the preference shares system or hold a negative attitude. For example, in our consultation with Beijing Administration for Industry and Commerce and Dongcheng District of Beijing Administration for Industry and Commerce, they told that the articles of associations for limited company shall not include preference shares stipulations, and that nor shall the articles of associations for stock limited company include preference shares regulations except for special approval. Also, China Securities Depository and Clearing Company holds negative attitude to the registration of preference shares of listed companies.
III. Legal Regime of Preference Shares and Case Study in the United Kingdom
A. Legal Regime of Preference Shares in the United Kingdom
The preference shares originated from the United Kingdom in or around 1825[Endnote 2] when some railroad and canal operators hungered for capital, the lack of which caused construction stoppage. The existing shareholders in these companies did not want to make further investment; issue of ordinary shares failed to attract new investors; these companies did not want to incur debt financing due to concern of repayment for the principal and interest; the authorities also imposed restrictions on the debt to equity ratio. In light of all circumstances mentioned above, railroad companies created preference shares as a means to raise capital for further construction.[Endnote 3]
In the United Kingdom, the main feature of the preference shares is that the holders are entitled to a fixed rate of dividend out of profits available for distribution, to be paid in priority to the ordinary shareholders. On the other hand, unlike ordinary shares, the holders of the preferences shares are usually not entitled to vote on the matters regarding business operations. The combination of such two features enables companies to raise capital from passive investors without concern of repaying principal and interest or interference with business operations. For example, in the recent global economic recession, the British government bailed out the banks by subscribing their preference shares.[Endnote 4] It is a win-win solution because the government can recoup the bail-out funds in a predictable period without participating in the daily business operations on the one hand and the banks do not worry about repaying the principal and interest or losing control over business operations on the other.
Statutory laws in the United Kingdom neither describe rights that can be attached to preference shares nor set restrictions on preference shares. Companies Act 2006 has a chapter titled “classes of shares and class rights”.[Endnote 5] The chapter provides the procedures for prescription and variation of rights attached to a class of shares, thus authorizing company to prescribe or vary preference according to their needs.
In the United Kingdom, additional rights attached to preference shares must be specified in an express provision in the terms of issue or the memorandum and articles of association because the courts would assume that the rights stated in the relevant documents are exhaustive. In Will v United Lankat Plantations Co., Ltd., the terms of issue provided that the preference shareholders were entitled to: a) preference dividend of 10 per cent per share; and b) a preference regarding payment of capital in liquidation.[Endnote 6] But the preference shareholders claimed the right to participate in any further profits made by the company. The court held that the preference shareholders could not participate further in profits if it was not expressly provided in the terms of issue. In Scottish Insurance Corporation Ltd v Wilsons and Clyde Coal Co Ltd., the company proposed to pay off the preference shares prior to liquidation but preference shareholders claimed a right to participate in surplus assets.[Endnote 7] The court held that preference shareholders could not participate in the distribution of surplus assets in the liquidation if such distribution was not contained in the bargain reached between the company and the shareholders.
In the United Kingdom, possible gaps regarding preference shares in the constitutional documents of the company will be supplemented or made up by the judge-made laws. These rules are usually expressed in terms of “presumptions”. Some examples are as follows:
i. Preference shares are assumed to be cumulative unless the memorandum and articles of association provides otherwise. In other words, arrears from previous years must be made good before any amount is paid to the ordinary shareholders. However, if the company enters into liquidation, preference shareholders are not entitled to have these arrears made up unless there is an express right to the arrears.[Endnote 9]
ii. Unless the memorandum and articles of association otherwise provided, preference shareholders are entitled to vote only when: (a)their dividends are in arrears; (b) there is a resolution to wind up the company; (c)there is a resolution which is likely to affect their class rights.
B. Case Study: Preference Shares offered by RBS
According to a prospectus dated July 2, 2007, the Royal Bank of Scotland Group plc (“RBS”) would issue 26,000 Non-cumulative Euro Preference Shares of €0.01 each, Series 3 (“Preference Shares”) on or about 4 October 2007 (“Issue Date”). The admission to listing on the London Stock Exchange would become effective on the Issue Date. The issue price is €50,000 per Series 3 Euro Preference Share.
The rights are attached to the “Preference Shares” as follows:
i. Right to Dividends:
From the Issue Date to the day immediately preceding September 29, 2017 (“First Redemption Date”), dividends will accrue at a rate of 7.0916 per cent. per annum, payable annually in arrear on September 30 in each year. From the First Redemption Date, dividends will accrue at a rate, reset quarterly, of 2.33 per cent. annum above three month Euro Interbank Offered Rate and will be payable quarterly in arrear on March31, June 30, September 30 and December 31 (“Quarterly Dividend Payment Date”).
The RBS's obligation to pay dividends is subject to (i) the sole and absolute discretion of the board of directors of the RBS or an authorized committee thereof and/or (ii) the requirements of applicable law, sufficiency of distributable profits and payment of dividends not causing a breach of the UK Financial Services Authority's (“FSA”) capital adequacy provisions.
The Preference Shares will rank junior as to dividends to the RBS's Cumulative Preference Shares and equally as to dividends with the RBS's other non-cumulative preference shares.
ii. Rights upon Liquidation:
If RBS is wound up or liquidated, holders of the Preference Shares will be entitled to receive €50,000 per Preference Share, payable by RBS out of surplus assets available for distribution to its shareholders.
The Preference Shares have liquidation rights which rank junior to the RBS's Cumulative Preference Shares but equally with the RBS's other non-cumulative preference shares as to entitlement to dividends due for payment after the date of commencement of liquidation and any other dividend payable in respect of the period from the preceding dividend payment date to the date of payment.
iii. Optional Redemption:
Provided that the FSA does not object and subject to certain other conditions, RBS may redeem the Preference Shares, at its option, (a) in whole but not in part on the First Redemption Date or on any Quarterly Dividend Payment Date thereafter, provided that RBS gives at least 30 days' but not more than 60 days' notice, and (b) in whole but not in part at any time during the period from and including December 31, 2012 to but excluding the First Redemption Date if the FSA has confirmed to RBS that the Preference Shares are no longer of the type eligible for inclusion in the Tier 1 Capital of RBS on a solo and/or consolidated basis.[Endnote 10] If RBS were to exercise either such option, it would redeem each Preference Share at a redemption price of €50,000 plus the dividends accrued and payable for the then-current dividend period.
iv. Voting Rights:
Holders of Preference Shares will only be entitled to vote at general meetings of the RBS's shareholders in certain limited circumstances, including (a) where the rights of holders of the Preference Shares may be varied or abrogated, (b) where a resolution has been proposed for a winding-up or liquidation of RBS and (c) where RBS has failed to pay in full the dividend on the Preference Shares for the most recent dividend period.
IV. Legal Regime of the Preferred Stock and Case Study in the United States
A. Legal Regime of the Preferred Stock in the United States
The corporation laws in the United States demonstrate the characteristics of authorized legislation, which have no specific regulations on the substantial and procedural issues, while leaving the shareholders and corporation with the right to agree upon the special rights and obligations of the preferred stock according to their own needs.[Endnote 11] Although different states in the United States adopt their separate corporation codes, these codes resemble in many respects. This section will focus on the Model Business Corporation Act and Delaware General Corporate law.
The Model Business Corporation Act (“MBCA”) is a model set of law prepared by the Committee on Corporate Laws of the Section of Business Law of the American Bar Association and is followed by twenty-four states.[Endnote 12] Under the MBCA, section 6.01 stipulates that a corporation may issue one or more classes of shares, including the preferred stock. According to section 6.01(c) which is not exhaustive, the articles of incorporation may authorize one or more classes of shares that: (1) have special, conditional, or limited voting rights, or no right to vote; (2) are redeemable or convertible as specified in the articles of incorporation; (3) entitle the holders to distributions calculated in any manner, including dividends that may be cumulative, noncumulative, or partially cumulative; or (4) have preference over any other class or series of shares with respect to distributions, including distributions upon the dissolution of the corporation. Section 6.02 allows the board of directors to determine the terms, including the preferences, rights and limitations, to the same extent permitted under section 6.01 if the articles of incorporation so provide. Moreover, section 10.04 provides that the holder of the outstanding shares of a class are entitled to vote as a separate voting group on a proposed amendment to the articles of incorporation in certain situations, for instance, such amendment would change the rights, preferences, or limitations of all or part of the shares of the class.
Delaware is the most important corporate jurisdiction in the United States, which serves as domicile to a majority of public companies. In 2002, Delaware was the domicile of fifty-nine percent of Fortune 500 firms and fifty eight percent of all publicly traded companies.[Endnote 13] Both the Delaware General Corporation Law (“DGCL”) and MBCA illustrate the features of authorized legislation. Section 151 of the DGCL specifies that every corporation may issue classes of stock which have voting powers, full or limited, or no voting powers, and such preferences, participating, optional or other special rights or limitations, as shall be stated and expressed in the certificate of incorporation or of any amendment thereto, or in the resolution or resolutions providing for the issue of such stock adopted by the board of directors pursuant to authority expressly vested in it by the provisions of its certificate of incorporation. Meanwhile, Section 151 sets out the special rights of any class or series of stock, including the right of redemption, dividends distribution, the preference in dissolution and the right of conversion, which shall be stated in the certificate of incorporation or in the resolution providing for the issue of such stock adopted by the board of directors. In addition, Section 242 provides that the holders of the preferred stock as the holders of a class shall be entitled to vote as a class upon a proposed amendment of certificate of incorporation in specified events, whether or not entitled to vote thereon by the certificate of incorporation. The specified events mainly refer to the situations where the amendment would alter the preferences or special rights of the shares of such class so as to affect them adversely.
Despite of the difference among the state corporation laws, most of the states adopt the authorized, instead of mandatory, mode with regard to the preferred stock. In fact, rights of preferred shareholders are primarily contractual in nature.[Endnote 14] The construction of preferred stock provisions are matters of contract interpretation for the courts.[Endnote 15]
B. Case Study of the Preferred Stock in the United States
Case 1: Wells Fargo & Company
Wells Fargo & Company issued 23,000,000 Depositary Shares (each depositary share entitles the holder to a proportional fractional interest in all rights, powers and preferences of Series P Preferred Stock represented by the depositary share) on March 15th 2013, each Representing a 1/1,000th Interest in a Share of Non-Cumulative Perpetual Class A Preferred Stock, Series P, no par value, with a liquidation preference amount of $25,000 per share (equivalent to $25 per depositary share) (“Series P Preferred Stock”).
In the Preliminary Prospectus Supplement, it carried out detailed provisions for dividends, voting, liquidation and redemption of Series P Preferred Stock.
(1) Right to Dividends
In the dividend aspect, the board of directors declare distribution quarterly at a rate per annum. Dividends not declared with respect to any dividend period shall not be cumulative. Until the full dividends for the then-current dividend period on all outstanding shares of the Series P Preferred Stock have been declared and paid or declared, (1) no dividend or distribution shall be declared and paid on any common stock or junior stock, and no shares of common stock or junior stock shall be repurchased or redeemed; (2) no dividend or distribution shall be declared and paid on any parity stock, nor no shares of parity stock will be repurchased or redeemed otherwise than pursuant to pro rata offers to purchase all, or a pro rata portion, of the Series P Preferred Stock.
(2) Voting Right
In the voting right aspect, in common, the holders of the Series P Preferred Stock do not have voting rights. However, whenever dividends payable on the Series P Preferred Stock have not been declared and paid at least six quarterly dividend periods or their equivalent (a “Nonpayment”), the holders of outstanding shares of the Series P Preferred Stock, voting together as a class with holders of Voting Parity Stock whose voting rights are exercisable, will be entitled to vote for the election of two additional directors of our board of directors. This two additional directors have vote right in some events including declaring dividends or issuing any class of preferred stock ranking senior to the Series P Preferred Stock. When full dividends for the equivalent of at least four quarterly dividend periods have been paid, the voting rights of the Series P Preferred Stock described above will terminate.
(3) Rights upon Liquidation
In the event of liquidation, the assets distribution of the holders of the Series P Preferred Stock is prior to holders of common stock or any of other shares of stock ranking junior to the Series P Preferred Stock. The total amount of liquidation is the liquidation preference amount of Series P Preferred Stock plus an amount equal to any declared and unpaid dividends.
(4) Optional Redemption
The Series P Preferred Stock is not subject to any mandatory redemption. However, company may redeem shares of the Series P Preferred Stock on any dividend payment date on or after June 15, 2018 in whole or in part.
Series P Non-Cumulative Perpetual Class A Preferred Stock does not have a maturity date nor any preemptive or conversion rights.
Case 2: Citigroup Inc
Citigroup Inc issued 58,000,000 Depositary Shares on March 2nd 2006, each representing a 1/1,000th Interest in a Share of Non-Cumulative Convertible Preferred Stock, Series T (“Convertible Preferred Stock”), $1.00 par value, with a liquidation preference of $50,000 per share (equivalent to $25 per depositary share). The provisions of dividends, liquidation right and voting right are similar to which in Case 1.
(1) Provisions on Convertible Right
Each share of the Convertible Preferred Stock may be converted, at any time, at the option of the holder, into 1,482.3503 shares of Citigroup common stock plus cash in lieu of fractional shares, subject to anti-dilution adjustments. On or after February 15, 2013, Citigroup may, at its option, at any time or from time to time cause some or all of the Convertible Preferred Stock to be converted into shares of Citigroup common stock at the then-applicable conversion rate. Citigroup may exercise this conversion right if, for 20 trading days within any period of 30 consecutive trading days ending on the trading day preceding the date Citigroup gives notice of conversion at its option, the closing price of Citigroup common stock exceeds 130% of the then-applicable conversion price of the Convertible Preferred Stock.
Upon a make-whole acquisition, Citigroup will, under certain circumstances, increase the conversion rate in respect of any conversions of the Convertible Preferred Stock that occur during the period (“make-whole acquisition conversion period”) beginning on the effective date of the make-whole acquisition and ending on the date that is 30 days after the effective date, by a number of additional shares of common stock (“make-whole shares”). Citigroup will notify holders, at least 20 days prior to the anticipated effective date of such make-whole acquisition, of the anticipated effective date of such transaction and whether the make-whole acquisition is anticipated to be a fundamental change. If a holder does not elect to exercise the make-whole acquisition conversion right, such holder will not be eligible to receive make-whole shares and such holder’s shares of the Convertible Preferred Stock will remain outstanding.
In the reorganization event, each share of the Convertible Preferred Stock outstanding immediately prior to such reorganization event will, without the consent of the holders of the Convertible Preferred Stock, become convertible into the kind and amount of securities, cash and other property receivable in such reorganization event.
Citigroup may redeem the Convertible Preferred Stock, in whole or in part, on any dividend payment date on or after February 15, 2015.If the Convertible Preferred Stock has been called for redemption, a holder will be entitled to convert the Convertible Preferred Stock from the date of notice of the redemption until the close of business on the second Business Day immediately preceding the date of redemption. Otherwise, Citigroup will covenant, for the benefit of certain holders of long-term indebtedness that is senior to the Convertible Preferred Stock, that it will not redeem or purchase, and it will cause its subsidiaries not to redeem or purchase, the Convertible Preferred Stock prior to February 15, 2020, unless some specific events.
The preference shares regime is well established in the United Kingdom and the United States, and again act as an effective financial instrument to attract investment in the governmental rescue in this round of economic crisis. However, it remains yet to be established in China. From our point of view, especially in the current environment where the enterprises facing great difficulty in raising capital, to substantially promote the establishment and development of preference shares regime in China, can provide effective capital support for the economic development, and help to enhance the diversity of security products in the capital market in China.
Mr. Jinrong Liu is the managing partner of Global Law Office and a member of Beijing Municipal Committee of Chinese People’s Political Consultative Conference. Mr. Liu specialized in capital markets, M&A, PE/VC and taxation. Mr. Liu has advised on more than 50 equity and debt offerings on both domestic and overseas capital markets (Hong Kong Stock Exchange, NASDAQ, New York Stock Exchange, Singapore Exchange, London Exchange and Toronto Stock Exchange). Industries in which he has been involved include manufacturing, Internet, hi-tech, energy, resources, telecom, financial services, shipping, real estate, retail, media, infrastructure, utilities and pharmaceutical, etc.
Mr. Jinrong Liu is the managing partner of Global Law Office and a member of Beijing Municipal Committee of Chinese People’s Political Consultative Conference. Mr. Liu specializes in capital markets, M&A, PE/VC and taxation. (E-mail: firstname.lastname@example.org)
Mr. Alex Liu is a Beijing-based partner with Global Law Office who specializes in takeover and restructuring of listed companies, cross-border M&A, onshore and offshore IPOs, debts financing, PE/VC investment, FDI and overseas investment, antitrust and transaction tax. (E-mail: email@example.com)
Endnote 1: In the Opinion on Regulating Stock Limited Companies promulgated by State Commission for Economic Restructuring on May 15 1992, article 23 provides that the stock limited companies may issue common shares and preference shares. The dividends of preference shares shall be paid as agreed, and the holders of preference shares have priority over the holders of common shares in distribution upon liquidation. The Opinion on Regulating Limited Liability Companies promulgated on the same day by State Commission for Economic Restructuring has no stipulation on the preference share regime. However, the PRC Company Law issued in 1993 has no regulation on preference shares regime, which is superior over the Opinion on Regulating Stock Limited Companies and Opinion on Regulating Limited Liability Companies. Article 135 of the PRC Company Law of 1993 states that State Council may separately formulate provisions on the issuance of shares of classes other than those provided for in this Law. Therefore, the legal basis of preference share regime has been disappeared along with the implementation of the PRC Company Law of 1993.
Endnote 2: Please refer to Shan Cong, the Practical Significance of Developing Preference Share Regime in China with Reference to the Foreign Experiences, 2011, 26-27.
Endnote 3: Ibid.
Endnote 4: Bank bailout massively boosts government exposure http://cn.reuters.com/article/companyNews/idUKTRE49D5CU20081014?symbol=HBOS.L
Endnote 5: Chapter 9, Part 17, Companies Act 2006.
Endnote 6:  AC 11.
Endnote 7:  AC 462.
Endnote 8: Webb v Earle,  LR 20 Eq 556.
Endnote 9: Re Crichton’s Oil  2 Ch 86; Re Wood Skinner & Co.  Ch 323.
Endnote 10: "Tier 1 Capital'' has the meaning given to it by the FSA from time to time.
Endnote 11: Please refer to Mengyao Wang, Introduction to the Preference Share Regime to Protect the Right of Shareholder, 2006, 30.
Endnote 12: L Bebchuk, The Case for Increasing Shareholder Power (2004-5) 118 Harvard Law Review 833, 844.
Endnote 13: Lucian Arye Bebchuk & Alma Cohen, Firms’ Decisions Where To Incorporate, 46 J.L. & ECON. 383, 391 tbl.2 (2003).
Endnote 14: Harbinger Capital Partners Master Fund I, Ltd. v. Granite Broadcasting Corp., 906 A.2d 218, 224 (Del.Ch.2006).
Endnote 15: Elliott Assocs., L.P. v. Avatex Corp., 715 A.2d at 852.